Portfolio Navigation Works Again

My portfolio is now 8% above where it was on February 21st when I published “The Last Straw” article, instead of waiting to break even.

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Nothing is as Bad as it Looks: 351,372 15,263

As of 7:00 am yesterday I was 83% in equities. The reasons:

  1. My DTR changed to 10%
  2.  I ran the numbers On Bloomberg Corona Update and found this:

        351,372  were confirmed Cases and 15,263 were deaths worldwide.                                     The font size was larger than I can replicate here.

  1. Where deaths have occurred Deaths Cases World
    Italy 5,476 59,138 9.26% 4.3%
    Mainland China 3,270 81,093 4.03%
    Spain 2,182 33,089 6.59%
    Iran 1,812 23,049 7.86%
    France 674 16,689 4.04%
    U.S. 460 38,951 1.18%
    U.K. 281 5,683 4.94%
    Netherlands 213 4,749 4.49%
    South Korea 111 8,961 1.24%
    Germany 94 24,782 0.38%
    Belgium 88 3,743 2.35%
    Switzerland 66 8,060 0.82%
    Indonesia 48 514 9.34%
    Japan 41 1,089 3.76%
    Turkey 30 1,236 2.43%

     

    Numbers don’t lie…but Marketers present them falsely.  The Heading font size announcing the number of confirmed cases and deaths was Huge (check it out yourself on the  Bloomberg  COVID-19 update)  What are these BIG numbers in BIG print supposed to accomplish?  Scares the ___ out of you!

    Below the Big print are the results for each country in terms of deaths, in the 1st column. That puts Italy at the top of the list. Italy deaths then becomes the opening remark on every newscast.

    What they don’t tell you is what I add in the 3rd column, the percentage of people who contract the Virus who die.  If they ranked by this statistic, Indonesia would be at the top, but then, everybody would say, what the hell, It’s only 48 people!

    What if they included with the BIG print introduction, the percentage of Worldwide deaths, which is 4%?  Well, that would detract from the story THAT WILL SELL…TO WHOM?  The Advertisers who take up half the airtime on their radio and TV programs.

    Don’t get me wrong. I am all for freedom of the press and I think all Americans should avoid crowded places and close contact with other people.  I just want news to be presented truthfully for the sole purpose of informing.  OMG! I’m starting to sound like Trump.

     

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Has Trump Ever Had A Stock Portfolio?

Trump: “I don’t want to have stock buybacks,” he said Friday at a White House news conference. “I don’t like buybacks. I didn’t like them the first time.”

Why? Because Biden said that is what he would do?  I agree, when you required corporations to return the money they were hoarding overseas, you should have required them to invest it in new plant and equipment. You put no strings on it. The buybacks are part of what made the market go to all-time highs this year.  But now is not then!  Now, we need anyone and everyone to buy, buy, BUY to prevent another 2008.  What do you want them to do with all that money, buy up other companies?  You and Biden said they are already too big and you want to break them up.

Mr. President, stop telling corporations what to do and when to do it. Fire all those jerks who are giving you this bad advice and save your ass and the country by cancelling all those stupid trade wars.  Wait a minute, on second thought, keep going the way you are.  The market will recover when you lose the re-election. Then you can go back to your real estate deals in all those countries you have befriended.

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Famous Sayings

If you can keep your wits about you when all around are losing theirs, you’re crazy…but right.

 

If everyone in your government is in agreement, they are probably wrong. If all governments are in agreement, they are definitely wrong.

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So, What to Do?

The very first video located on the right hand side of this page is about the importance of calculating one’s DTR (Desired Target Return).  As my personal DTR has increased from 4% to 8%, due to the excessive and irrational gains pointed out in the “Then and Now” posting 1/9/2020 and  Figure 3 from the subsequent March 9th posting. As a result, my current equity allocation is 66%.

The Theory supporting this action is called: Portfolio Navigation” and is described in the second video.  How I arrived at this was explained under “Archives”, as the posting for March, 2013.  An empirical investigation for DB plans was posted March 2015.  Finally, Kal Salama, Chief Investment Officer of The Headlands Group, and I showed how this methodology could be applied to individual accounts, like IRA’s in the June 2017 post. To my knowledge, nobody has written a paper explaining why Portfolio Navigation is not better than the old buy and hold strategy and is not better than the rebalancing strategy that always maintains a constant mix.

So, I will play Devil’s advocate.  Portfolio Navigation ignores human emotions and forces humans to sell equities as returns exceed their DTR and buy equities as returns fall below their DTR.  Investors want to do the opposite.  Advisors must therefore, force clients to do what they do not want to do at highs and lows in the market. That will no doubt result in losing clients as clients look for the advisor who made the most money at the top and the one who lost the least at the bottom. Clients are their own worst enemy.

I am my only client and I do not want to ever have to be required to tell clients what they do not want to hear just to keep their business.  I would not want that responsibility even if they gave me carte blanch authority to make decisions in their behalf.  I will be 88 this month and will not accept that awesome responsibility. I limit my thoughts to the few who watch this blog, to do with it as they think best.

 

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A Perspective

Who was stupid enough to buy this morning?  C’est moi .  Yes, I had a buy order in for SPY at 286 and it executed at 275.  I am now at 60% in SCHO and 23% in 4 tech stocks and my portfolio is now down .78% for the year.  There are things worse than losing money. You could contract Covid-19.  Evin worse, you could die.  Even worse, someone you love could die.   As published in my last posting, I recently started buying after being 100% in cash equivalents on December 3rd.

How’s that working for you Frank?  I am currently 60% in SCHO, 15% in SPY and 23% in 4 US tech stocks.  More importantly, my wife is doing well with her chemotherapy.  Life is good and the outlook is even better. So, enjoy it and remember to  Laugh:

The robber says: “Your money or your life”!  Jack Benny says nothing. The robber shouts: “I said your money or your life”!  Jack Benny says: “I’m thinking, I’m thinking”.

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When to be Afraid

The time to be afraid was a week ago. I am starting to buy.

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The Last Straw

Bloomberg news had an interesting article in their February 17th magazine titled, “Selling Private Equity (PE) at The Superstore.” Yes, that sector of the market reserved for the very rich may soon be available as an ETF or mutual fund or both by VanGuard.  Isn’t that wonderful!  The retail investor will be able to put a few thousand dollars in PE that used to require $millions or $Billions.  That begs the question, who’s selling?  Wasn’t it just last year that I read about the hoards of cash PE companies were holding because they couldn’t find any worth while investments?  Some were even returning cash to shareholders.

My 60 years in the investment business tells me, anytime the institutional investors are selling something previously not available to retail investors, I should not be buying and neither should you.  You might say, If it is good enough for Warren Buffett to buy GEICO and Sees Candy and bring them private, why shouldn’t I get in on it?  Because you’re not Buffett and that was then and now is now. Also, last year Buffett warned:

“We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest,” Buffett said Saturday at Berkshire Hathaway Inc.’s annual meeting. “If I were running a pension fund, I would be very careful about what was being offered to me.”

This is another indicator of a top in the market and a signal to stop buying equities and take profits.  To support this view, I provide the following update on some software my Colleague, Hal Forsey and I developed to provide a picture of the uncertainty you are facing in the stock market:

This may be a strange shape in Figure 1 for some of you. It is not bell shaped.  A bell shape implies you could lose an infinite amount of money and you cannot.  The Fed will make some banks bail you out like they did with AIG and Portfolio Insurance.  The bell shape calls for measuring risk as deviations about the mean and assumes volatility above the average return is just as risky as deviations below the mean.

We believe the mean is the wrong location point and deviations about the mean is the wrong measure of risk.[1]

                                                        Figure 1 

The shape in Figure 1 is a lognormal, given our inputs at the bottom of the graph. This version of the lognormal was developed by two professors at Cambridge University, Aitchison and Brown, and it allows the distribution to be flipped so that it is negatively skewed, as it would be at a top in the market.  I believe this is one of the greatest advancements in describing uncertainty yet devised. So, let’s flip it.

                                                     Figure 2

Only the sign of the extreme value has changed from negative to positive, causing the skewness toward negative returns. Now we measure reward and risk in terms of dispersion above and below the DTR, not the mean.  The DTR chosen is 8%, the most frequently used actuarial return by defined benefit plans.  Returns above this DTR will fund their plan within their cost constraints while returns below will cause them to be underfunded.  Risk and reward are thus directly related to the DTR, which cannot be said for standard deviation.  A DTR can be calculated for anyone investing to achieve a specified payout at a specified time.

We use Dr. Peter Fishburn’s proposed measure of downside risk (below target deviations) and measure reward (Upside potential) relative to the DTR in a ratio we developed with Professor van der Meer and his colleagues at Groningen University.  Here is how to interpret the ratio of upside potential to downside risk shown in Figure 2 above: 5.5% divided by 9.7% = .56, meaning, there is 44% more downside risk than upside potential.  Compare this to the Upside potential ratio in Figure 1 of .92, indicating only 8% more downside risk than upside potential and you see the difference between believing the outlook is positively skewed and believing it is negatively skewed.

Now, suppose you think the market will be more volatile than normal.  We accomplish this in Figure 3 by simply increasing volatility to 25%.

                                                       Figure 3

Note: The extreme kurtosis (pointiness) results in a 75.3% chance the return will be greater than the DTR, producing the potential to exceed the DTR by 8% for a total return of 16%.  Sounds even better than Figure 2?

That is a misleading statistic unless it is adjusted for risk as shown in the Upside potential ratio which has now dropped to .35.  Meaning, if volatility increases to recent levels, we are now facing 65% more downside risk than upside potential.

Conclusions:

Figure 1 represents my opinion of a best-case scenario.  If you truly believe these are normal times, don’t panic and sell positions you may never be able to restore at these levels. The almost equal trade-off between downside risk and upside potential indicates you are risk neutral, not, risk averse if you accept this trade-off. in that case a buy-hold strategy is appropriate.

Figure 2 is my most likely scenario.  The already dangerous levels of debt are bound to get higher in response to the corona virus impact on world trade and it is an election year and Bernie Sanders is leading the Democratic race.  Even Fareed Zakaria says, the worst outcome may be if he is elected President and is allowed by a Democratic Congress to implement his platform.  One thing both parties agree on is: the tech industry needs to be regulated and downsized. Therefore, the returns are probably skewed to the downside and the proper strategy would be to take some profits in tech stocks and put them in short term treasuries.

Figure 3 is my worst-case scenario.  Just like 2007 when people thought they could flip houses forever and the bull got killed after goring several financial matadors.  We all knew it would eventually happen but most (not me) believed it was far off.

 

You can download the “Forsey-Sortino” software free and change the inputs as you wish at:

https://drive.google.com/open?id=1j-lL2Y33dqHFBLdXfvNuKHZXtPvV7RxM

Instructions are provided in the readme file included in the download.

[1] For papers and books supporting this view see past postings on the right-hand side of this page.

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Then and Now

Remember when President Trump said: “I could stand in the middle of Fifth Avenue and shoot somebody and wouldn’t lose any voters, okay?” Well, he just shot a foreign general with a rocket in a foreign country and then lied to congress about why he did it and guess what? The stock market is up over 100 points and Bloomberg posted this:

WOW!  Things are better than the best of times? What was going on in October of 2000?

Oh yes, the S&P index crashed for 3 years and didn’t fully recover until 2007.  And then we had the great real estate bubble! But that was then and now things are different.

This looks even worse to me! This time it is tech stocks and real estate. How did we get here?  We are $20 trillion in debt and our budget deficit is growing at a trillion dollars a year.  The result is, you can still buy the same house and the same stocks now as in 2000, it just takes 100 times more worth-less dollars. When I left the investment business and went back to UC Berkeley and then U of Oregon to get a PhD in finance, I was told that budget deficits were bad and trade wars were bad.  Now there is a new theory, MMT, that says they are good.

Hmmm, I remember back in October of 2000 I published a report in Pensions and Investments magazine that said, in effect,  get out! As of last month, I am taking that advice again.  I am out of the stock market, out of debt and into short term treasuries.

My best wishes to the twenty somethings who believe in MMT. I respect you, but not your theory. I didn’t write this for you. I wrote this out of concern for old people like me who are retired and won’t be able to replace the assets they are living off now.  Investing for us should not be exciting. Peace of mind is worth its weight in profits.

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The Final Solution

The only thing standing in the way of President Trump using the Federal Reserve to bankroll his real estate empire or a Democratic congress using the Fed to provide massive infrastructure and universal health care without raising taxes is…Nothing and Nobody!

How this is going to happen is explained in a paper by Charles Plosser at the Hoover institute at their 2018 Monetary Policy Conference. The entire book covering the conference, “The Structural Foundations of Monetary Policy . Hoover Institution Press. Kindle Edition” can be purchased at Amazon for $2. I have copied and pasted excerpts from Plosser’s presentation below.  The bold highlights are the parts that support my outrageous opening remarks.

………………………………………………………………………………………………………………………….

The Risks of a Fed Balance Sheet Unconstrained by Monetary Policy                                                                                    Charles I. Plosser

My focus today is on the Fed’s balance sheet and how institutions, and the incentives they create, matter for how it is managed. Since 2006, the balance sheet of our central bank has grown about fivefold, primarily because of the Fed’s unconventional policies during the financial crisis and subsequent recession.

Regardless of the rationale, the actions amounted to debt-financed fiscal policy and a form of credit allocation. Thus, such changes in the mix of assets held by the Fed are frequently referred to as credit policy. Prior to the crisis, the Fed operated with a relatively small balance sheet. Its size was determined by the demand for currency and the demand for required reserves. That is, it expanded or shrank reserves in the banking system

to achieve its funds rate target. This operating procedure required the Fed to increase or decrease its balance sheet accordingly. The size of the balance sheet was integral to setting the instrument of monetary policy—the fed funds rate.

Several economists (including former Fed My focus today is on the Fed’s balance sheet and how institutions, and the incentives they create, matter for how it is managed. Since 2006, the balance sheet of our central bank has grown about fivefold, primarily because of the Fed’s unconventional policies during the financial crisis and subsequent recession. Once the Fed had reduced the targeted fed funds rate to near zero in December 2008, it embarked on a program of large-scale asset purchases. Initially, those purchases were motivated by a desire to provide liquidity and maintain financial market stability. Those goals were largely achieved by mid-2009, yet quantitative easing (QE) continued and expanded. It was justified not on the grounds of financial market dysfunction but as a means to provide more monetary accommodation to speed up the recovery.

Currently, the Fed’s balance sheet is roughly $4.5 trillion, compared to about $850 billion prior to the financial crisis. The composition of the balance sheet is also quite different today than it was prior to the crisis. In 2006, the asset side of the balance sheet was predominately US Treasury securities. Today, approximately 40 percent of the balance sheet is composed of mortgage-backed securities (MBS), while Treasuries account for most of the rest. In addition, at various points during the crisis the Fed held hundreds of billions of dollars of other private-sector securities or loans, although most of these private-sector securities have rolled off the balance sheet, leaving primarily Treasuries and MBS. The liability side of the balance sheet also reflects the impact of QE. In 2006, currency accounted for more than 90 percent, or $785 billion, of the $850 billion, and bank reserves just about 2 percent, or $18 billion, almost all of which were required reserves. Today, currency represents about $1.5 trillion, or just 33 percent of the balance sheet, while reserves have risen to about $2.6 trillion, or about 60 percent of the balance sheet, of which only $180 billion are required.2 So there is about $2.4 trillion in excess reserves today compared to zero in 2006.

chair Ben Bernanke, now at the Brookings Institution, and John Cochrane at the Hoover Institution) have argued that since the Fed now has the ability to pay interest on bank reserves, it is possible, desirable, and perhaps more efficient to maintain a large balance sheet and use the interest rate paid on reserves (IOR) as the instrument of monetary policy rather than the fed funds rate. The basic idea is that by setting the interest rate it pays on bank reserves, the Fed establishes a floor for short-term risk-free rates.

Who will determine the amount of excess reserves created and how will they do it, since the monetary policy instrument will be the IOR? Unfortunately, there is little discussion or analysis of how to determine the appropriate amount of excess reserves that should be created. Is it $10 billion, $100 billion, or $1,000 billion? First and foremost, an operating regime where the Fed’s balance sheet is unconstrained as to its size or holdings is ripe for misuse, if not abuse. A Fed balance sheet unconstrained by monetary policy becomes a new policy tool, a free parameter if you will. Congress would be free to lobby the Fed through political pressure or legislation to manage the portfolio for political ends. Imagine Congress proposing a new infrastructure bill where the Fed was expected, or even required, to buy designated development bonds to support and fund the initiative so taxes could be deferred. This would be very tempting for Congress. More generally, the temptation would be to turn the Fed’s balance sheet into a huge hedge fund, investing in projects demanded by Congress and funded by forcing banks to hold vast quantities of excess reserves on which the central bank pays the risk-free rate.

Recall that in 2015 Congress raided the Fed’s balance sheet to help fund a transportation bill. In 2010, the resources for the Consumer Financial Protection Bureau were found in Fed revenues. These were all efforts to exploit the central bank for fiscal policy purposes. Imagine the political debates over appointments to the Board of Governors. Hearings might focus on the nominees’ views on the investment policy for the balance sheet rather than monetary policy. Political pressure to purchase various forms of securities to support favored projects or initiatives could be enormous and fraught with controversy.

I have other concerns surrounding the implementation of monetary policy under a big-balance-sheet regime. The evidence accrued to date suggests that the IOR does not provide a firm floor for the funds rate or other short-term rates. One way the Fed has sought to address these problems is by increasing its interventions into the short-term money markets. This program is the reverse repo program, or RRP. This program allows non-depository institutions to borrow Treasury securities from the Fed overnight (which soaks up reserves) with an agreement that the Fed will repurchase the securities the next day.

Thus, we have some evidence that the floor system currently in place does not provide a firm floor and must be supported by the RRP program, which effectively drains reserves from the banking system on an ongoing basis.

The Fed has become a larger and more deeply embedded participant in the short-term financial markets than ever before. This is a worrisome development, as RRPs give large financial firms a safe and reliable place to flee in times of volatility—and making it easy to do so may increase systemic risk rather than reduce it. The instrument of monetary policy in a floor system is the interest paid on reserves. Unlike the funds rate, the IOR is an administered rate rather than a market rate. Under current law, the IOR is set by the Board of Governors, not the FOMC. In other words, it is the Board of Governors rather than the FOMC that technically determines monetary policy. Under a pure floor system, the FOMC would become irrelevant. Gutting the FOMC’s role in monetary policy would undermine independence and result in monetary policy becoming far more political.

A large Fed balance sheet that is untethered to the conduct of monetary policy creates the opportunity and incentive for political actors to exploit the Fed and use its balance sheet to conduct off-budget fiscal policy and credit allocation. Such actions would undermine Fed independence and politicize the Fed to a far greater degree than it currently is. Without changes in the Federal Reserve Act, it would shift the conduct of monetary policy to a more politicized Board of Governors and away from the FOMC. Finally, it seems to require that the Fed play a much larger, directive role in the functioning of short-term money markets, potentially reducing the traditional role of market forces. For these reasons, I think the economy would be better served if the Fed returned to an operating regime based on a smaller footprint, where the balance sheet is more directly linked to the conduct of monetary policy. (It ain’t going to happen but Trump will stack the board with incompetents who will do his bidding and Democrats will create bigger entitlement programs and neither will want to pay for it by increasing taxes. But don’t worry, the stock market will probably go up…until it doesn’t)

Source of quotes

The Structural Foundations of Monetary Policy (pp. 15-16). Hoover Institution Press. Kindle Edition.

 

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