A Citigroup equity strategist named Robert Buckland was cited in the FT yesterday making a bearish case for equities. Included was this little snippet about inflation and equities;Equities have never been particularly good at hedging inflation anyway, and now index-linked bonds can do a much better job .
I'm not sure that's right. Over the last ten years this is correct but 20 years ago the S&P 500 was at 296, so it is up 185% (again that is after cutting in half over the last year) plus dividends and the US postage stamp which is a good proxy for longer term inflation is up 110% for the same period and that is much closer than normal.
Be that as it may it raises an interesting theoretical question. If financial plans rely on growth and equity indexes can't grow then investment capital must be allocated to substitutes for equity indexes. From a bigger picture wen you buy equities you are buying that which you expect (or hope) will grow. TIPS are a relatively new product that cover the inflation protection part of the dilemma but not the growth part.
For purposes of what is being explored in this post I should note that even if equity indexes continue to flounder there will be individual stocks that do well but those will be harder to find. If the big names in various sectors won't do it then it stands to create a huge problem for many people and the need to be very innovative.
Can one avenue of solution come from buying growth on the ground in various countries? Increasing commerce that might come from a turn up in the economy would seem to create revenue growth for shipping ports, airports and state of the art toll roads like the one pictured above in Bolivia (I don't know if that is a toll road or not I just get a kick out of those photos).
I looked at a few countries just to get a sense of whether, during the previous bull market, these types of "commerce" stocks generally moved up with the market. In past cycles there has been a correlation between broad stock market indexes turning up and the economy turning up (obvious). In a way the broad indexes have been proxies for economic expansion (also obvious) but the question is whether the broad indexes which are made up mostly of banks, oils stocks, the phone company and so on will struggle to go up at a reasonable rate and if they do struggle can ports and roads be proxies?
So it worked in Australia with Transurban (TCL.AX), New Zealand had mixed results with Auckland Airport (AIA.NZ) and Port of Tauranga (POT.NZ), it worked in France with Societe Des Autoroutes Paris (ARR.PA) but Aeroports de Paris (ADP.PA) doesn't chart far back enough and the last one I looked at was China which had a mixed result in terms of correlation between a couple of toll road stocks and Beijing Capital which is an airport stock.
In terms of practical investment application, well first there needs to be something to it and we don't know yet because almost nothing is going up these days. If I dip a toe into these waters it would be with one stock at first and then maybe a second for a max of 5%.
As this post was just a theoretical exploration there is no answer, maybe just more questions or a push to get you to think about this on your own or explore different things that catch your interest. I think there is something here with these stocks there is still more to learn.
9 comments:
Roger,
While I've long appreciated your sensible "this too shall pass" equanimity, I'm curious to hear if you have a "Plan C" (on the assumption that we're already deep into Plan B, and given the political struggles to "do something" as the Mich Gov so earnestly desires, likely to birth something unintentionally abominable in that direction).
As more economies drift in Iceland's (and Ireland's) direction and people around the world "hunker down", (or increase their "social unrest"), and if China begins to seriously crack down, where is the "pull" going to come from for all this string we're going to be printing?
The hard cynic might hear the guns of war on the not so distant horizon (as the true "stimulus" that pulled us out of Depression 1.0).
Do you ever entertain such thoughts/plans?
R in NY
I don't frame it that way, plan b and all. at least not yet.
my plan called for some defense ages ago (shocking how long it was and the market is still not right). from the initial commitment to get defensive my plan called for subjective assessment of the landscape. i concluded more defense along the way and then in the last three months i have bought a couple of stocks but still have a very large cash balance.
one thing i really tried to avoid, and i wrote about this often, is having to radically change things in a very reactive fashion.
so far so lucky, I have tweaked things but not plan b'd the portfolio.
from here if i sold two stocks and bought 3% into the double short i would be greatly decreasing the portfolio's correlation to the market which already low. don't feel that need yet but my point is just a little action could change things a lot.
hope that makes sense.
protectionism update
http://online.wsj.com/article/SB123388103125654861.html
faaantaaastic
(read sarcasm)
maybe something along the lines of what you posted about taleb's idea and tom drake's post is the way going forward for portfolio management..90% safe/10% risky...the 10% could be very actively managed i.e. traded vs just dumped into lottery tickets...maybe this will be the way going forward?
have a good weekend
bill_m
good post - this seems to offer an insight into your process that we don't always see - thanks
Roger- I received this from Morningstar and thought you may be interested....
Barclays Opens a Brand New Asset Class
Individuals can finally invest in volatility, but what is it? by Bradley Kay, ETF Analyst | 02-06-09
We cannot tell if the timing is superb or terrible, but individual investors can finally invest (almost) directly in volatility now that Barclays has released
two iPath ETNs based on the widely tracked VIX index: iPath S&P 500 VIX Short-Term Futures ETN VXX and iPath S&P 500 VIX Mid-Term Futures ETN VXZ. While the recent crash reminded us all why volatility is the ultimate diversifier, it has also made investors wary of ETNs and the credit risk they carry. Investors need only read our previous article on ETNs http://news.morningstar.com/articlenet/article.aspx?id=272009 to see that we would suggest caution before running out to buy any of these debt instruments. However, these intriguing new exchange-traded products allow access to an exotic asset class that used to be the preserve of institutions that could trade complex options strategies or enormous futures contracts. Strategic stakes in volatility could help sophisticated investors protect their portfolio from the
next big crash, which is why we called out for these funds a scant five months ago
http://news.morningstar.com/articlenet/article.aspx?id=253170. Now that they
have finally arrived, we wish to take the opportunity to elucidate how these new indexes work, why we were so excited about the prospect of a volatility
investment in the first place, and why you shouldn't rush to invest just yet.
How Do You Index What You Can't See?
Virtually all the indexes that we use on a daily basis rely on the most transparent attribute of any stock: its price. Every weekday, millions of investors, traders, and speculators make their best guesses as to the worth of tens of thousands of listed companies. These guesses, in the forms of bid and
ask prices, average into a market price that provides a collective estimate of the company's worth. But as an average, the price ignores another helpful piece of information, which is the certainty of those guesses. That is what volatility roughly estimates. If the value of a particular company is extremely certain, it will have very low volatility because anyone looking to sell could find plenty
of buyers at a slightly below-average price while anyone willing to buy would find a deep pool of sellers at a slightly above-average price. If no one can value the company very precisely, market participants are far less willing to make large bets on the stock, so major sellers need to lower their acceptable price even farther and major buyers need to raise their acceptable bids to find investors for the other side of their trades. This drives higher volatility as market prices oscillate wildly with the sentiment of marginal traders.
Volatility certainly provides some useful information then, but how do we isolate it? We can look at the variation in the market price over trailing time
periods, known as the "realized volatility," but that is a backward-looking measure. We would rather use an estimate about the future volatility, similar to how a stock price captures an estimate of future profitability and cash flows. Fortunately, the market provides these estimates through the large and vibrant trade in index options.
Future gyrations in stock prices drive the value of options, with higher instability making them more valuable. Think about a call option on the S&P 500
at a value of 800. If the only possible future values in a month are 850 or 750, and they are equally likely, that option is worth $25 as there is a one half chance it will be worth $50 and one half chance it will expire worthless. If volatility rises, so the possible future values are now 900, 850, 750, or 700, and they are all still equally likely, the call option is now worth $37.50 because it has a one quarter chance of being worth $100, one quarter chance of being worth $50, and one half chance of expiring worthless. The math that goes into valuing actual options is far more complex due to the nearly infinite possible future prices, but it requires an estimate of how large future price
movements will be. It is possible to reverse this process, taking the resulting option prices and extracting the volatility estimates that produced them. Every month, the Chicago Board Option Exchange crunches the numbers on the market prices of their S&P 500 Index options to produce the market's own estimate of the S&P 500's volatility over the next month. This estimate of instability in the near term is published as the VIX index, and is the most widely followed measure of market sentiment.
So Why Would a Long-Term Investor Care?
Predictions of short-term volatility may not seem very helpful to anyone with a multiyear time horizon for their portfolio. After all, the variation of prices in one month will not matter much when you plan to hold your investments for five years or more. But due to the way market prices and volatility interact, it also has some great uses for sophisticated investors looking to manage their
asset allocations. Volatility measures such as the VIX provide an excellent proxy for the amount of uncertainty in the market, and if there's anything the stock market does not like, it's uncertainty. Think about if you were asked to bid on a pure gold coin that you could weight and assay and knew had $100 worth of gold in it. I bet you would gladly bid $99.50 for that coin. Now, imagine
instead you were bidding on a coin that was about twice as heavy and looked like 14 karat gold, but it could be only 10 karat or it could be 20. The expected value would be about the same as the assayed coin, but I know that I would bid much lower. Greater uncertainty as to the coin's true value substantially lowers its price, even if we can reasonably expect it to have the same value on average. The same effect occurs in the stock
market, which is why volatility spikes and price crashes go hand-in-hand.
This relationship between volatility and prices makes the VIX one of the best diversifiers for an equity portfolio in existence. Some assets like commodities and government bonds show near-zero correlation, but volatility has a strong
negative correlation with stock prices. Unfortunately, like any other incredible
insurance, you need to pay up. The VIX over time has shown strong mean-reversion, which means that it always returns to an average value that
hovers around 25. During periods of low risk and small market movements, it sits down at lows below 20. During crashes and extreme dislocations, it will skyrocket to values of 40 or higher. But most of the time it just hovers in between. Ultimately, it will not produce any long-term gains because the market does not grow structurally more risky with time. Thus you pay for the insurance of a volatility position by tying up part of your portfolio in a
non-appreciating asset class and accepting the drag on your overall returns.
Why Do These ETNs Only "Almost" Invest in Volatility? That one-word caveat in the first sentence of this article requires a whole lot
of explanation. These ETNs do not actually attempt to track the VIX index itself. Tracking the index would require massive, expensive turnover on a
portfolio of options, and would likely still incur large tracking error due to the difficulty of buying the less liquid contracts. However, the Chicago Board Options Exchange also carries futures on where the VIX index will trade near the
end of each forthcoming month. Institutions frequently use these futures to
hedge their volatility exposure, producing visible, accurate prices for the ETNs
to track throughout the trading day.
The major drawback to the VIX futures is their negative roll yield. Because
firms tend to buy these futures as insurance on their equity portfolio, they are
willing to overpay slightly for the future protection. Just like anyone else
buying insurance, the trader buying the VIX future will pay a higher price than
current volatility so the seller can expect a profit on average. As the
expiration date on the futures approaches, their insurance value deteriorates,
and so does their premium to current volatility. This means that, whereas
volatility will typically produce an expected return of zero during stable
markets, a basket of rolling volatility futures such as those tracked by these
new iPath ETNs will actually produce a negative return. The yield on the cash
that serves as collateral for the futures helps dampen the losses, but not
fully.
Because futures price for expected future volatility, they also tend to not move
as sharply as current volatility. When current volatility is low, futures prices
remain higher due to their insurance premium. When current volatility is high,
futures prices stay lower to account for expected mean-reversion and slightly
calmer markets in a few months' time. The short-term contracts tracked by VXX
follow spikes in current volatility more closely than the mid-term contracts and
have as strong of a negative correlation with the S&P 500 as current volatility,
but investors should not expect their futures positions to appreciate 150% when
the VIX spikes from 30 to 80 as it did in September and October of last year.
The mid-term contracts tracked by VXZ provide even less exposure to the sharp
movements of current volatility, but in return they have a less negative roll
yield. So this ETN will lose less in normal times than its short-term contracts
cousin while providing less insurance
during major downturns.
Nothing Comes for Free
Ultimately, these drawbacks to the VIX futures just illustrate that there is no
free lunch in investing. If you want returns, you need to pay for them with
risk. If you want insurance, you need to pay for it by giving up returns. The
trick is finding the right balance. We believe these new ETNs could provide an
interesting new tool for asset allocators who want a small slug of insurance
against any sudden market crashes. However, due to their complex structure and
the current worries about ETNs, we would suggest that only the most
sophisticated investors try to find a place in their portfolio for these funds.
Even those who understand the risk and return of these instruments should put up
only small stakes to avoid a heavy drag on potential returns given today's
promising bond and equity prices. Buying volatility at 40 has rarely paid off in
the past, and unless we face another October/November 2008, it will not do well
in the future either.
thanks for leaving the M-star article. One thing, I called iPath and was told there would be no distribution from the t-bill holdings.
Further I am confused why, as a debt instrument it will own futures. On that I was told it can own futures and does own futures to start. I asked well why isn't it an ETF than and was told it can't be. Oh.
I am just relaying what I was told, which contradicts the article a little, I do not knwo if I was given correct info as I have not read the prospectus.
Excellent paper on the stimulus plan and implications by John Cochrane of the University of Chicago. Here's an excerpt:
"Sooner or later banks will figure out that borrowing deposits at 4% and holding reserves that pay 0.75% is not a good long-term business model. If the resources are not there to unwind our current operations, to quickly retire at least two trillion dollars of newly created debt, a large inflation will result as people dump government debt. If history is any guide, this outcome will unleash economic dislocations on a scale to make our current troubles look like a pleasant memory."
Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?
http://tinyurl.com/b8by7e
Post a Comment