Diversify Your Holdings (or not - That's Cool Too)

 Should you put all of your money in one stock or should you spread your bets across many investments? If it is the latter, how many investments should you have in your portfolio? The debate is a good one at one end is the advice that you get from the efficient markets camp: maximum diversification across asset classes, and within each asset class, across as many assets you can hold: the proverbial “market portfolio” held in proportion to its market value. At the other is the “all in” investor, who believes that if you find a significantly undervalued company, you should put all or most of your money in that company, rather than dilute your upside potential by spreading your bets.


Which Gospel? Mark or John
These arguments got media attention recently, because two high-profile investors took opposite positions. The first salvo was fired by Mark Cuban, who made his substantial fortune (estimated at $2.5 billion), as an entrepreneur. Cuban's profile has increased since, largely from his ownership of the Dallas Mavericks, last year's winners of the NBA championship. With typical understatement, Cuban claimed that diversification is for idiots and that investors, unless they have access to information or deals, should hold cash, since hedge funds have such a tremendous advantage over them. In response, John Bogle, the founder of Vanguard, countered that "the math (for diversification) has been proved over and over again. It's not just the first thing an investor should think about, but the second, the third and probably the fourth and the fifth thing investors should think about."

So, should you diversify? And if so, how much should you diversify? The answers to these questions depend upon two factors: First, how certain your assessment of value and second, how certain you are about the market price adjusting to that value within your specified time horizon.

At one limit, if you are absolutely certain about your assessment of value for an asset and that the market price will adjust to that value within your time horizon, you should put all of your money in that investment. Though this may seem like the impossible dream, there are two possible scenarios where it may play out:

1. Finite life securities (Options, Futures and Bonds): If you find an option trading for less than its exercise value: you should invest all of your money in buying as many options as you can and exercise those options to make a sure profit. In general, this is what falls under the umbrella of pure arbitrage and it is feasible only with finite lived assets (such as options, futures and fixed income securities), where the maturity date provides a endpoint by which time the price adjustment has to occur.
2. A perfect tip: On a more cynical note, you can make guaranteed profits if you are the recipient of inside information about an upcoming news releases, but only if there is no doubt about the price impact of the release (at least in terms of direction) and the timing of the news release. The problem, of course, is that you would be guilty of insider trading and may end up in jail.

At the other limit, if you have no idea what assets are cheap and which ones are expensive (which is the efficient market hypothesis), you should be as diversified as you can get.

Most active investors tend to fall between these two extremes. If you invest in equities, at least, it is inevitable that you have to diversify, for two reasons. The first is that you can never value an equity investment with certainty; the expected cash flows are estimates and risk adjustment is not always precise. The second is that even if your valuation is precise, there is no explicit date by which market prices have to adjust; there is no equivalent to a maturity date or an option expiration date for equities. A stock that is under or over priced can stay under or over pced for a long time.

How Diversified?
Building on the theme that diversification should be attuned to the precision of your valuations and the speed of market adjustment, the degree to which you should diversify will depend upon how your investment strategy is structured, with an emphasis on the following dimensions:

A. Uncertainty about investment value: If your investment strategy requires you to buy mature companies that trade at low price earnings ratios, you may need to hold fewer stocks , than if it requires you to buy young, growth companies (where you are more uncertain about value). In fact, as a general rule, your response to more uncertainty should be more diversification.


B. Time horizon: To the extent that the price adjustment has to happen over your time horizon, having a longer time horizon should allow you to have a less diversified portfolio. As your liquidity needs rise, thus shortening your time horizon, you will have to become more diversified in your holdings.


In summary, then, there is nothing crazy about holding just a few stocks in your portfolio, if they are mature companies and you have built in a healthy margin of safety, and/or you have the power to move markets. By the same token, it makes complete sense for other investors to spread their bets widely, if they are investing in young, growth companies, and are unclear about how and when the market price will adjust to value.


Bottom Line
Most investors are better off diversifying as much as they can, investing in mutual funds and exchange traded funds, rather than individual stocks. Many investors who choose not to diversify do so for the wrong reasons (ignorance, over confidence, inertia) and end up paying dearly for that mistake. Some investors with superior value assessment skills, disciplined investment practices and long time horizons can generate superior profits from holding smaller, relatively undiversified portfolios. Even if you believe that you are in that elite group, be careful to not fall prey to hubris, where you become over confident in your stock picking and market assessments and cut back on diversification too much.

CBlakely CFP®, CTFA 02/2012

Source: New York University Stern/Damodaran

Recession Par Deux?

Are we slipping back into recession? The answer may be yes and while it may last awhile, there is no evidence to support that this recession will be as catastrophic as the last one that began in 2007. Unemployment remains stubbornly high. Actually, it feels as if the new normal in HR jargon is increased productivity not new jobs. The 5-year Treasury rate is less than 1 percent, which is a recessionary signal. Real gross domestic product - the output of goods and services produced by labor and property located in the United States - increased at an annual rate of 1.3 percent in the second quarter of 2011, according to the "advance" estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 0.4 percent. The "second" estimate for the second quarter, based on more complete data, will be released on August 26, 2011. July economic numbers looked ok, but consumer confidence and retail sales are trending lower. Stock markets have been routed in August.



While both gold and Treasury securities have more room to run, buyers should hold off at current prices as both are overdue for a pullback. The ten-year Treasury yields about 2 percent currently. If you believe in mean reversion (I do) then the overnight funds to ten-year treasury rate spread currently at 2 percent, should fall to the long-term mean of 125 basis points. Since overnight rates are effectively zero that means there is room for the ten-year to rally.


There's no reason to be completely out of equities, but prudence suggests underweighting the amount of equities relative to what you would own in a cyclical bull market, which this assuredly is not (this mirrors recent suggestions regarding stock weightings in the portfolios we're managing).


For the DIY type, the equities you do own ought to be defensive in nature, not cyclical, they should have good earnings visibility and growing dividends and a decent dividend yield. These screens are readily available to retail investors.


The government, which has little in the coffers to provide a multiplier impact, could consider energy policy, which may be one of the last policy bullets available. A natural gas infrastructure build-out for example would put thousands upon thousands of Americans to work and could eventually lead to much lower energy prices for consumers (think of it like a tax cut) leading to a higher amount of disposable income.


Let’s hope we get a narrative from Washington or the private sector that trends this economy upward and to the right (that’s demand curve not political view).


CBlakely CFP®, CTFA 08-2011


Source: Bureau of Economic Analysis

Stories Sell

Happy Ending?

The stories our leaders tell us matter, nearly as much as the stories our parents tell us as children, because they orient us to what is and to what could be. Our brains evolved to expect stories with a particular structure, with good guys and bad guys, a hill to be climbed or a battle to be won.  

 In that context, Americans needed their president to tell them a story that made sense of what they had just been through, what caused it, and how it was going to end. We are all scared and angry. Many have have lost their jobs, some their homes. This was a disaster made by Wall Street’s best educated, who speculated with our assets and therefore our futures. It was caused by politicians like Phil Gramm who told us that if we just deregulated we would be more competitive. Unabashed greed and recklessness were the unintended consequences.

We are suffering from the same ending we experienced 80 years ago, when the same people sold our grandparents the same bill of goods. Can we draw on their wisdom?

Like most Americans, at this point, I have no idea what the President believes on virtually any issue. The president tells us he prefers a “balanced” approach to deficit reduction, one that marries “revenue enhancements” (a weak way of describing popular taxes on the rich and big corporations that are evading them) with “entitlement cuts” (an equally poor choice of words that implies that people who’ve worked their whole lives are looking for handouts).

When 400 people control more of the wealth than 150 million of their fellow Americans, when the average middle-class family has seen its income stagnate over the last 30 years while the richest 1 percent has seen its income rise astronomically, it bodes ill for the U.S. economy. Now that Standard & Poor’s has downgraded the U.S.’s AAA credit rating, it is important to respond boldly and, at the same time, lower expectations.

The first step is for our political leaders to frankly acknowledge the problems at hand: The U.S. economy will face a hard slog for an extended period; the political system is polarized; and, under current policies, the budget deficit will remain large.

Expect Slow Growth
We can expect sluggish economic activity for years, not quarters, and we face the risk of another recession. Those who in January were predicting growth of 4 percent or more for 2011 did not sufficiently appreciate the evidence from economists that foretell what most often comes after a systemic financial collapse is a decade of weak growth. (Read “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises.”) Two years ago Bill Gross of PIMCO called it the “new normal.” I sense he was right.

Government Opportunity

We should take this opportunity to reconsider what government should properly do. We need to invest more in roads, bridges, railroads and the like, and the best way to do this would be to create a new infrastructure bank in the same mold as the Tennessee Valley Authority.

The Executive branch needs to lead us again with a simple but strong narrative repeated over and over to keep our attention focused on the slog ahead and importantly the light at the end of the tunnel.

Our Opportunity

Rahm Emanuel, the former White House chief of staff, once famously remarked that one should never let a serious crisis go to waste. It may be time to make nuanced shifts in your portfolio.

This correction is likely near a bottom and therefore, valuations in the U.S. are now attractive on a long-term basis. Price to earnings ratios on forward (future) earnings for most major U.S. stock market averages are under ten. On an earnings yield basis, stocks look remarkably attractive relative to bonds.

On a relative basis, stocks are about as cheap as they have ever been compared with bonds.

 Hard Assets - It’s too late to buy gold and other precious metal safe havens for this cycle. In the long-run no one knows. But, a price drop would happen quickly, if at all.


 Bonds - Keep your powder dry. Shorten bond durations and look to corporate notes for a little yield, or Canadian or German government bonds if you must own sovereign debt. There is very little value left in the U.S. Treasury curve at this point.


 Equities - Financials have completely broken down, but have dropped to extremely attractive long-term values. Consumer staples and utilities act defensively during market downturns, but leadership usually shifts to other sectors at the bottom of the market. Consumer discretionary, industrials, materials and tech should lead as the economy finds stable footing.

CBlakely CFP, CTFA  08/2011

Sources: This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, Reinhart, Rogoff: The New York Times Sunday Op-ed page July 2011, Bloomberg LP. PIMCO

The 14 Percent Solution

Bond Mavens United

Stock analyst Meredith Whitney grabbed headlines recently with her perilous prognostications for the U.S. Municipal bond market. Hundreds of billions in municipal defaults will plague the country over the near term is essentially what she has been saying to the media.

While I disagree with her headline grabbing prediction (as do most reasonable analysts), many purveyors of municipal debt have said the effect of this will be to move municipal rates up thereby creating a buying opportunity for tax-free income investors. It is true municipal rates have jumped over the last few months, but is this a buying opportunity? I don’t think so.

Currently, the major risk with municipal debt (corporate and government included) is not credit risk but interest rate risk. Yields have recently increased but are still deep in the pygmy range. That is what will eventually hurt you (your net worth specifically).

James Grant, a leading authority on interest rates and bond markets, along with Bill Gross from PIMCO and others have essentially been saying the same thing. Stargazers beware; a bear market in bonds is in the offing - a secular move from decreasing interest rates to an environment of sustained interest rate increases.

Central bankers have lowered the cost of money for 30 years now, following global disinflationary forces downward, but also allowing for increased leverage due to lower real interest rates. Today however, yields have less to do with disinflation and more to do with providing fuel for an asset-based economy. 10-year real interest rates fell from over 5 percent in the early 1980s to just less than 1 percent recently.

But the tide is at the turn. U.S. Government debt has experienced recent price declines (yield increases) as the European Central Bank said monetary policy has to be monitored, and if needed, corrected. China’s central bank raised reserve requirements for lenders for the second time this year to counter inflation and curb property-price gains. German producer prices are increasing at the fastest pace in more than two years.

Inflation will be a dominant theme as we look ahead, global inflationary forces will generally push rates higher around the world. A Morgan Stanley gauge of stocks such as Archer Daniels Midland Co. and Deere & Co. meant to rally when inflation expectations match Federal Reserve targets added 46 percent since August 2010, almost double the Standard & Poor’s 500 Index.  While emerging-market equities beat developed countries every year in the past decade, except in 2008, you should not count on that now as Brazil, Russia, India and China battle higher food and commodity inflation.So what is one to do? Confront the risk and reward tradeoff, look hard at alternative strategies. Shorten the average maturity (duration) of your fixed income investments. Look at alternatives, such as a high quality mortgage REIT like Annaly Mortgage (NLY). This company greatly weathered the great recession, ROE looks good and using measured leverage has kept the stock in a fairly tight range, all while paying a 15 percent dividend. Buy blue chip stocks that pay higher dividends. There are options to explore that can mitigate the deleterious effects of higher interest rates and inflation.

C Blakely CFP®, CTFA 02/2011

Sources: Grant’s Interest Rate Observer, PIMCO, Bloomberg LP

Tim Geithner Should Resign......Unless

Financial reform seems to be going nowhere fast. Legislation has been proposed, but it is complicated and diffuse. Most of the proposed fixes are incremental changes that don’t seem likely to prevent future meltdowns or bubbles.

The House and Senate are squabbling over which federal agency should take the lead in supervising banks. The Secretary of the Treasury, as well as Congress, have fallen into the trap of trying to fix everything. Instead, they should agree on the most important remedies.

The banking crisis exposed several serious problems:

• Mortgage regulation was too lax and in some cases nonexistent.
• Capital requirements for banks were too low.
• Trading in derivatives such as credit default swaps posed giant, unseen risks.
• Credit ratings on structured securities such as collateralized-debt obligations were deeply flawed.
• Bankers were moved to take on risk by excessive pay packages.
• The government’s response to the crash also created a big hazard. Markets now expect that big banks won’t be allowed to fail, weakening the incentives of investors to discipline big banks and keep them from piling up too many risky assets again. It’s time to end too big to fail by making it less palatable for banks to remain big.

The first of these problems, mortgages, has already been addressed by the Federal Reserve and other regulators. It is much harder today to get a "ninja" loan or a mortgage with no money down. Banking regulators should ensure that the reforms stick by adding a policy principle: mortgages should be approved only on the basis of a borrower’s ability to service the loan, not on the expectation that the loan will be refinanced.

There has also been a hint of progress on the second problem - capital requirements. The Group of 20 nations have agreed to raise standards for banks when the world economy recovers. The U.S. does not need to wait we should insist on higher standards now. Leverage is already down from pre-crash levels, so regulation would ensure that banks won’t return to their old, highly leveraged ways.

The Securities and Exchange Commission and bank regulators should update model-based approaches that set leverage ratios according to Monte Carlo-type formulas. These formulas focus on too narrow a range of probabilities wherein we know that the tails, while statistically small, are significant.

The proposed legislation attacks the third issue by requiring that some derivatives be traded on an exchange where, presumably, they would receive adult supervision. Critics are unhappy because many derivatives still could be traded in customized, private arrangements.

But the issue of where derivatives are traded is secondary. AIG got into trouble because it had to post tens of billions of dollars in extra collateral as its positions went way against them. Thus, the relevant question is the amount of collateral supporting each trade.

A regulatory expert from Harvard Business School, has suggested an ingenious solution. Exchanges should require traders to post significant collateral, and the SEC should mandate that, for derivatives traded off exchanges in private transactions or elsewhere, traders adhere to the highest collateral minimums set on the exchange.

Moody’s, Standard & Poor’s and Fitch Ratings fed the mortgage bubble with crazily permissive ratings on mortgage-backed securities. The ratings companies were paid by the Wall Street firms who put the deals together and needed the ratings to market their products.

Yes this is a conflict-ridden arrangement but I believe the ratings agencies did not understand what they were rating. Chuck Prince the previous CEO of Citibank had no idea or understanding of what his derivatives desk was doing - he just let them do it (it was good for his bonus!). Also, a money management firm asked me to review a retail CDO (collateralized debt obligation) in 2008 and at first blush it looked fine, a triple A rated, 7 percent government agency bond (in a 3 percent market, hmmm). After a deeper analysis I realized this was a Wizard of Oz offering - lots of smoke and mirrors. The ratings agencies need to continuously educate their analysts to stay abreast of the new new securities coming out of Wall Street.

Inflated compensation, is endemic to all industries, not just financial firms. But it encouraged excessive risk-taking, and thus high leverage, on Wall Street (and in Charlotte). The government is trying to restrain compensation in various ways, such as rulings from the pay czar and Fed guidelines for banks. They aren’t working -- witness the return of big bonuses on Wall Street. Moreover, the new fixes suffer from micro- management. I really don’t want bureaucrats sifting through paychecks.

A better fix would be to require shareholder approval for large pay packages, say $3 million and up. Many banks would pay just under the threshold to avoid a vote. Investment bankers might discover that life can be acceptable on $2,999,999 a year. And for those who get shareholders to approve greater swag, that’s capitalism at work.

Finally, when regulators bailed out Bear Stearns, Fannie Mae and Freddie Mac, they insisted they weren’t setting a precedent for future rescues. Fed Chairman Ben Bernanke said addressing the problem of too big to fail should be a "top priority." In a perfect world, all banks would be allowed to fail.

We know from recent experience they aren’t. Endowing them with a privileged position promotes reckless behavior. The government, instead, should make it undesirable for banks to be within the circle of protection. It could do this by charging big financial institutions larger insurance premiums and by further raising their capital standard. This would encourage them to shrink to a size where failure didn’t pose a threat to the U.S. economy.

As bad as the financial crisis was, we don’t need the government running Wall Street nor do we need new federal agencies. We need a few carefully chosen rules to reassert proper incentives and proper limits. So get on it Tim, your time is running out

C Blakely 11/2009 VGKDWNUGWKGK

Sources: Bloomberg LP, WSJ, Harvard Business Review