Archive for June, 2012

This and That: Eurobonds, investors behaving badly and more …

June 29, 2012

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Will Germany say ja to Euro bonds?

Despite Germany’s staunch opposition to issuing bonds jointly with other European countries, this article argues that Germany will eventually cave and pay up because the costs of a Euro breakup will be disastrous for it.

Investors behaving badly

With all the volatility in the markets, it is hardly surprising that investors have responded by stampeding out of stock markets. According to the Investment Company Institute, which tracks mutual fund flows in the US, investors have been net sellers of equity mutual funds in 12 of the past 12 months.

Dividend Investors are worry warts too

If you hear dividend investors talk, you’d think that all there is to investing is to buy some dividend payers, sit back and collect the dividends and not worry what the markets are doing. It turns out many dividend investors worry about the market direction just like other investors. This Globe and Mail column quotes dividend investor Tom Connolly worrying that “stocks may be in a long-term bear market” and “the lows of the 2009 bear market could be retested”.

Adding Commodities to a Portfolio

This article points out that adding commodities to a portfolio can reduce volatility without impacting returns.

Escher in LEGO blocks

And now for something completely different… It is amazing to see M. C. Escher’s lithograph print Ascending and Descending rendered with LEGO blocks here.

This and That: Tightening mortgage rules, risk taking and more…

June 21, 2012

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A 2×4 to the Housing Market?

Finance Minister Jim Flaherty announced steps to cool the housing market by (1) reducing the maximum amortization to 25 years from 30 years (2) lowering the maximum refinancing amount to 80 percent and (3) reducing the ratios used to calculate mortgage affordability and (4) limiting mortgage insurance to homes priced under $1 million. You can read the news release and links to more information here.

Concurrently, the OSFI announced that the maximum Loan-To-Value of Home Equity Lines of Credit (HELOCs) will be lowered to 65 percent (from the current 80 percent). HELOCs will continue to remain revolving lines of credit and will not require amortization. If you currently have a HELOC and are close to the 80 percent limit, do not worry (though you may want to think about paying it down to a comfortable level): the HELOC rules will not apply retroactively.

The Biology of Risk Taking

Recent research is providing some interesting insights into the role that testosterone might be behind exuberant market conditions and the stress hormone cortisol behind market pessimism.

John Coates, the researcher behind these findings also shared his views in an interview with the CBC’s Anna Maria Tremonti.

Buy-and-hold dies again

Gordon Pape says that “to a degree, it’s true” that buying-and-holding index funds is a dead idea. So, what should investors do? Mr. Pape suggests looking at stock charts, companies with “industry leadership”, strong balance sheets, good dividend record and relative strength in bad markets. One wishes picking winning stocks were so easy.

The Importance of Rebalancing

It’s often painful but Rob Arnott explains why it is important to rebalance out of highfliers and into beaten up and unloved securities.

Interest Rates may not go up afterall

Conventional wisdom holds that interest rates have nowhere to go but up. Jason Zweig explains why conventional wisdom may be wrong and low, low interest rates may be here to stay for a long time.

The 1% writes back

A one-percenter makes the case that the very wealthy, even those who speculated with other people’s money and brought the world to the brink of disaster, deserve the riches because their innovations is bringing vastly more benefits to the other 99 percent.

And finally, on a non-related subject, NASA has made available some spectacular video and images of the transit of Venus across the sun on June 5, 2012.

The Frequency of Black Swan Events

June 20, 2012

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How frequent are Black Swan Events (defined as monthly declines of 20 percent or more) in financial markets? The answer to the question is important for investors who want to perform a cost-benefit analysis on the Black Swan Exchange-Traded Funds that were launched by Horizons ETFs recently. The cost side of the equation is clear: a portfolio that buys puts as protection against market crashes will lag the long-only portfolio by the net cost of the puts.

The marketing material put out by Horizons gives some idea of the magnitude of the gains that put options can provide in the event of a market decline. Horizons says that a hypothetical portfolio with a Black Swan overlay is expected to increase in value by 13 percent when the underlying market declines by 30 percent. That sounds enticing but how often do these events occur?

Based on S&P 500 index rolling month returns, Horizons ETFs says that Black Swan events are far more frequent than one would expect: 25 declines of 20 percent or more over the past 50+ years. Therefore, concludes Horizons (see table in this page), a Black Swan overlay would deliver protection from market crashes approximately every two years.

It is hard to find justification for Horizons conclusions in S&P 500 daily closing prices going back to 1950 available on Yahoo! Finance. It is true that if one looks at rolling monthly returns there were 25 instances of declines of 20 percent or more. However, rolling monthly returns vastly overestimates the number of serious declines. To see why, imagine that the S&P 500 is at 1200 for 19 days, plunges to 900 (a 25 percent decline) and stays at that level for another 19 days. If one looked at rolling monthly returns (Day 1 to Day 20, Day 2 to Day 21, … , Day 20 to Day 39) one would conclude that there were 20 Black Swan Events in that 39 day period! But, in reality there was exactly 1 Black Swan Event that an investor could have profited from: the crash on Day 20.

It turns out Black Swan events were extremely rare. In the S&P 500 data since 1950, there are only three Black Swan events (declines of 20 percent or more): 1987, 2008 and 2009. Surprisingly, (at least for me), the market declines of 2000-02, even in the immediate aftermath of the terrorist attacks of 9/11, the markets did not decline more than 20 percent.

It is hard to draw conclusions about how frequently Black Swans events occur from the limited data set that we have. An investor starting out in 1950 would have endured 37 years (!) of under performance waiting for her put option strategy to pay off. But, assuming Black Swan protection works as advertised, it would have paid off twice in the span of 2 years in 2008 and 2009.