Andy Sutton & Chris Wilson from yourcontrarian.com discuss the markets, the broader economy, and where things are headed over the coming weeks and months. Don’t miss this informative session! Listen Here

What does this mean? It means more reliance on foreigners for everything from food to fuel, to consumer trinkets. It means larger trade deficits (since you can’t export government – although it would really be nice to export the whole doggone thing right now!), and further pressure on the US Dollar.

Cost vs. Price

It would probably be rather hard to find a single American that didn’t know the price tag of the stimulus bill. $787 billion has been included in nearly every news piece regarding the topic. What most people are not aware of, however, is that $787 billion only represents that amount of money actually put into the economy by the feds. It comes nowhere near addressing the actual cost of the program. A good recent example of this miracle of government accounting is the Medicare part D prescription benefit program. The price tag was $394 billion, but the cost is much higher – around $8.7 trillion and counting depending on which numbers you want to use. Granted this represents the net present value of the cost of these ongoing benefits over a 75-year period, but you get the idea.

Fortunately for taxpayers, the stimulus package is not an ongoing expenditure (yet), and as such consists of predefined outlays. Despite this, the total cost of the bill as compiled by the Congressional Budget Office is approximately $3.27 trillion. Amazing in this is the fact that we’ll pay nearly as much for debt service on the stimulus bill ($744 billion) as the measure was supposed to provide to the economy! Talk about sticker shock. The gory details are here.

The question now becomes one of return on investment. What exactly are we going to get for our $3.27 trillion? It had better be good too, because nearly all of it is borrowed from someone – either foreigners or the Fed. Unfortunately, such is not the case. Using the $3.27 trillion projected cost, the ROI for the stimulus bill stands at a whopping -415%. In the private sector, such a revelation would result in a project being killed instantly in the concept phase. Not so in the hallowed halls of Congress where the laws of economics and common sense do not apply.

A Good Deal for Taxpayers?

We have been assured in almost doublespeak fashion that the stimulus bill was necessary, and was in fact, a good deal for the American taxpayer and would create or save millions of jobs.

The ballyhooed cash for clunkers program deemed such a success ended up costing taxpayers around $24,000 for every car sold under the program. This when the actual benefit to the buyer was only $4,500. Some other examples, courtesy of AP, include:

- A company working with the Federal Communications Commission reported that stimulus money paid for 4,231 jobs, when about 1,000 were produced.

- A Georgia community college reported creating 280 jobs with recovery money, but none was created from stimulus spending.

- A Florida childcare center said its stimulus money saved 129 jobs but used the money on raises for existing employees.

One disconcerting admission in the past week came from Christine Romer, the head of the Council of Economic Advisors. She stated that the largest impact from the stimulus had already been felt and that moving forward, the stimulus would only serve to prevent the economy from slipping further rather than contributing to any growth. Sounds like a recovery eh? It would sound as if Ms. Romer is already laying the groundwork for the next brainchild of economic ignorance: Stimulus – The Sequel. Here are her quotes:

“By mid-2010,” she said, “fiscal stimulus will likely be contributing little to further growth.”

“While job losses will likely end early next year, robust job gains may still be several quarters away,”

“This is not a normal recovery, Coming out of this, we’ve got lots of things working against us.”

Like the laws of economics for starters?

What also must be noted is that the federal deficit alone for FY 2009, which doesn’t included net present value of unfunded liabilities, was $1.4 trillion. The fact that such a large sum of money had to be spent to prevent an all-out collapse of the US economy should be alarming to anyone with a pulse. The fact that current projections are for $1 trillion plus deficits annually for the next ten years should curl your eyebrows.

Let’s assume for a minute that Ms. Romer is correct and that we’ve seen all the bounce we’re going to get from the stimulus. According to AP, the number of jobs created directly by stimulus spending was around 25,000. Sure, there are probably some others that slipped through the cracks and it is very likely that some firms held off on layoffs because of the temporary burst of cash. But lets look at the cost of those jobs JUST in terms of the debt service created by the stimulus bill. Each of the 25,000 jobs created cost the taxpayer $29,600,000 in debt service alone.

Keep in mind that unemployment has been going up constantly during the time when we were getting the maximum ‘benefits’ from the stimulus. As soon as the money wears off, firms will fall back on their original plans, which include cutting back on staff. Another stimulus package will be needed – and soon – to stave off the infamous double dip that many economists and commentators have long been forecasting. The proverb that a house built on a rock will weather any storm, but one built on sand will certainly collapse rings very true in our current state of affairs.

The real question that needs to be posed to anyone supporting additional foolish stimulus needs to focus on an exit strategy. How will additional stimulus create a foundation for fundamental, healthy economic growth? The short answer is that it won’t, but lets make them answer anyway.

Types of Risk

In general, there are two broad types of risk: systematic (non-diversifiable) and non-systematic (diversifiable). Keep in mind that what we are discussing here is slightly different from geopolitical risk, currency risk, interest rate risk, etc although each of those specific types of risk do contribute to the overall riskiness of a particular stock and as such cannot just be ignored.

The data in the chart below is from a 1987 study on diversification just after the market crashed. Obviously, at that time, diversification was a hot topic as investors scrambled to adjust portfolios and recoup the losses. The data below lists the number of components, the standard deviation of annual returns for each portfolio, and a comparison of the standard deviation of the portfolio to that of a single component.

Number of Components in the Model Portfolio Average Std. Deviation of Annual Portfolio Returns (%) Ratio of Portfolio Std. Dev. to Std. Dev. of a Single Component

Below is a graphic representation of the data in the chart above. It may clearly be observed that standard deviation of the portfolio is asymptotic (law of diminishing returns) as it relates to eliminating the systematic (diversifiable) risk. In fact, once the number of portfolio assets surpasses 30, the standard deviation does not drop appreciably, even when another 970 components are added! Obviously, this reality enforces that quality is better than quantity.

Think of the case of the individual investor who buys 100 stocks thinking he is diversifying away all his risk. He has borne a significant opportunity cost in the form of commissions without purchasing much in the way of additional protection from non-systematic risk. The upper portion of the chart deals with non-systematic risk, which can be largely diversified away. Notice though that even when the portfolio contains 1000 components that the standard deviation is still 19.21%. That constitutes the systematic risk.

A good example of systematic risk is pure market risk. Obviously if the capital markets crash again as they did in 2008, it will be exceedingly difficult to put together a basket of stocks that will withstand such a downward draft. There are other types of risk such as geopolitical, currency, inflation, interest rate, industry, and geographic. By using a crosscut approach to diversification, one is able to not only mitigate much of the non-systematic risk, but a good portion of the systematic risk as well. This is accomplished by looking at your themes selected several weeks ago, then addressing each type of systematic risk in your selection of assets. This approach is one of the main reason that our Centsible Investor Model Portfolio has done so well while the broad markets have languished.

Beta (ß)

Quantitatively, Beta is the generally accepted measure of systematic risk for a stock and is defined as the amount of systematic risk present in a particular risky asset relative to that in an average risky asset. Essentially what Beta does is compares a particular stock in this case with an average stock, or more accurately, a benchmark basket of stocks:

where ra measures the return of the asset, r_p measures the return of a portfolio of risky assets (often the stocks in an index), and Cov(r_a,r_p) is the covariance of the returns.

Interpreting Beta is rather simple. 1.0 is the Rubicon so to speak. Betas lower than 1.0 indicate that the stock in question has a lower level of systematic risk than the ‘market’ while a Beta of greater than 1.0 indicates a stock that has a greater level of systematic risk than the ‘market’.

Knowing this, it becomes a rather simple matter to calculate the Beta of your portfolio simply by ascertaining the weight of each component and then multiplying it by that component’s Beta. Let’s use a hypothetical example where we have a 3 stock portfolio; Stock A is 25% of the portfolio, Stock B is 40% of the portfolio, and Stock C is 35% of the portfolio. The Beta of Stock A is .75, Stock B is .50, and Stock C is 1.25:

Beta_portfolio= .75(.25) + .50(.40) + 1.25(.35)

Beta_portfolio = .83

This calculation indicates that this 3 stock portfolio has systematic risk that is lower than that of the market, however, its non-systematic risk would be considerably higher than one would desire since there are only 3 components. All else being equal, the ideal would be to find a portfolio of perhaps 25-30 stocks that has a Beta_portfolio of .83, as this would mitigate much of the non-systematic risk as well.

Beta and the Risk Premium

While using the term risk-free in today’s financial and economic climate might result in a shower of protest, the concept of the risk-free asset has an important place in the discussion of risk vs. reward, particularly when selecting portfolio assets.

Let’s use an example of a stock with an expected return of 20% and a Beta of 1.6. Let us also assume (entirely for illustrative purposes) that the risk-free asset has a return of 8%, with a Beta of zero since it has neither systematic nor non-systematic risk. In the case of expected return, we are relying on an educated guess, but in the case of stocks that pay dividends, one could easily plug the dividend yield into the expected return as well. When we plot out our stock and the risk-free rate and generate a Security Market Line (SML), we get the following:

The chart above is relatively easy to interpret; we consider the ‘risk-free’ asset R_f with its corresponding Beta of zero and return of 8% and our stock with its Beta of 1.6 and its expected return E(R_A) of 20%. When we connect the dots and measure the slope of the line (rise/run), we get a slope of 7.5%. From this graph, we can ascertain that our stock has a reward to risk ratio of 7.5% meaning that our stock has a risk premium of 7.5% for each ‘unit’ of systematic risk. Obviously, the higher the reward to risk ratio, the better, meaning we’d want to see higher E(R_A) and/or lower Beta; either of which would increase the slope.

In a final example, let us now compare our stock in the previous example (called Stock A) with a second stock (Stock B). Stock B has a Beta of 1.2 and an expected return E(R_B) of 16%. When we construct our Security Market Line, we end up with a slightly different picture than we had with Stock A.

The reward to risk ratio (or slope of the line) for Stock B is 6.67%.

What this tells us (all other things equal) is that in essence, Stock A is a ‘better’ choice than Stock B simply because it generates more reward for each unit of systematic risk undertaken.

This analysis is especially useful when one is selecting portfolio components and wants exposure to a particular industry or sector, has multiple candidates, but doesn’t want to include them all for fear of being overweight that particular area. In this manner, the candidates may be lined up and compared to see both visually and quantitatively where the best bang for the buck lies.

Of all the areas discussed in our sample exercise over the past few weeks, diversification and risk are the two areas where investors are most likely to stumble. Many fail to properly diversify because they don’t understand the value of it or because they don’t have enough capital to diversify by purchasing individual stocks and should look to ETFs, open-end or closed-end funds as an alternative.

While the analysis above was primarily for stocks, those investors seeking to hedge their portfolios with precious metals can certainly plug their favorite shiny coins into this analysis. For those so inclined, Betas may be hand/Excel-calculated for commodities using the major indexes, or commodity indexes, such as the CRB as the ‘market’ portion of the calculation.

In summation, probably the most important takeaway from this article should be that a portfolio doesn’t need 100 components to be adequately diversified in terms of non-systematic risk. 30-40 will do just fine. A second important point is that by using your economic themes and how they relate to systematic risks in your selection of an appropriate number of assets, you can mitigate a good deal of the systematic risk to your portfolio as well.

It is therefore worth chronicling his recent reversal on the prognosis for the US economy. Long known as a ‘bear’ and as recently as June 15th skeptical of Helicopter Ben’s ‘Green Shoots’, Roubini now sees ‘light at the end of the tunnel and for once, it is not a train’.

It is hard to understand how any economist who looked at our broken system in a proper enough fashion to predict what has happened over the past 18 months could suddenly come to a different conclusion given that virtually nothing has changed – unless you want to count the exacerbation of many of the problems which got us into this mess to begin with.

How could persistent multi-trillion dollar deficits, more intrusive government policies, the apparent guarantee of additional tax burdens, debt monetization, and higher than expected unemployment numbers (even the watered down BLS numbers are above administration and Fed estimates) cause someone of Roubini’s intellect to suddenly change his mind and see green shoots instead of yellow weeds?

Whatever the reasons were, the markets loved it. The DOW continued its winning streak, dragging the NASDAQ and S&P500 with it. Interestingly enough, the Wilshire 5000 did not exactly follow suit, actually losing ground at the end of the day while the benchmark indexes gained.

This is just another bit of anecdotal evidence that the rally from March 6th has nothing to do with green shoots for the broader markets and the economy, but rather resembles Jack’s beanstalk. And we all know what happens when you play with magic beans.

Added from Roubini’s Blog on 7/16:
“It has been widely reported today that I have stated that the recession will be over ‘this year’ and that I have ‘improved’ my economic outlook. Despite those reports – however – my views expressed today are no different than the views I have expressed previously. If anything my views were taken out of context.”

The Mainstream’s Darling – P/E

If you turn on your television, perhaps the most popular measurement of ‘value’ is the price/earnings or P/E ratio. While P/Es are mentioned frequently, rarely does anyone stop to really think about what it represents. Simply put, the P/E ratio is the price of a share of stock divided by the earnings per share. In essence, it is how many dollars you will pay in share price for each dollar of earnings. I will be honest; I rarely use P/E as a decision tool simply because I don’t believe it is applicable in most situations. An average investor is not buying earnings. Sure, earnings may help drive the share price in the future, but they just as easily might not. News events about a company can drive price as much if not more than earnings, so perhaps a Price/News ratio would be appropriate too? And really, why would anyone ever want to pay more than a dollar for a dollar’s worth of earnings anyway? By definition then, a P/E of greater than 1.0 would mean the stock is expensive. The argument will also be used that one is not simply buying the earnings, but a claim on the assets of the corporation. While this is theoretically true, you can’t drive down to your local Home Depot and take a truckload of lumber out of the store without paying just because you’re a shareholder!

So there are many conceptual problems with the idea of P/E ratios yet once the P/E of the DOW goes below a certain point, we’re supposed to buy because stocks are now ‘cheap’. This to me is drawing some parallels that are eerily similar to herd mentality. All this should not be construed as an indictment of the P/E ratio, but rather to point out its limited relevance in terms of determining ‘value’.

Another frequently used, but less popular metric is the Price/Book ratio or P/B. Simply put this is dollars paid in share price for each dollar of book value. This is more of a liquidation metric, however, than an actual investing metric. Now there are some obvious instances where once might sniff out a bargain. Our example in the prior week’s issue of food companies is a bit lacking, but let’s use the example of a natural resource company. If for example, the company has proven resources in its properties and the P/B is .75, we might, in the absence of extenuating circumstances conclude that this is a bargain and that the stock is currently undervalued.

Some Situational Metrics – Cash Flow Generating Securities

One of my personal favorites is calculating the Net Present Value/Breakeven point for a stock that pays a stable dividend stream. This metric actually has relevance because the dividend is a cash payment that comes directly to the investor as a consequence of owning the shares. In the short-term, dividends are a known quantity. Obviously the metric only applies in the case where a dividend is paid. In the case where an investor is focusing on dividend investing for income purposes or simply for generating the maximum cash from their investing capital, these are important considerations.

An example is on order. Let’s say that an investor purchases 100 shares of a stock trading at $10/share that pays a $1/share annual dividend. The dividend yield on his investment is 10%. The P/Div ratio is 10. This means that the investor paid $10 for every dollar in dividends. Now the nice thing about dividends is that they are cash streams and we can use some common time value of money calculations to make determinations as to whether or not to invest. Let’s use the 100 shares as an example and do a net present value calculation with the following assumptions:

• Our time horizon is 25 years

• Dividends over the 25 years will average the current $1/year

• The Cost of Capital (COC or inflation) will be 6%/year for the duration of the exercise

Most popular spreadsheet programs contain the NPV function where you can set your COC and the value of the individual cash flows if you desire to perform this analysis for yourself.

The Net Present Value of this situation is $262.58, giving a positive indication or a ‘buy’ signal. This alone should not be used to make a buy determination, but should be used as a tool to validate or invalidate individual investment opportunities that arose from our analyses in parts I and II.

The Time to Cover or Breakeven point of this hypothetical investment is Year 15. What this means is that after 15 years, the dividends (after accounting for the deterioration in value due to inflation) will cover the cost of the initial investment. Whatever the investment itself is worth at that time is added value. So even if our stock is still at $10/share, it is paid for, we’re in the clear, making dividends for another 10 years before we need the funds, and can sell the stock at any time thereafter for a pure profit. And since inflation has already been figured in, we’re talking about real gains. We can easily modify the analysis to accommodate hypothetical taxation circumstances as well.

Another important point may also be made from the above analysis. Considering that we’re getting $1/year in dividends, in nominal terms, the Time to Cover/Breakeven would be 10 years. Inflation at a rate of 6% per annum increased the breakeven point by 50% or 5 years. While 6% doesn’t seem like that much, this example illustrates exactly how much of a burden on wealth it represents. If anyone really wants to see why clipping bond coupons isn’t such a hot idea, run this analysis on the 30-year Treasury Bond and it will become immediately obvious.

Moving forward, when looking at dividend paying investments, we are looking for lower P/Div ratios (higher yields), and consequently lower Time to Cover/Breakeven points. While looking at the yield gives some good insight, using the NPV and breakeven analysis allows us to quantify the deleterious effects of inflation over time. The yield alone doesn’t give us that ability since it is a snapshot in time and changes as the price of the underlying security changes. It is important to note that in this study, we are NOT valuing the firm. We are valuing the cash streams that the firm pays to shareholders and discounting them to the present.

The risks to the above analysis are obviously many. 25 years is a long period of time, and things can change dramatically. Firms can go out of business or eliminate dividend payments thereby rendering the above effort worthless. Also, the major types of risk such as market, currency, political, and systemic cannot be accounted for over such a long period of time. This is one of the reasons why it is never a good idea to buy today and walk away. Successful investing is a journey, not a destination. As soon as you think you’ve got it all figured out, that is when you’ll get bitten. Vigilance is the name of the game. Another obvious takeaway here is that we’re dealing with long term investing, not trading. Such studies are a moot point for the short-term trader since their focus is on a different goal. Realize I am not trying to be impertinent towards traders, but simply pointing out the difference between their objectives and those of long-term investing.

Non Cash Flow Generating Securities

For firms that do not pay dividends, the investor is limited to just one way to make money directly (other than writing options) from owning the stock and that is appreciation. In this situation, choosing appropriate themes becomes even more important because say for example, you selected a firm that pays no dividend and is in a market niche that relies heavily on discretionary consumer spending. When the economy entered into recession in late 2007, you would have had very little in the way of flexibility since there is in effect no longer anything supporting the price of your stock. You’re not being paid dividends while you wait out the business cycle. So you can either write covered calls and ride out the storm or just pull up stakes and get out of town. Below are charts of the XLY (Consumer Discretionary Sector) and the XLP (Consumer Staples Sector).

Let’s compare these two distinctly different themes.

From peak to trough, the loss for XLY was approximately 58% while the loss for XLP was 29%. For sure, 29% is not anything to write home about, but it does serve to illustrate the importance of picking the proper themes.

Earnings Growth

However, there is one quantitative metric that is very useful in determining the success of a firm’s operations in the absence of dividends, and that is earnings growth. I prefer using earnings growth to sales growth or margin growth simply because earnings are at the bottom of the income statement and represent the impact of the entire operation including all of its cost centers on the bottom line. Companies that are able to consistently grow their earnings even during troughs in the business cycle are obvious candidates for any investor’s portfolio. While it remains true that the investor isn’t paid those earnings, companies that make money and grow their earnings are generally looked on favorably by the market, and as such are positioned to do well, all else being equal. One spinoff of this methodology is the PEG ratio or price/earnings/growth, which is stated below:

P/E Ratio

——————– = PEG Ratio

EPS Growth

The PEG ratio gives some degree of relevancy to the P/E ratio because it factors in growth. Obviously, the lower the PEG ratio, the ‘cheaper’ the stock is because in essence, you’re paying less for growth. Or, put another way, you’re paying less for the likelihood that the stock will go up in the future all other things being equal.

When valuing firms that don’t pay cash streams to the shareholder, it also becomes important to focus on intangibles because many times, they are what will drive the share price, rather than solid fundamentals such as earnings growth. There is an old market saying that goes as follows: “The market can be wrong far longer than you can remain solvent betting against it”. If you have the luxury of a long time horizon and no immediate need for your cash, you can afford to buy into the themes you feel will do well in the long term, monitor them, and wait for the market to sort it all out.

This is one of the main reasons I prefer dividend-paying investments. First of all, from an analysis standpoint, they provide something quantitative to analyze. Secondly, if you’re a long-term investor and the market hasn’t gotten on board with you yet, you are being paid (in some cases very handsomely) to wait. Thirdly, if you come to a decision where you’d like to retire and need some income, you already have it coming in. You’re not forced to sell into a potentially bad market to find income.

Next time we’ll take a look at risk, diversification, and portfolio construction now that we’ve been able to select our themes, come up with some portfolio candidates, and use various metrics to make some value judgments regarding those candidates.

For investors who are concerned about battling inflation, and operating within our new economic paradigm of spiraling debt and taxation, we are hosing a complimentary seminar on July 28th in Bethlehem, Pennsylvania. For anyone who would like more details, information, or registration instructions, please visit www.sutton-associates.net/seminar_reserve.php

Despite the calm appearance on the economic waters of late, there is quite a bit of turbulence building beneath the surface on a multitude of fronts. Several developments have emerged that fly directly in the face of the idea that we’re headed for a green shoots recovery. Even more surprising, when you take a deeper look at these issues, some rather remarkable inconsistencies emerge in that the methods being used in some critical areas virtually guarantee that they will not be successful. We’ll take a look at two of these areas, but first, let’s discuss maneuvering room.

A compressing timeline – less time for proactivity

Last week we presented a chart of the spread between 10 year and 2 year bonds and noted how with each interest rate ‘cycle’ that the spread is getting bigger. For reference, that chart is included below.

What is perhaps even more alarming than the increasing spread with each successive cycle is that the timelines are becoming compressed meaning that there is less time for recovery with each subsequent cycle. Such as has been the case in many other fiat systems when they begin to degrade. Volatility increases while the business cycle compresses. This is exactly what we’re seeing here. Firms and cohorts become reactive rather than proactive and it seems they’re always a day late and a dollar short. Not only do they have limited time to properly position for the next cycle, but with each subsequent cycle, they emerge with diminished resources as well.

No Green Shoots for Consumers?

Consumers are not far behind in this regard. As consumer prices continue to be on the increase due to the recent blowout in the monetary base (M1), expectations will switch from deflationary to inflationary.

However, there is a problem in this regard; the fuel for this inflation is not present. In order to see a meaningful inflation at the consumer level, money or credit has to find its way into the hands of consumers to monetize demand. Wages have been remarkably stagnant, with the most recent data suggesting that wages are increasing at a 1.2% annual rate. Consumer credit, which is another potential source of spending money, has been in a contractionary pattern over the past 4-6 months.

Fiscal stimulus by the federal government has largely left consumers out of the picture as the government has opted to try to initiate consumers to spend their own money instead of monetizing demand directly through rebates or other types of transfer payments. The shift from the direct stimulus method, which was used at the beginning of 2008 to the indirect method of using tax credits, has been important. Ostensibly, from a financial perspective it doesn’t really matter which means are used. The government will either spend money directly or lower future tax receipts as people take advantage of the credits.

The message here is clear. The government would prefer that people didn’t save, opting rather to borrow and consume in the present and avail themselves of a tax credit at the end of the year.

This is evidenced by the ever-growing list of tax credits that are available for doing various things like buying a home, putting in alternative energy systems, or installing energy saving devices. The problem is that in order to take advantage, consumers must have access to the money and/or credit to make the expenditure in the first place. This is probably the worst way to stimulate consumption in a cohort that is already grossly overextended. Consumers, to a certain degree have sniffed this out as is evidenced by increased savings rate in recent months. Job losses haven’t helped to encourage spending and certainly won’t do much for consumers’ willingness to borrow. If the government was interested purely in consumption, there are much better ways to stimulate it.

It would seem possible that there are some ulterior motives at work here. Namely that the government would prefer that consumption remain tepid or even contract without them actually coming out and saying it. More on this a bit later.

Mortgage bond yields continue to rise

The Federal Reserve publicly plans to purchase $1.25 Trillion in mortgage bonds this year alone in an effort to keep mortgage rates down. However, rates have shot up from just under 4.8% to nearly 5.5% in just the past few weeks. One would wonder what exactly is going on here. How can this be, given that the Fed has pledged its undying support to this market? It would appear they have, at least for the meantime, reneged on their pledge. Consider the following:

As of April 30th, the Fed held a total of $367.728 Billion in mortgage backed securities. That number increased to $384.115 Billion on 5/14, $430.485 Billion on 5/21, and reached a peak of $430.902 Billion on 5/28. However, as of yesterday, Fed holdings of MBS actually fell to $427.612 Billion, meaning the Fed sold over $3 Billion of MBS during the past week.

So not only has the Fed slowed its support of this endeavor in the weeks leading up to 5/28, they are now contributing to higher mortgage rates by selling into an already weak market. I would contend that they never should have been buying MBS in the first place, but since they decided to monetize this market, why all of a sudden are they content to allow rates to jump nearly 15% in two weeks by withdrawing their support? Every piece of Fed testimony would lead one to believe they firmly attach the success of the housing market to the success of the overall economy. So why pull the plug on that support just when there seemed to be at least something of a bottom forming? No doubt the quick increase in rates will scare buyers away. A three quarter percent increase in rates will quickly eat up any tax credit the government is providing.

Again, similar to the issue with consumers, it would seem as though there is an attempt being made to throttle recovery without coming right out and admitting it.

One possible answer – The $100 Trillion consumption gap?

It has long been the view of this weekly editorial that our climbing debt levels would eventually be what sank the US as the premier economic world superpower. Even more than the debt itself is the impact such debt will have on future generations. Unfortunately, this is one angle that is rarely looked at. Most government reports reflect the national debt, trade, and budget deficits as a percentage of GDP. Using this measure, it is easy to look at the debt picture of the US in a rosy light. On a purely percentage basis, the debt looks manageable and is not out of line with other industrialized nations. The problem lies in the ability of both the economy, and the working class young to repay the debt. In other words, we never look at the impact of the debt, but rather choose focus on the size of it.

When one starts to examine the impact of our mounting debt and take into account generational and demographic factors affecting our population, it becomes immediately clear that not only is our current standard of living unsustainable, but it is downright foolish to expect that it can continue. This week on our Spin Cycle podcast, we talked with Professor Laurence Kotlikoff who can easily be considered an expert in the field of generational accounting. He pointed out during our discussion that there was more than a $100 Trillion gap between our ability to produce, and our appetite for consumption. Such studies are stretched out over many years with the future dollars being discounted to the present so we can compare apples with apples.

Certainly those in the upper levels of government and finance are aware of these realities and realize that there is simply no way we can continue to consume at our present rate, enjoy the same standard of living, and ever have any hope of paying for it without a massive hyperinflation and the resultant economic and social discord. Another contributing factor in this analysis is the growing likelihood that not only has global oil production peaked, but that our ability to procure ever-increasing amounts of other materials necessary for our standard of living has peaked along with it.

For more information about generational accounting and our current fiscal and consumption gap, listen to our interview with Professor Laurence Kotlikoff by visiting our podcast page: www.my2centsonline.com/radioshow.php and looking in the ‘Spin Cycle’ section. Next week we’ll conclude our cubic analysis with a discussion of energy and natural resources with Zapata George Blake. That podcast will be available on 6/10/2009 and may also be found at the above link under the same section.

While it may seem rather inappropriate to talk about hedging strategies while the markets are retracing at least a portion of 2008’s devastating plunge, common sense continues to support the position that the worst is yet to come. Granted, focus has shifted to ‘less bad’ economic data and the anointing of government spending as the elixir that will return the American economy to prosperity. Yes, that whole “We’re going to spend our way to prosperity” mantra is once again in play. Make no mistake about it; what we are witnessing right now will be viewed years from now as the biggest suckers rally in history – so far.

That said, now is the time to start talking about protecting portfolios from the next move down. The techniques below were used either singly or in tandem to drastically limit losses in our client portfolios during the 2008 liquidation. Some of these strategies have been sold to the investing public as ten feet tall and bulletproof, but don’t work out too well unless the intricacies are understood. And still others are exceedingly complicated to execute and rely on a preponderance of difficult predictive successes to be beneficial.

Flight to Cash and Equivalents

This move is an obvious one and constitutes either a partial or total exit from the market in question and the capitalization of whatever gains/losses existed to that point. Depending on the type of account you’re dealing with you will have a taxable event. Under many circumstances, it may be detrimental to sell out of the market. This can especially be the case if you are one of those folks who have invested in a dividend-producing portfolio and need the income from those investments for living expenses. Obviously, people in this position don’t want to see their portfolio go down in value, but can’t necessarily afford to sell those assets either.

In terms of the average investor, this is undoubtedly the easiest hedge to execute with the opportunity costs being commissions, possible tax consequences, and the forfeited gains if you’re wrong.

Going Short the Market

Shorting shares and/or indexes is one way investors will choose to hedge portfolios during times when they believe markets will head lower. Let’s use the DJIA as an example.
Let’s say that an extremely prescient (and lucky) trader identified the last major top in the Dow Jones on 5/19/2008 at 13,028.16. That day he shorted 100 shares of DIA at a price of $130.23 for a total of $13,023 with a $10 commission. So our trader has $13,013 in his pocket, knowing he’ll have to cover those shares at some point. Let’s assume once again that our trader gets lucky and picks the precise bottom on 3/6/2009 with the DIA at $66.23 and decides to cover. He buys 100 shares for $6,633 ($10 commission) and has $6,380 as his gain.

Obviously, this is a best-case scenario, and ironically enough, this is often how many investment ‘get-rich-quick’ schemes are presented.

The following is the flip side of shorting the market.

In this scenario, our trader, having seen his brokerage account drop by 25% since the beginning of 2008 decides to short DIA on 10/22/08. He is scared to death of a further decline. He shorts 100 shares at a price of $84.59 on the DIA, pays the same $10 commission and has $8,449.00 in his pocket. Unfortunately, he has picked a short-term bottom and the market rallies substantially immediately after he takes his position and our trader is scared into covering on 11/4/08 at $95.19. Including commissions, his short position just cost him a quick $1,080 – in just 9 trading days.

With the benefit of 20/20 hindsight we can easily point out that our trader would have been much better off waiting a few more weeks to cover. He would not have lost anything, and in fact would have helped his portfolio.

The take-home point here is that shorting is not for the faint of heart. You’d best have a solid understanding of market behavior and fundamentals before even considering short-selling shares. As we learned above, the risk to the trader is unlimited. Lets say the DJIA would have gone all the way back up to its 2007 high after our trader shorted on 10/22/2008. He’d have been out over $5,700. In shorting, the rewards are finite (a stock can only go so close to zero) whereas the risks are theoretically infinite.

For the average investor, shorting shares is difficult in that you must pledge the balance of your account as collateral in case your bet goes bad. This nullifies the ‘qualified’ status of IRAs therefore IRA custodians will not extend margin privileges to IRA accounts. Standard brokerage accounts may be used to short stocks and such an account could be used to hedge other investments. While this strategy may bear occasional fruit, it is not for everyone, particularly those with short time horizons or a low appetite for risk.

Inverse Funds – Not what they’re cracked up to be?

Before beginning this segment, a few things must be said. For those who read this column regularly, you know that I rarely use specific companies or funds in these discussions, and tend to stick to sectors, fundamentals, and macroeconomic conditions. However, in this article, specific examples are going to be used to illustrate the points made and to show investors how these funds don’t always perform the way they’d expect. This is not to imply that there is an attempt to deceive on the part of the fund sponsors, but rather a misunderstanding by the investing public of the stated objectives of these funds.

Dow Jones UltraShort Profund (DXD) – The stated objective of this fund is as follows:

The Fund seeks daily investment results, before fees and expenses that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones Industrial Average.

Let’s use a couple of hypothetical examples to illustrate how a leveraged inverse fund works. We enter our position when the DOW is at 10,000 and the price of DXD is $100/share. For the purposes of the example, we’re going to forget about the expense ratio. While the expenses must be considered, they are not necessary to make our point.

So over the course of our hypothetical 10-day trading period, the DJIA lost 8.28%. Conventional wisdom would have expected DXD to come in at a 16.57% gain. However, it only returned 14.44% (before expenses). Granted, this is not a big difference, but when you start putting it in the context of a million dollar investment you’re talking about some serious money.

Now, for the sake of argument, let’s use DOG, which is the non-leveraged inverse ETF for the Dow Jones Industrial Average, and see what happens.

The performance of the non-leveraged inverse ETF wasn’t quite as bad as it netted 7.64% (before expenses) when compared to an 8.28% loss in the Dow Jones Industrials Average.

Now let’s apply a real-world example from earlier this year and watch what develops:

On February 9th, 2009, the Dow Jones Industrial Average closed at 8270.87. The Ultrashort DOW ETF (DXD) closed at $58.07 that same day. Now, shortly before close on 5/13/2009, the Dow Jones Industrials Average is at 8274.05, while DXD is at $51.33 – a difference of $6.74 from the 2/9/09 price. Conventional logic would have surmised the DXD prices would be within a few cents given the trivial difference in DOW levels. For comparison, the non-leveraged ETF (DOG) closed at $71.82 on 2/9/2009 and sits at $68.60 shortly before the close on 5/13/2009 – a difference of $3.22. Conventional logic would have also expected the price of DOG to be very similar. What is going on here?

Here’s what. It is all in the objective of the fund. Remember how it mentioned the daily performance? These funds track the index on a day-by-day basis, but as time goes on, the tracking becomes more and more sloppy. Volatility enhances this condition as was evidenced in our 10-day hypothetical study from above.

It is due to the fickle nature of mathematics that a 10% drop followed by a 10% gain doesn’t put you back where you started. This is where the inverse funds fail to protect portfolios in the longer-term. Now, if prices always moved in straight lines, the inverse funds would do fine. Obviously prices don’t behave that way. The above analysis should not be construed as an indictment of the DOG and DXD inverse funds, but rather suggests they only be used with a clear understanding of their objectives. Furthermore it must be realized that you might not get quite the level of protection you anticipated even if you’re right and the market goes down but takes a lazy path to get there.

For the average investor, inverse funds are an easy way to ‘short’ the market without actually taking the full risk of shorting. Think of it this way: if you invest in an inverse fund and the fund goes to zero, you’ve lost only your initial investment. Your actual risk is known going in. A second plus is that inverse funds may be bought in non-marginable accounts like IRAs. The major drawback, outlined above, is that you may not get the performance you expected for your buck – particularly over extended periods of time.

Using Options to Hedge Portfolios

Another potential strategy for hedging portfolios is through the use of options. We have previously discussed covered call writing for the purposes of generating income, but this week’s topic varies considerably and requires looking at things from a totally different perspective. This discussion focuses on using options for protection ONLY – not for day trading or other speculative activities.

While this is not intended to be a primer on options trading and involves prerequisite knowledge, there are some important concepts that must be highlighted when using options for hedging purposes. For most average investors, hedging with options involves the purchase of put options, which can be done from many types of accounts. However, individual brokers have their own restrictions on what can and cannot be done in particular types of accounts.

Time – Options are good for a specified period of time and after such time has passed expire worthless. Even in the month (or sometimes more) before their witching (expiration), options begin to degrade in value and investors find that they’re not doing their job in terms of protecting the portfolio. Options have ‘sweet spots’ and if you’re going to use them to protect a portfolio you’d better be able to align the option’s sweet spot with the period when the market’s decline will be most dramatic. Otherwise you’re not getting the full benefit of the option and your portfolio isn’t being protected. This is no easy task by any stretch of the imagination.

Strike Price – In the case of the Dow Jones Industrials Average, put options could be purchased on DIA. If you feel the decline will last 6 months and start today, you’d look at options that expire 11/2009 or beyond. In the case of DIA, 12/2009 put options are available. Now you must decide how far you think the market will fall. Buying an option with a strike price that is too low may result in it staying out of the money in which case you might not get the full performance; especially if the decline is not as steep as you anticipated. Buy an option at a strike price that is too close to the current price of DIA and you’re going to pay a hefty premium for the option. If your prediction ends up being right that won’t be an issue, but if you are wrong, you just wasted a lot of your money.

Know Your Portfolio - A common mistake of investors who use options for hedging is that they buy the wrong option. It is imperative to understand the components of the portfolio that you’re trying to protect. For example, hedging a portfolio of junior gold mining stocks with Dow Jones Industrials Average puts is probably not a great idea. While the junior gold stocks may trace the DJIA to a certain extent there are plenty of times when such is not the case. Using a simple statistical correlation study between your portfolio’s value and the value of different market indexes can help you identify which markets your portfolio tends to track and you can then hedge more effectively.

The major benefit of buying options is that you’re taking a known level of risk. Your outlay for the option and related commissions is the extent of your risk. If you are wrong and the market moves up your option will expire worthless and you lose your initial investment only. It must be noted that this defined risk does not apply when one is writing uncovered (naked) options. These types of activities are extraordinarily risky and are highly inadvisable merely for hedging purposes.

In conclusion, there are many other factors that play into hedging and would require a dissertation to elucidate all of them to proper justice. Each investor must consider their own objectives and risk tolerance and should also consult a qualified advisor before implementing any investment strategy.

The important thing to take away from this discussion is that if done properly, hedging can provide relative comfort during periods of market mayhem such as we just witnessed last year. However, if undertaken without a solid understanding of both the benefits and detriments of the hedging methodology you choose to employ, not only will you not enjoy comfort, you’re quite likely to be a regular in the antacid aisle at your local pharmacy as well.

Improper hedging techniques and use of hedging vehicles are some common mistakes investors make. Consider taking a look at our free report about 7 additional mistakes investors make – and how to avoid them. To get your copy click the following link: www.sutton-associates.net/7mistakes_report.php

Back in 2006, Marketwatch Columnist Mark Hulbert made the comment that those who had invested at the 2000 market top had finally gotten their money back.A long six years to get back nominal dollars that had decayed significantly by the time they were ‘gotten back’.

We wrote the pilot issue of the Centsible Investor in early November 2007; right after the market peak. Was this an accident? Hardly. Our keynote article in that issue dealt with our purchasing power coming under attack and we vowed to put together a portfolio model that would fight inflation by providing a high rate of current income with a secondary goal of capital preservation.

Today, I am proud to announce that while the Dow, NASDAQ and S&P are all down (38%, 39%, and 40% respectively), that the total return on our Portfolio Model is now positive at .51% as of close of business 5/8/09. Where traditional investors had to wait several years from the bottom to get their dollars back, our Portfolio Model has accomplished the same feat in just over 2 months – and has paid great dividends while we waited!

For those who have been subscribers over this 18 month roller coaster called the markets, I am hopeful that our publication has demonstrated its worth and you will consider renewing. For those who have not subscribed to this point, I am hopeful you will consider doing so. The attack on our purchasing power is only beginning and will feed on the inflation created to support unsustainable government spending and the various bailouts. Vigilence is required now – more than ever.

As an added incentive, we are currently offering $30 off our one year subscription. Get 12 issues plus interim updates for just $99. This special will last through Memorial Day.

The Centsible Investor’s Subscription Page may be found below. If you have any questions or need assistance, please reply to this email.

http://www.sutton-associates.net/newsletter.php

Best Regards,
Sutton & Associates, LLC

DISCLAIMER: The statements made in this communication are for informational and educational purposes only and do not constitute an offer to either buy or sell any security, nor should any statements herein be construed as investment advice. Neither Sutton & Associates, LLC nor any contributor to the materials contained in the above-referenced report shall be liable for any losses as a result of these or any other investments.

Recently, there has been more than idle talk about converting most of these loans to equity stakes, which do NOT need to be paid back. Furthermore, future disbursements would like be made by buying equity stakes in the firms rather than making loans. Sound the same? Not quite. Here are some reasons why:

1) In the event of bankruptcy, creditors are paid off before shareholders from any proceeds of liquidation. Given the vaporization of BSC and LEH, this is definitely worth mentioning. Historically, shareholders are left holding the bag in a true bankruptcy and subsequent liquidation.

2) Even if the firms remain solvent, there is significantly more risk in holding equity than debt. The taxpayer’s investment would be subject to all the risks generally associated with holding stocks. Taking a look at the performance of banking stocks during 2008 gives a pretty good idea of what I am talking about here.

3) Current shareholders are negatively impacted by dilution if more shares are created out of thin air for the government to purchase. And even if the shares are bought in the open market, the mere size of the stake could have a rather deleterious affect on existing shareholders should that stake need to be sold en masse.

4) By taking an equity interest, the government is consummating an incestuous relationship with the banking industry. Nationalization is the term typical used in this type of situation, but the term has become taboo in the mainstream media in recent weeks.

5) Also, bear in mind that the banks don’t really need this money at all. They have been printing their own currency for years now via unregulated, non-transparent OTC derivatives. Now that some of their bets have gone bad, the taxpayers have been forced to ‘legitimize’ this activity by the infusion of trillions of less-funny-money (dollars).

Sea changes can be either dramatic or subtle. The recent direction in terms of supporting the financial system sounds subtle enough, but with dramatic results.