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US bond yields in historical perspective

Unprecedented low interest rates in modern US history:

(click to enlarge; source: St. Louis Fed)

Decipher the growth-return fallacy

For a while, I have lost track of my favorite column at Financial Times, “Short View”.  Now I got it back working again in my RSS reader.  Here is an interesting piece on the growth-return fallacy in investing.

Growth does not equal return. It all depends on your entry point or purchase price. Previously, I have introduced this simple idea in an interview with Jeremy Grantham. In practice, more often than not, you will find people rarely get it.

(click on the graph to play)

Ten predictions for the next ten years

From Bob Doll, chief equity strategist at BlakRock:

1. US equities experience high single-digit percentage total returns after the worst decade since the 1930s.

2. Recessions occur more frequently during this decade than only once a decade as occurred in the last 20 years.

3. Healthcare, information technology and energy alternatives are leading growth areas for the United States.

4. The US dollar continues to become less dominant as the decade progresses.

5. Interest rates move irregularly higher in the developed world.

6. Country self-interest leads to more trade and political conflicts.

7. An aging and declining population gives Europe some of Japan’s problems.

8. World growth is led by emerging market consumers.

9. Emerging markets weighting in global indices rises significantly.

10. China’s economic and political ascent continues.

Read more  about his predictions here.

Bill Gross: Investment outlook

Bill Gross says new growth thrust has to be put into US economy. The current policy is just to flush money into toilet.

How to watch China bubble

Ed. Chancellor of GMO (in Boston) has put out an excellent piece on the Chinese market and the “red flags” for investors.

The paper addresses how to identify the proper “speculative manias” and associated financial crises in the country. Chancellor sums it into key points, breaking down the bare essentials:

1. Great investment debacles generally start out with a compelling growth story.

2. A blind faith in the competence of the authorities is another typical feature of a classic mania. In other words, you can’t always trust the numbers that a government is putting out.

3. A general increase in investment is another leading indicator of financial distress. Capital is generally misspent during periods of euphoria.

4. Great booms are invariably accompanied by a surge in corruption. Countrywide, anyone?

5. Strong growth in the money supply is another robust leading indicator of financial fragility. Easy money lies behind all great episodes of speculation from the Tulip Mania of the 1630s – which was funded with IOUs – onward.

6. Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts.

7. Crises generally follow a period of rampant credit growth. In the boom, liabilities are contracted that cannot subsequently be repaid. The U.S. will ultimately be a perfect example of this.

8. Moral hazard is another common feature of great speculative manias. Greed isn’t necessarily good and we tend to act irresponsible during intense periods of speculation.

9. A rising stock of debt is not the only cause for concern. Investments financed with borrowed money don’t generate enough income to either service or repay the loan (what Minsky called “Ponzi finance”).

10. Dodgy loans are generally secured against collateral, most commonly real estate. Thus, a combination of strong credit growth and rapidly rising property prices are a reliable leading indicator of very painful busts.

VIX as a contrarian indicator

VIX is a measure of market volatility.  Is volatility equal risk?  Most people and finance textbook would tell you this is the case. Here I share with you two insightful pieces that surely offer you a fresh new perspective.

First, James Montier elaborates:

Modern risk management is a farce; it is pseudoscience of the worst kind. The idea that the risk of an investment, or indeed, a portfolio of investments can be reduced to a single number is utter madness. In essence, the problem with risk management is that is assumes that volatility equals risk.

Nothing could be further from the truth. Volatility creates opportunity.

For instance, was the stock market more risky in 2007 or 2009? According to views of risk managers, 2007 was the less risky year, it had low volatility, which they happily fed into their risk models and concluded (falsely) that the world was a safe place to take risk. In contrast, these very same risk managers were saying that the world was exceptionally risky in 2009, and that one should be cutting back on risk. This is, of course, the complete opposite of what one should have been doing. In 2007, the evidence of a housing/credit bubble was plain to see, this suggested risk, valuations were high, it was time to scale back exposure. In 2009, bargains abounded, this was the perfect time to take ‘risk’ on, not to run away. Risk managers are the sorts of fellows that lend out umbrellas on fine days, and ask for them back when it starts to rain.

Second, Wall Street Journal has a wonderful piece with the similar idea —extreme low volatility often implies high risk ahead; and extreme high volatility often comes with huge opportunities.

The stock market’s most closely followed volatility index dropped this past week to its lowest level in nearly two years. Some investors who study volatility believe low readings are a bullish indicator for stocks. Historically, the market has tended to rise as volatility falls, and vice versa.

So the latest numbers are a surefire buy signal, right? Not necessarily. Dig a little deeper and you might even spot a contrarian indicator telling you to sell.

The Chicago Board Options Exchange’s volatility index, or VIX, is a gauge of investor sentiment. But its predictive power is limited to tallies of trades that have been made in the past. “The VIX is an important tool,” says Ben Londergan, co-chief executive of Group One Trading. “But it’s not the be-all and end-all factor to time your entrances and exits to the market.”

If anything, the VIX is most useful as a contrarian indicator. When the index remains unusually high or low for an extended period of time, it can mean a major market change is in the offing. For instance, the VIX had trended downward, and stocks upward, for several years leading up to the Dow Jones Industrial Average’s record close on Oct. 9, 2007. Then the subprime meltdown sent stocks plummeting as a historic bear market took hold.

One year later, during the diciest moments of the financial crisis, the VIX spiked to a record high of 80, capping a yearlong rise. Then it reversed course and fell sharply as stock markets enjoyed their most dramatic rally in decades.

Right now the VIX isn’t pointing to a major market move, since it is just now settling into its historical range. Under normal circumstances, the index moves in a fairly narrow band, mostly between 10 and 20. Having drifted gently downward for months, the index now sits at 17.

The recent drop is partly the result of an unusually steady stock market rally: In eight consecutive sessions over the past two weeks, stocks gained a total of just 2.2%, an amount that could easily be erased in one trading session.

So how can traders best make use of this oft-misunderstood index? By studying what is happening in the futures market. Professional investors have traded futures contracts on the VIX since 2004. When the futures are significantly different from the VIX itself, it is a signal that the index—and possibly the stock market—could soon reverse course. When the futures are significantly lower, it could be a bullish signal. When they are markedly higher, it could be bearish.

The latter is the case now. As of Friday’s close, the July futures on the VIX were trading at 23.25 and August futures at 23.40, considerably higher than the VIX’s 17. That suggests the pros are bracing for more volatility as the year wears on. If they turn out to be right, that could bode poorly for stocks.

Market has changed direction

David Rosenberg looks at the market direction from its 120-day change.

It clearly shows the market peaked in last August, then went sideway until last December; from last December, the market has been trending down.

This bear market rally was so long that surprised every professional investor. Now it’s the time to reckon.

(click to enlarge)

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Those investment fools

A reality check on long-term investing, from Jason Zweig:

What are we smoking, and when will we stop?

A nationwide survey last year found that investors expect the U.S. stock market to return an annual average of 13.7% over the next 10 years.

Robert Veres, editor of the Inside Information financial-planning newsletter, recently asked his subscribers to estimate long-term future stock returns after inflation, expenses and taxes, what I call a “net-net-net” return. Several dozen leading financial advisers responded. Although some didn’t subtract taxes, the average answer was 6%. A few went as high as 9%.

We all should be so lucky. Historically, inflation has eaten away three percentage points of return a year. Investment expenses and taxes each have cut returns by roughly one to two percentage points a year. All told, those costs reduce annual returns by five to seven points.

So, in order to earn 6% for clients after inflation, fees and taxes, these financial planners will somehow have to pick investments that generate 11% or 13% a year before costs. Where will they find such huge gains? Since 1926, according to Ibbotson Associates, U.S. stocks have earned an annual average of 9.8%. Their long-term, net-net-net return is under 4%.

All other major assets earned even less. If, like most people, you mix in some bonds and cash, your net-net-net is likely to be more like 2%.

The faith in fancifully high returns isn’t just a harmless fairy tale. It leads many people to save too little, in hopes that the markets will bail them out. It leaves others to chase hot performance that cannot last. The end result of fairy-tale expectations, whether you invest for yourself or with the help of a financial adviser, will be a huge shortfall in wealth late in life, and more years working rather than putting your feet up in retirement.

Even the biggest investors are too optimistic. David Salem is president of the Investment Fund for Foundations, which manages $8 billion for more than 700 nonprofits. Mr. Salem periodically asks trustees and investment officers of these charities to imagine they can swap all their assets in exchange for a contract that guarantees them a risk-free return for the next 50 years, while also satisfying their current spending needs. Then he asks them what minimal rate of return, after inflation and all fees, they would accept in such a swap.

In Mr. Salem’s latest survey, the average response was 7.4%. One-sixth of his participants refused to swap for any return lower than 10%.

The first time Mr. Salem surveyed his group, in the fall of 2007, one person wanted 22%, a return that, over 50 years, would turn $100,000 into $2.1 billion.

Does that investor really think he can get 22% on his own? Apparently so, or he would have agreed to the swap at a lower rate.

I asked several investing experts what guaranteed net-net-net return they would accept to swap out their own assets. William Bernstein of Efficient Frontier Advisors would take 4%. Laurence Siegel, a consultant and former head of investment research at the Ford Foundation: 3%. John C. Bogle, founder of the Vanguard Group of mutual funds: 2.5%. Elroy Dimson of London Business School, an expert on the history of market returns: 0.5%.

Meanwhile, I asked Mr. Salem, who says he would swap at 5%, to see if he could get anyone on Wall Street to call his bluff. In exchange for a basket of 51% global stocks, 26% bonds, 13% cash and 5% each in commodities and real estate—much like a portfolio Mr. Salem oversees—the institutional trading desk at one major investment bank was willing to offer a guaranteed rate, after fees and inflation, of 1%.

All this suggests a useful reality check. If your financial planner says he can earn you 6% annually, net-net-net, tell him you’ll take it, right now, upfront. In fact, tell him you’ll take 5% and he can keep the difference. In exchange, you will sell him your entire portfolio at its current market value. You’ve just offered him the functional equivalent of what Wall Street calls a total-return swap.

Unless he’s a fool or a crook, he probably will decline your offer. If he’s honest, he should admit that he can’t get sufficient returns to honor the swap.

So make him explain what rate he would be willing to pay if he actually had to execute a total return swap with you. That’s the number you both should use to estimate the returns on your portfolio.

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