Koesterich, The Ten Trillion Dollar Gamble

Russ Koesterich, iShares chief investment strategist and global head of investment strategy for BlackRock Scientific Active Equities, anticipates a rather bleak economic future for the United States. In The Ten Trillion Dollar Gamble: The Coming Deficit Debacle and How to Invest Now (McGraw-Hill, 2011) he explains why we should expect higher interest rates and slow growth. He then offers solid practical advice for the investor, from a series of tells that are useful in timing market shifts (because, as he writes, “timing is critical to your success” [p. 43]) to asset allocation in this new environment.

The picture Koesterich paints of the future is familiar. Barring major reform of entitlement programs, especially health-care spending, the U.S. structural deficit will only get worse. And “in the not-too distant future, it will start to push rates higher and economic growth lower, and it eventually may set off an inflationary spiral.” (p. 22)

“The not-too-distant future” is of course terribly vague. Given the looming economic risks, “you should hold a portfolio with less money in U.S. equities and bonds, more in cash, and a higher allocation to commodities. But you want to move to these new allocations at the right time. You don’t want to move too late, but you also don’t want to anticipate conditions that may take a few years to develop.” (p. 44)

What should an investor watch in order to decide when to act? A lot: debt (government, corporate, and consumer), both supply and demand; the yield curve; labor markets, especially wage growth; capacity utilization; the money supply; the Fed’s balance sheet.

The author’s recommendations do not require the investor to make a dramatic shift in asset allocation; it’s not that he should dump stocks and go into commodities whole hog. It is a question of more or less, not all or nothing.

In five chapters covering cash and debts, bonds, stocks, commodities, and real estate, Koesterich explains specific steps the investor should take in the new environment. For example, keep your debts long and your cash short—that is, have a fixed-rate mortgage instead of a variable-rate mortgage and keep cash in money market funds or short-term CDs. And hold a lot of cash in a rising rate environment.

Are TIPS a good way to hedge inflation risk? Yes and no. “The TIPS will not insulate the holder from a rise in real interest rates. Also, the extent to which the TIPS insulate you from inflation will be determined by the inflation expectations that are embedded in the bond and the breakeven level, as well as the holding periods. The breakeven level refers to the amount of inflation that the TIPS bondholders are expecting. If the expectations are too high, and you don’t hold the bond to maturity, you may still be better off with a plain vanilla bond.” (p. 108)

Koesterich recommends investing the majority of your stock portfolio outside of the United States, with particular attention to emerging markets. The remaining portion devoted to the domestic market should overweight “stocks and sectors that are more resilient to rising rates. Practically this means overweighting stocks in the energy, health-care, and technology industries and owning less of financial, utility, and consumer discretionary companies.” (p. 133)

Commodities should be part of every portfolio. The recommended allocation is half to a broad commodity basket and the other half to gold, starting with 5% of your total portfolio to each and doubling that position “when the leading indicators of inflation start to flash yellow.“ (p. 165)

Koesterich acknowledges that the economic scenario he envisages may not come to pass. There may actually be real fiscal reform, although the odds are against it. So he sketches out two portfolios, one defensive (if deficit spending continues unabated) and the other aggressive (in the wake of meaningful deficit reform). The former will hold 10-15% cash, 15-25% bonds, 40-55% stocks, and as much as 20% in commodities and gold. The latter will hold 5-10% cash, 20-25% bonds (especially high yield bonds), 60% stocks, and about 10% commodities (energy and industrial metals, not gold).

The Ten Trillion Dollar Gamble is a well-crafted book. At every turn the author explains the rationale for including or excluding particular assets in a portfolio, especially as they react to higher interest rates, slower growth, and possible inflation. The investor who is worried about protecting his wealth in the coming decade(s) would do well to consider Koesterich’s advice.

Meyers, The Technical Analysis Course

You’ve finally broken down and decided you need to know something about technical analysis. You could turn to classic texts such as Technical Analysis of Stock Trends by Edwards and Magee. But if you’d like a much easier read with more recent examples, you could instead opt for Thomas A. Meyers’ The Technical Analysis Course: Learn How to Forecast and Time the Market, now in its fourth edition (McGraw-Hill, 2011).

The book, covering both basic chart patterns and technical indicators, is structured as an introductory course. It includes frequent exams and a 110-question final. Answers are at the back of the book.

Since the paperbound book measures 8 ½” x 11”, the charts—some hand drawn, the rest produced using MetaStock software—are easy to read. In keeping with the author’s top-down approach to the equity market, there are charts of market indexes, industry groups, and individual securities.

For Meyers the structured approach to technical analysis is more or less the same, no matter what kind of chart it is being applied to. In the case of individual security analysis, it consists of seventeen steps, some basic and others optional. The basic steps are: (1) construct a bar chart of a security, (2) examine it for reversals, consolidations, and gaps, (3) draw trendlines and support and resistance lines, (4) perform relative strength analysis comparing a security to its industry group or to a market index, and (5) calculate and plot a simple moving average of closing prices. Optionally, one can: (1) draw trend channels, fan lines, percentage retracement levels, and speed resistance lines, (2) examine the chart for bull and bear traps and failed trendline signals, (3) perform a volume analysis, (4) calculate and analyze on-balance volume, (5) analyze volume using the volume reversal technique, (6) calculate and plot weighted, exponential, and multiple moving averages, (7) plot trading bands, (8) plot Bollinger Bands, (9) calculate and analyze momentum, rate-of-change, and moving average oscillators, (10) calculate and analyze the RSI, (11) calculate and analyze stochastics, and (12) calculate and analyze MACD. These seventeen steps pretty well summarize what is covered in the book.

One good feature of this course is that it includes a lengthy case study, using Starwood Hotels (plus its industry group as well as the S&P 500 Index). The author presents 40 marked-up charts over longer and shorter time frames, all generated as of December 31, 2009. Each chart comes with commentary.

My major concern with a book that is so elementary is that it may leave the reader with a false sense of competence. Although I didn’t take the tests myself, I looked at enough questions to realize that they were incredibly easy. Pity the reader who aces the exams and considers himself ready to commit money to the equity market using technical analysis. This is like getting an “A” in first-semester French and thinking you can land a great job in Paris, fluent French required.

Admittedly, Meyers makes no such claims for his book; indeed, he refers his readers on to twelve technical analysis books that “offer a wealth of valuable information.” (p. 329) So should those neophytes interested in learning about technical analysis skip the baby step and plunge into material that is denser and sometimes more nuanced? That’s all a matter of personal preference: do you want intense elementary French (two semesters packed into one) or a language course that proceeds at the normal pace? Given my singular lack of talent for learning foreign languages I would opt for the latter. But since I am a quicker study in things financial, I would probably choose the former.

Hirsch, Super Boom

Some of you may remember my review of the 2011 edition of the Stock Trader’s Almanac with its prediction of Dow 38820 by 2025. I was not the only skeptical voice at the time, and mine was far more muted than most. Undaunted, Jeffrey A. Hirsch has turned this prediction into a book, Super Boom: Why the Dow Will Hit 38,820 and How You Can Profit from It (Wiley, 2011).

The track record of predictive literature has not been stellar. We have only to think about the embarrassing 1999 call of Dow 36,000 by James Glassman and Kevin Hassett. Since Hirsch’s price target is similar to theirs, though his target date is much farther out, he feels compelled to explain where they went wrong: basically, they had a myopic view of history.

In contrast to the many pie-in-the-sky predictions, Hirsch recounts forecasts that were both timely and accurate, most notably his father’s call in January 1977 that the Dow would rise 500% (to 3420) over the next 13 years. In an appendix he reprints this Smart Money special report, which included a portfolio for the superboom.

Following in his father’s footsteps, using similar reasoning and an identical 500% gain (from the intraday low of 6,470 on March 6, 2009), Jeffrey Hirsch explains why we should see outsized returns for the stock market in the coming years. What will trigger this super boom? “Super booms of the past were conceived during wartime and financial crises, which produced elevated government spending, rising inflation, and pent-up demand. They were weaned on peace, stable political leadership, and effective governing. Finally, they were fed a steady diet of cultural paradigm shifting, enabling technology that changed the world and the way the average person lived. As the boom gains traction and heightened consumer spending spurs business and economic growth, the so-called ‘animal spirits’ of business, entrepreneurs, and investors are restored, shifting the boom into high gear. Finally, the boom reaches overdrive before falling back to earth.” (p. 13)

At the moment the economy remains strangled, and the author thinks that “we will be in a funk for several years”; the next super boom won’t begin until around 2017. (p. 56) We are still involved in Iraq and Afghanistan, government policies have not always been supportive, and inflation—at least as measured by core CPI—remains tame. Even if we include the volatile food and energy sectors, between September 11, 2001 and the November 2010 reading “the inflation index is up a meager 23 percent.” Ah, but the CPI has been revised numerous times, to what end is unclear (perhaps to dampen perceived inflation). “Having made numerous trips to the market and gas station over the past decade, it is simply unimaginable that prices are only up 23 percent. Energy costs have doubled, if not tripled. Medical costs have skyrocketed.” (p. 119)

Even if it’s not here yet, more inflation, hidden or evident, is on the horizon. For the owner of stocks, that’s good news because “the secular bull will not start until inflation returns to our economy and has time to level off, allowing for growth and innovation.” (pp. 126-27) The best hedge against inflation, the author stresses, is the stock market. Between 1980 and 1999, when the CPI more than doubled, “the inflation-adjusted Dow was up 444 percent versus a 22 percent loss for inflation-adjusted gold.” (p. 122)

What kinds of stocks should profit from the coming super boom? Hirsch identifies five areas to explore for investment ideas--alternative energy, biotechnology and genomics, population growth, traditional energy, and emerging markets—and recommends specific ETFs in each area.

Super Boom may turn out to be a book that’s talked about around the water cooler, but in the final analysis it is disappointing. It’s not that I’m taking issue with Hirsch’s 38,820 target. (In this review I have referred to it as a prediction or forecast even though Hirsch himself writes that “DJIA 38,820 by 2025 is not a market forecast; it is an expectation that human ingenuity will overcome, as it has on countless past occasions throughout history.” [p. 110]) I have absolutely no idea where the Dow will be in 2025.

My problem is that the book is cobbled together from Yale Hirsch’s work, Stock Trader’s Almanac research, and a somewhat superficial survey of twentieth-century booms and busts. Arguments are brief (although on occasion presented more than once), and the reasoning is somewhat elusive. Often, it seems, the author is letting his father speak for him. Perhaps the book was simply rushed to press. Whatever the case, it did not rise to the level of my expectations, admittedly elevated because I have great respect for the Hirsch Organization.

Stein and DeMuth, The Little Book of Alternative Investments

I’m quickly becoming addicted to Wiley’s “Little Book” series. Its most recent addition is The Little Book of Alternative Investments: Reaping Rewards by Daring to Be Different by Ben Stein and Phil DeMuth. With the breeziest of styles the authors transform a topic that is somewhat shopworn into one that belongs on display in a (financial) store window.

The authors believe that an investor should start with a couple of low-cost broad market index funds, such as VTI, VEU, and BND, and then exploit market anomalies to make adjustments at the margins. Here are three such anomalies: (1) value stocks outperform growth stocks, (2) small cap stocks do better than large cap stocks, and (3) low beta stocks “perform better than expected on a risk-adjusted basis.” (p. 22) The authors suggest some mutual funds that capture these anomalies.

And then it’s on to alternative investments, not all of which are attractive. Take collectibles, for instance. The problem is that you always pay retail and you normally end up selling wholesale; you’re buying high and selling low. The authors criticize PBS’s Antiques Roadshow, which “gives viewers a misleading impression of the easy money to be made trafficking in collectibles. Their appraisers always tell people the insurance value or the replacement value of the gewgaw they have hauled in, or what it might fetch in some ideal auction before expenses…. What they don’t say is what they, the knowledgeable dealer, would pay for it in cash money right there and then on the spot, or what we might call the actual value.”

And, the authors continue, although “it’s always fun to watch the delight on the face of somebody who paid $250 for a painting in 1950 when he discovers that it’s supposedly worth $5,000 today … [w]hat this scenario doesn’t show is the opportunity cost: If he’d just put that same $250 in the stock market in 1950, he’d have $130,000 today.” (pp. 43-44) So, scrap collectibles as a good investment idea.

Joining collectibles in the scrap heap are private equity, buy/write funds, structured products, 130/30 funds, and precious metals. Let’s look at just two rejects. Why discard buy/write funds? Many buy/write funds hold a stock index and then sell covered calls against it, a strategy that “delivers nearly all the downside of equities with the upside clipped off.” Others add out-of-the-money puts to the mix, thereby collaring the portfolio. But the authors “were able to simulate the total returns of a buy/write fund from 1994 to 2010 almost to the penny just by putting half [their] money in the S&P 500 index fund and keeping the rest in T-bills. In other words, if you want to control risk, you don’t have to pay fund managers extra money to do it for you this way.” (pp. 56-57)

The case for owning gold is iffy; it “depends entirely on the start and stop dates we choose to make the argument. During certain date ranges, picked after the fact, gold adds a Midas touch. During others—and especially over the long haul—it sits there like lead.” Faced with goldbugs who claim that there are special reasons to own gold now, the authors pull out the ultimate weapon—Warren Buffett, who recently told the authors: “You have a choice. On the one hand, you can have all the gold in the world. It fits into a cube of metal about the size of a large McMansion. Or, you can have all the farm land in the United States. Plus, you can own 10 Exxon Mobils. Plus, you can have one trillion dollars of walking-around money. Which would you choose? Which is likely to be the more productive long-term investment?” (p. 64)

Having rejected several possibilities, the authors turn to the alternative investments a person should consider adding to his portfolio. First of all, commodities and REITs. And, the ultimate alternative investments, hedge funds or “hedge fund pigs in mutual fund blankets.”

The authors give an uncommonly clear account of the desirable alternatives, especially hedge funds. I have shot my wad in this review by focusing on what to avoid whereas the authors rightly reverse this: they spend most of the book explaining what to buy. They describe ten basic hedge fund strategies and then point readers in the direction of mutual funds that try to capture these strategies. They even suggest a way to set up a “do it yourself” mini-portfolio that “has a low beta, a low volatility, and a low correlation to the market’s volatility” and that would be “a satellite to the rest of your holdings.” (p. 186)

All in all, this is a great little book for investors who are trying to improve their asset allocation. Lots of meat and fun to read.

Cornehlsen and Carr, Conquering the Divide

Conquering the Divide: How to Use Economic Indicators to Catch Stock Market Trends by James B. Cornehlsen and Michael J. Carr (W&A Publishing, 2010) is an intriguing read for investors with some talent for system design. The authors are in search of economic indicators that turn ahead of the stock market. “Ideally,” they write, “the indicator would offer a signal in advance of a bull and bear market, but that may not be possible. We will focus on the risk aspects. Spotting a potential bear market early and avoiding losses can be more meaningful to the individual investor than being able to time stock market bottoms.” (p. 79)

Cornehlsen and Carr focus on cyclical stock market trends that reflect the underlying business cycle, trends that can last from a few months to a few years. Using regression analysis, they tested a host of economic indicators to see whether they have any predictive value. Among the candidates (and here I’m pulling almost at random) were the 10-year government bond, average hourly earnings, building permits, consumer confidence, copper, CPI, crude oil, ECRI weekly leading index, employment advertising, Fed funds rate, imports of goods and services, ISM manufacturing and non-manufacturing, retail sales, and the unemployment rate.

A book review is not the place to delve into statistical methodology; suffice it to say that they smoothed both the raw monthly S&P data and the economic indicator data by using a six-month rate of change. They then studied regressions when the economic series led the S&P 500 by three, six, and nine months, when it lagged over the same time frames, and when it was coincident. They determined statistical significance using the P-value.

Of the indicators the authors tested, eighteen proved to be reliable leading indicators. But some of them were available only by subscription, others were redundant, still others had too short a data history, and some just didn’t make sense. The authors therefore winnowed the list down to three: ISM manufacturing, the Baa corporate bond spread, and new orders of durable goods. They then set out to construct a composite model with simple buy and sell rules and tested it out on S&P data from 1992. The bottom line is that following their rules would have more than doubled the performance of a buy-and-hold strategy.

Cornehlsen and Carr’s book opens a window for investors who have a penchant for research and system design. It’s too bad that there is no accompanying web site with Excel spreadsheets, which would make the process a tad easier for the statistically challenged. The tabular summary of the authors’ regression analysis is no substitute.

Sincere, Start Day Trading Now

Michael Sincere’s Start Day Trading Now (Adams Media, 2011) is written for the rank novice who missed the heady days of the late 90s when anyone with half a brain was a genius and who now dreams of catching up. Day trading equities is not a moribund enterprise, but it’s no longer the cash cow that it was perceived to be earlier. Many day traders, butting up against the restrictions of pattern day trading and looking for greater leverage, have moved over to futures. Sincere, however, sticks with equities.

Not surprisingly, a good chunk of the book is devoted to chart reading, interpreting patterns, and using technical indicators. The author also explains the basics of order entry and trade management. Then comes a chapter on Hal—not the computer but a rookie trader who makes every mistake imaginable and in one very costly trade learns 33 lessons.

The penultimate chapter is the most interesting because it contains advice from three professional traders—Toni Turner, John Kurisko, and Peter Reznicek. Timothy Sykes also outlines some shorting strategies. Let me share one quotation that I particularly enjoyed, in part because it starts with the name of this blog (well, okay, I the overachiever claim to read more than one market).

“Reading the market is like getting lost in a dangerous forest… An experienced guide will know what signs to look for, see the animal tracks, and find a way out. If an inexperienced person got lost in the forest, he probably wouldn’t last the night.”—Toni Turner (p. 154)

Although the paperback cover screams “Anyone Can Day Trade!” Michael Sincere is much less sanguine. He points out potential pitfalls and urges caution at every turn. He stresses the need for hard work and continuing education. This is definitely not a get rich quick book. It is a measured, well written account of what it takes to get started day trading.

CSS Analytics

A heads up to readers who thought that CSS Analytics had gone dark except for its weekly update of the Livermore “Active Issues” Index. David is back, offering technical indicators that are the product of data-based, imaginative reasoning. Those of you who aspire to be system traders should try to emulate his thought processes, though you probably won’t succeed.