Category Archives: Portfolio Management

On Bubbles

Charlie Bilello from Pension Partners pointed out that the CAPE is now over 30. His piece is balanced and well written as always but it won’t prevent others from using the data to once again proclaim that the market is expensive and that we’re in a bubble, etc. So far so good and I might even agree. But if the implication is that there is impending doom then I have to beg to differ.

Many writers, the eminent Larry Swedroe among them, have argued that the historical context of the P/E ratio has evolved. I find no reason to doubt them, so let’s take the shorter term relative movement as an indication of multiple expansion or contraction. In 1921-29, the CAPE ratio went from 5 to 30, for a gain of 6X. In 1982-2000, the CAPE ratio went from about 7 to 44, another 6X. The CAPE low of 2009 was about 12.5. Now I’m not about to forecast a CAPE of 75 (although within the realm of possibility, cf. Japan 1990), but surely an increase of mere 2.5X can’t be the end of this bubble if it can be called such? If this is indeed the coming-home-to-roost of all the QE by all the central banks since the great financial crisis then we will have much, much further to go. To say otherwise is to say “this time is different”.

I have been saying on this blog since last November that we’re entering a generational bull market. Currently the model is seeing a consolidation low in July, flat in August, but a truly maniacal phase for 12-18 months thereafter.

Speaking of bubbles, the Collaborative Fund recently published The Reasonable Formation of Unreasonable Things. Here are a couple of gems:

The majority of your lifetime investment returns will be determined by decisions that take place during a small minority of the time.

Bubbles are not anomalies or mistakes. They are an unavoidable feature of markets where investors with different goals compete on the same field. they would occur even if everyone was a financial saint.

It’s a hallmark of thought-provocativeness that the readers may draw different conclusions from the ones the author intended. It reads to me that one of the article’s main purpose was to warn long-term investors of the dangers of irrational pricing during bubbles. Pointing out the difference in goals and time frames was a beautiful rebuttal to EMH which sometimes is used to justify “buy at any price”. But to me the greater take away was the importance of the bubbles — rational, inevitable, and the driver of long term returns that those smooth, monotonically uptrending curves from a fantasy land called Excel would have you overlook.

Two recent articles by Jason Zweig (here and here), speaks to the difficulty of riding a bubble: specifically, a money manager Samuel Lee and his experience with Ethereum. Except in this case, the final chapter, or more than likely the second act, has not yet been written. Jason Zweig is too good a writer and has too much understanding to express an opinion other than saying it’s really hard. So here I would like to give myself some pointers that I hope to follow:

  • Participate — showing up is half the battle, especially when others are calling it a bubble.
  • Don’t be greedy. Position size control is paramount. Set a volatility limit as well as a position limit.
  • Do not envy those in earlier with a lower cost basis, nor those in later with a larger position.
  • Take profits, often. It’s impossible to catch the exact bottom or top. Play with the house’s money.
  • Do not take positions to justify a point.
  • The majority of the portfolio should be in an allocation that one would have in the absence of bubbles.

The last point is an import one for me. My speculative positions are benchmarked against cash, not the 60/40 much less 100% stocks. Why would it be otherwise if the bubble is expected to be short lived? Taking profits, even partially, forces one to re-evaluate the whole position.

We live in interesting times. I see three bubbles in progress or developing that require very different treatments. In cryptocurrencies, I have taken a position and am simply content to sell a little bit as prices rise. In PMs I have a 15% baseline allocation but trade around the cycles. Exposure can be increased by being in silver, miners, 3x ETFs and options while maintaining the same nominal allocation. In stocks and Nadaq in particular, I’m willing to increase the overall allocation along with highly leveraged option positions. These are in contrast to their neutral allocations of 0%, 15% and 45% (for all equities), respectively.

The next year or two should be very interesting.

Investing Philosophy

I’ve been meaning to update the my portfolio post which is linked under the “portfolio” navigation tab, but I’m in the process of deploying cash as part of the on-going correction. So I figure I’ll write a separate post about my investing philosophy.

Below is a list of the basic tenets that I try to follow:

  • Long biased
  • Globally diversified
  • Minimize taxes and expenses
  • Diversify sources of return
  • Strategy diversification
  • Market timing according to cycles of years of duration or longer
  • Use options to generate income and smooth the ride

The first three bullet points are in the “main stream”. As a rule, I don’t have a regular “cash” allocation in either passive or active strategies. Instead, there is a separate emergency fund component in the total portfolio. I’m also far more comfortable being long than short. In the passive accounts at least, I maintain a 50/50 US/international split in equities, although the composition such as large/small US equity or international developed/EM can be fluid. To the third point, I maximize tax deferred contributions every year, including back-door Roth. All assets in the passive accounts are tax-advantaged with the exception of physical PM bullions. In the active accounts, the taxable fixed income CEFs are in tax advantaged as are about half of PM miners and bullion funds. Expenses are minimized by using best-of-breed funds for each asset and doing everything myself. In passive accounts, that means Vanguard index funds/ETFs or equivalent. For individual stocks, I use InteractiveBrokers where the commission is usually under 1 basis point, and partially covered by the interest from security-lending. My expense ratio for holding stocks is at least one order of magnitude less than that of the lowest cost index funds.

The fourth point “diversify sources of return” motivates me to look beyond the traditional stocks and bonds. It’s the reason I have a significant allocation to leveraged fixed-income CEFs (target 24% of active). Taxable multi-sector CEFs have equity like returns and volatilities but are no more than 40% correlated to equities (e.g. VTI, correlation is period dependent, cf. PortfolioVisulizer.com). Leveraged muni CEFs provide tax-free income and even lower correlation to equities (same comment as before). In contrast, sub-sectors within equities are correlated to whole at 90% or above. In the context of mean variance optimization, assets with reasonable returns AND low correlations are extremely valuable in portfolio construction. This is contrary to the Bill Bernstein view that one should take risks in equities and fixed income is for safety — a view that unsurprisingly leads to equity dominated portfolios and equity dominated risk profiles. Note that when the fixed income allocation is viewed across my entire portfolio, the risk profile is a “bar-bell”: stable value funds in passive and leveraged CEFs in active. Diversification is also a reason behind my overall 15% allocation to PMs which I discussed here. The blog post by Charlie Biello is highly recommended — I think of it every time I read a straw man attack on gold along the lines of: gold is thought of useful as an inflation-hedge, data shows it is not; therefore gold is useless. Another often-heard objection is based on the inclusion of gold’s return data just 1975 when gold ownership was again legal despite data from PortfolioCharts shows gold’s ability to lower volatility from multiple starting and ending dates. From a portfolio construction perspective, the only requirement for the inclusion of gold is the low correlation to other assets. I haven’t seen any evidence or prediction that this correlation is going to change in the future.

The fifth point “strategy diversification” speaks to my adoption of both passive and active approaches. The passive/active debate is all the rage in financial media today. Passive is clearly winning and the shift is far from over. Lower fees is undoubtedly beneficial to the investing public. However in so far as the democratization of investing makes it easier to invest and funnels more capital to assets, their valuation must rise thus suppressing future returns. A recent post from the always-insightful PhilosophicalEconomics discussed from a similar perspective. As passive grows in dominance, another danger is the synchronization of investor’s emotional response to market declines. This is a major reason I employ both passive and active strategies so as to be able to hedge from within the active accounts when the time comes. I also try to avoid the most obvious pit falls in active, i.e. high fees, lack of diversification, to at least give myself a shot at beating my benchmark.

The sixth point “market timing” is perhaps the most controversial. My reasons were laid out this post. The primary objective is to avoid large draw downs in preparation for early retirement within 10-12 years. If my portfolio should suffer a 30% draw down, there would be a significant impact on the quality of retirement or alternatively the retirement date. I haven’t been able to find a static asset allocation that provides adequate protection while simultaneously provide a high return – that pretty much captures the main dilemma facing all investors. A more diverse allocation can reduce the size of the hedges necessary but no static allocation can ever be truly “all weather”. I believe the solution is market timing but only at the right intervals. The tools I rely on are a specific equity pricing model and technical analysis. A second objective of market timing is to enhance returns. I have been say since last November that we’re entering a blow-off phase in the stock market; the view reinforces my long bias and allows me to increase my equity exposure from a baseline of <50% overall. My current projection for the market top is S&P 3000+ sometime around Q4’18 to Q1’19. I also see PMs in a bull market which gives me license to go above a baseline allocation of 10% gold bullion to include silver and mining equities that are leveraged to gold. My current view is that PMs will top after equities, probably later in 2019. Gold should be over $3500 and has a good shot at $5000/oz.

Lastly I use options to enhance returns. More opportunities are provided by directly owning individual stocks than an index as the parts will move more than the whole. I’m a premium seller since it’s known that realized volatilities are lower than implied volatilities. I predominantly sell margin/cash secured OTM puts on stocks I’d like to own while use technical analysis for entry points. From time to time, I also use options for leveraged longs as discussed here.

So there you go, these are the seven tenets that guide my investing decisions. People attach an almost religious fervor to their chosen investment approach, so I’m not out to convert anyone. It is a human condition that no amount of back testing or modeling can predict the actual returns which will only be known at the end of our investing lives by which time it’s too late to change. I have made peace with my path and will accept anything that comes my way.

A Correction May Be Upon Us

The long waited correction may be finally upon us. The 1%+ drop in the S&P on Mar 21st was the first in over 100 days. The bounce on the 22nd was anemic and accompanied by low volume. Most of today (23rd) was spent in positive territory but sellers took over in the last two hours — a very tell-tale sign. As in the chart below, we have broken below the trend line from the November election. Given this evidence, I’m of the opinion that an intermediate correction of months in duration has started.

I’ll go out on a limb again in trying to forecast a duration and depth of this correction. My model is signaling a bounce in April and a resumption of decline in May with a hard drop and bottom into July. I have little confidence in the exact path but a correction of 4+ months in duration will match that of the rise, a symmetry that would be appealing. The Fibonacci levels for this “Trump rally” aligns nicely with regions of minor support/resistance. I don’t trade at those time intervals but it’s interesting nonetheless. Given the nature of the in-flows of this rally, and that the market is never kind to Johnny-came-latelies, there is a high probability we’ll retrace all the way to the November bottom and more. I would go so far as saying that the “Brexit” bottom of 1991.68 is also in play.

Why do I bother with this kind of predictions and what do I plan to do with that information anyway? First and foremost it’s to develop a feel for the market and secondly to build confidence in the model. I’ve been clear on my approach to market-timing. My main goal is to be able to avoid the “big one” and ensure that my family is provided for. The skills that I’m honing are essential in deciphering the macro trends.

Since the inception of this blog, my most significant market timing move, in terms of duration and amount of capital, was the avoidance of nominal bonds. 35-40% of my passive portfolio has been in stable value funds paying 2 or 3% per annum. It’s been a good move — AGG has lost 3% since Aug’16. Compared with that that my pruning of stocks is rather opportunistic. In full disclosure, my pace of selling picked up in Feb/Mar, but it was not due to my market view. The main reason was the rotation in my fixed income allocation precipitated a desire to limit dividend payouts. This morning I closed out the MCD/DIS option spreads mentioned in this post, along with a couple other positions to give me a 12.7% cash position in my active portfolio. I don’t have plans for more sales; instead there are 7-9 buy candidates. My longer term view remains that we are in a full-blown bull market; but first, we’ll have to wait out this correction.

Performance Tracking January 2017

For calculation methodology see earlier post

2017 started with a bang — precious metals performed well even though it was looking to retest the 2015 lows at the end of last year. Since PMs are the main drivers in the “tracking error” (I hate that term!), my portfolio did well relative to the overall market. The S&P also had a good month, gaining 1.79% while the bonds gained 0.21%, meaning the benchmark 60/40 portfolio picked up 1.16% for the month.

Passive Portfolio

The total passive portfolio gained 2.11%, the portion outside of the 15% allocation to PMs gained 1.34%. In this post, I outlined my plan to increase the equity allocation by 5%. I’m about half way done. Funds has already come out of TBM but has not been added to equities just yet. The market has been directionless for a long time. Since the model has a low in February and I know it can’t be timed perfectly, I have already started to transfer funds slowly. I can only access the emerging market index fund, VEMAX, in a Roth IRA at Vanguard and the space is limited. Hence I had to dial down its allocation by 1% and shift to VTIAX. The allocation for the rest of 2017 looks like this:

Active Portfolio

The overall active portfolio gained 2.37% despite the drag from DGI whose main culprits were victims of presidential tweets and Target. Large changes are being made in FI: reducing muni CEFs in taxable and adding to taxable CEFs in taxed advantaged. I’m using this opportunity to cull back certain dividend stocks.

Plan and Forecast

Transition to my AA is straight forward and should be completed by the end of February. In the active portfolio, the goal is to maximize tax advantaged space for taxable CEFs. Consequently, dividend stocks will all end up in taxable. Tax considerations alone forces me to favor stocks with high dividend growth over high current payout. Currently, the blended payout ratio for my DGI stocks is 2.74% vs. 2.03% for SPY and 2.93% for VXUS. I expect this ratio to come down further. I’ve also started positions in MKL, aka “the baby Berkshire”. It doesn’t pay any dividends so doesn’t count towards DGI. I’m taking my time to buy the taxable CEFs as they have all been on a good run — patience is definitely a virtue. This process may continue well into March or April.

Portfolio Changes 2017

A new year is always a time for reflection and planning for the future. This is especially true for one’s investments. My investment policy statement (IPS) allows for a once-a-year plan review and gradual changes in my passive allocation. Those changes don’t have to be implemented right away and can subject to a range of dates or pre-conditions. The important thing is to keep a record of them and hold myself accountable.

2016 Results

I was quite happy with the portfolio level gains in 2016: 10.87%. It was calculated with the Simple Dietz method which meant contributions were properly accounted for. One of my pet peeves for many personal finance blogs is the co-mingling of contributions and investment returns. Another widely used formula is (end value – start value – contributions)/start value. It’s generally fine except when the contribution is large. The simple Dietz method adds half of the contribution to the denominator to approximate the time-weighted return. The 10.87% figure was calculated on an annual basis, more accurate would be to chain link monthly figures. Unfortunately the official record for this blog was only started in August. I’ll have much more data to work with in the future.

AllocateStartly had a summary of various allocation strategies for 2016. The Golden Butterfly portfolio which I drew inspirations from was the top dog at 10.79%, while the benchmark 60/40 portfolio returned 7.71%. So it doesn’t seem I have much to complain about. Though in all fairness I took on more risk — I have silver/miners in my PM sector, my equities are higher and cash position lower. Conversely, the equity slice-and-dice to include international hurt my returns. The timing of the start of this blog was unfortunate as July was the high watermark in terms of percentage gains. I gave back more than 3 points in the 2nd half of the year while the S&P was going gang-busters, so the results from August look rather poor. I’m an unabashed market timer, so that’s definitely something to improve on.

A New X

I have no plans to disclose actual dollar amounts — I hope it doesn’t detract from the ideas discussed here. At times I have spoken about the portfolio value in terms of X, where X is my non-inflation-adjusted, no-mortgage, target annual pre-tax retirement income. More recently, after some thought about desired life-style and future medical expenses, I’ve decided to increase X by about 10%. I don’t foresee any further changes to this figure.

Current investible assets stand at 17X after a contribution of 1.3X and a gain of 1.6X in 2016. I define “financial independence” as 25X plus a paid-for primary residence. There is still 4.5X left on the mortgage. Being naturally conservative I’ll probably keep working until reaching 30-35X. This amount will also include any future financial support for my daughters. There’s definitely some margin of safety in X, such that I call investible assets at 20X “financial independence lite” even without paying off the mortgage. It’s tantalizingly close, with luck may even be reached in 2017.

Passive Allocation

My guiding assumptions for the next couple of years are based on an equity pricing model I have been following. So the plan is to increase the equity allocation slightly after a drop in the market in the first quarter.

I’ll maintain the 50/50 split between US and international and increase the overall equity allocation by 5% which comes out of TBM. No changes in PMs.

Active Portfolio

The active and overall portfolios don’t follow a set allocation, although I do check it for risk management purposes. The overall equity allocation may grow to 55% by the end of 2017 from 50%. I expect the DGI portfolio that is heavy in consumer staples to under perform the broader market but don’t plan to make any major changes. Additions to the DGI will likely be old tech (MSFT, QCOM, CSCO), or a high-growth, low payout name like V. I plan to add more to growth stocks, currently at 7% of the active portfolio, and bring it up to 10%.

Option writing was a reasonably successful endeavor last year but my activity tapered off as job responsibilities increased. It’s still something I plan to continue this year, although I don’t have a target in mind. It is reassuring to know that if I ever lose my job I can generate some income this way. I do plan to use more synthetic equities (buy call, sell put) as a means to increase leverage. More details will follow when I open such positions.