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Starting a Financial OODA Loop

I want to explore a different and structured way of thinking about investments. I have been involved in investing for the better part of the last three decades so I have seen my fair share of new ways to think about investments. Most of them are of limited utility or are just restatements of the obvious.

Finding ideas in unusual places

I encountered this particular idea about 10 years ago and it really spoke to the way I try to look at investing. I have tried to implement elements of the theory on an institutional level but it didn’t work. Part of the reason is that the theory is designed for use by an individual, not a committee (the latter being the key mechanism most institutions employ to reduce risk). The other part of the reason is that it was always more important to “sell the product” and/or make sure the product performed within the given parameters rather than try to introduce new thinking amongst colleagues in the office or headquarters. If you are Bill Gross, John Hussman or the guys at Oaktree, you can indulge in some philosophical thoughts…the rest of us need to focus on the bottom line.

I came upon General John Boyd’s OODA Loop at the suggestion of an old friend. As usual, he was trying to demonstrate that he was smarter than me (which he is, by the way). There was also an element of my friend hoping to show that he knew a thing or two about F-16 fighter strategy. Why? Because frankly, the thought of flying a fighter jet is much sexier than the desks, telephones and Bloomberg screens that we usually piloted. That said, either one of us would probably get a nose-bleed just standing within 30 feet of one of these machines.

John Boyd’s theory appealed to me because it described what I would call my ideal operating conditions. Not my everyday conditions because believe it or not, there have been some blah days over the last 30 years in my career. Nor am I talking about bull market conditions. Full throated bull runs are great fun but investing in one of them requires all the skill one might employ in falling out of bed. When the markets are running, just showing up is often the most important ingredient to landing a big bonus.

No, I am talking about the markets at turning points and during choppy performance when keeping one’s head on straight, ignoring the specious nonsense, not over trading and maintaining good investment discipline will determine whether you finish the year in the top or bottom quartile. Fund manager votes, hedge fund trades and asset flows all depended upon and flowed towards the best performance. A few bad decisions could quickly wipe out a lot of good will, assets, revenues and profits.

General Boyd developed his OODA Loop to quantify how a good jet fighter pilot makes decisions in a combat situation. The acronym stands for Observe, Orient, Decision, Action and it is meant to run as a continuous loop with feedback from each stage going back into the beginning Observation Stage. As the fighter pilot makes decisions and takes actions, his position in the battlespace changes and his opponents will respond. While much less dramatic and dangerous than dogfighting, we can draw some parallels when we apply the same framework to investing. Once you have decided to overweight a particular asset class or sector in your portfolio, your risk/return profile has shifted. Going forward, you need to take your new position and the different perspective that the new position gives you into your evaluation process. Clinging to the original paradigm or thought processes can lead to many of the cognitive biases which plague all investors to a greater or lesser extent and cause us to lose money.

General Boyd’s thought a lot about how we as humans process information. He observed that in order to make our way and thrive in the world, we are compelled to make a steady stream of decisions. Our ability to make good decisions hinged on our ability to create and manipulate mental concepts to represent observed reality.

His hypothesis was that a pilot who could process observations through to decisions and actions faster than his opponent would be able to win on the battlefield. Perhaps his most significant intellectual contribution comes with the definition of the Orientation part of the process. General Boyd recognised that several different, personalised filters go to work on data. Understanding how each of these filters were build and operate helps the OODA Loop user to optimise the process. As many observers have noted as they have tried to apply the lessons to business organisations, the OODA Loop is optimised for a single user and depends on that user’s ability to cycle through the steps quickly and recycle information, observations, decisions and impressions that such cycling generates back into the start of the cycle. Therefore, it is not terribly well suited to a large organisation where developing consensus and buy-in are important end points for the decision process. As organisations become larger, the consensus building process naturally develops its own inertia. That is why one time innovators like Yahoo, Apple and Google are often seen in the market place buying up nimble startups to ensure that they do not lose their ability to innovate. In a military setting, the aircraft carrier needs to operate on a different tempo to the fighters it launches from its deck.

It is important when using the OODA Loop to have an overarching view of your circumstances. The new information, analysis and decisions and actions need to take place against a specific background. In John Boyd’s model, this is called the Implicit guidance and Control. Fighter pilots do not just take their planes out for joy rides looking for enemy planes to engage when they are in the mood. They have command structures, missions, strategies and parameters. A typical parameter is the type of plane they are flying. If it is an unarmed electronics warfare plane, the pilot is going to react to situations very differently that if he is flying a fully armed top of the line jet. And the mission is important. In a hot war where the opponent is an immediate and deadly threat, the decision to attack is arrived at much more quickly than it might if the two sides were just experiencing tense relations along a shared border.

The same concepts should apply to us as investors. We need to use the information and our own circumstances to decide how to change the composition of our portfolio to return it to the correct orientation to achieve the long term goal or strategy that we have set. That is why “hot tips” are rarely useful. Unless the person delivering the “hot tip” actually knows what your situation is, it is unlikely that the great opportunity he is pushing will suit your situation. It is great to hear that a friend has implemented a fast trading, complex options strategy which is a “sure thing” but unless we are able to watch the markets as closely as our friend, it is probably a non-starter.

And let’s be honest, most of us are not fully armed F-18 pilots with our hair on fire when it comes to investing. There may be fledgling Facebook, Google, Amazon or Federal Express ideas out there and we may even stumble across one from time to time. But sadly, for most of us, we do not have the wherewithal to pursue these ideas to their multi-billion dollar conclusion. It is great to say that we will copy Warren Buffett but unless you have an insurance company’s cash-flow to back you up, decades of high profile experience and a couple extra billion in the bank, many of the opportunities to pick up sweet convertible bond deals will not come your way. For most of us, our near term obligations (mortgage, food, tuition for the kids) are too great to roll the dice on a fantastic but highly speculative idea. That is just the way things are. As in the Air Force, someone needs to drive the refueling plane.

With investing, however, just because we are conservative, perhaps less sophisticated investors today does not mean we cannot train ourselves and get up the learning curve with new methods and new markets. The trick is to make sure than you realise when you are moving out of your comfort zone and keep new ventures small while you are learning the ropes.

Where does one start? How does one take the first step? The beauty of the OODA Loop is that it is designed out of the box to give you that answer.

You do not need to worry about what the right first step is because you have already taken it. Right now, you have an investment portfolio. It may not be a terribly complex portfolio (all in cash at a bank) or it may look like a teenager’s room after a sleepover party (or in my house, almost any morning). It doesn’t really matter because one has to start where one is, not where one might hope to be. The hoping part is for later. That is for where we want to end up. And where might that be? Well, there are generalities that one can assume (enough money for retirement, money for college fees, a second house, whatever). Your goals can be quite personalised. In fact, the more specific, the better. But that is part of the process which will come into play as we take our observations into the second O or Orientation Phase. For now, let’s gather up some observations to see where we stand today.

Observation – the first O in OODA

So how does the world look today? Let’s start by focussing in on observable reality as much as possible. It is very easy to be swayed by the financial media, newsletters, online chat groups, friends and family. We will get to all of that in the Orientation Phase.

Putting all of the noisy bits off to one side, let’s look at the financial markets in terms of what we can measure with hard numbers (Index levels, interest rates, inflation gauges, and other sundry prices).

Starting with the largest and most liquid markets, we look to the US bond and equity markets. Let’s start with that bellwether of risk free return, the US Treasury markets. Even though Standard and Poor’s foolishly chose to downgrade US sovereign debt from Triple-A (an act which had repercussions a few years later), most investors still use US Treasuries as a starting point for pricing investments. LIBOR is another place to look for a short term indication of pricing levels but despite the best efforts of London traders, LIBOR still largely tracks the comings and goings of the larger US Government debt market.

So how do things look in Treasury land? On the face of it, not bad at all. Interest rates are much lower than most of us remember for quite a while. According to the gurus at the Federal Reserve, inflation is not a problem for the near term and the cost of acquiring and holding assets (like a house on a 30 year mortgage) is low and should encourage more business activity. A quick check of the housing markets suggest that quite a few people have taken advantage of relatively low rates which has pushed housing values up to and beyond pre-crisis levels (2006-2007) in some markets. Since housing construction and consumption related to housing makes up a significant portion of America’s GDP (almost a fifth, broadly defined), this is positive.

How about over on the equity side of things? The markets have rebounded smartly from the lows in 2009, setting a string of new records for the broad indices lately. Corporate profitability is at an historically high share of GDP and most of the representative large corporations are in strong financial positions.

The US financial markets are broadcasting a fairly positive scenario for the foreseeable future.

In fact, from the US domestic economy’s point of view, there are only two dark spots on the horizon. Healthcare and overall employment. Healthcare is undergoing a massive reorganisation on the back of the implementation of Obamacare. Love it or loathe it, one-sixth of the US economy is being reorganised and that will mean a period of consolidation as some portions are encouraged while others are cut back. But the larger question mark is the observable (as far as the figures allow) lack of employment growth. The labor participation rate has fallen as the economy has failed to produce enough new full time jobs to re-employ those laid off in the Great Recession as well as absorb the new workers who have entered the market place since 2008. Some of this is due to the start of the great Baby Boom Retirement Wave which may have been front-loaded by the Great Recession (older workers laid off and deciding to retire rather than attempt to reenter the workforce).

Just because we start with the big markets doesn’t mean we can stop there. Often trouble does not show up on the big indices but in smaller or less transparent markets. A quick search of recent history will turn up an avalanche of comforting comments back in 2007 about how a small problem in the US subprime mortgage market was miniscule relative to the overall financial markets, fully hedged and well within the handling capacity of banks. The Asian Crisis of 1997 started in small to middling Thailand and the tiny Russian Government bond market nearly brought the global financial markets to its knees just over a year later when Long Term Capital Management sank beneath the waves.

Europe is the next stop because it also boasts large, liquid markets and, via London in particular, controls a large chunk of the world’s trade finance, derivatives and foreign exchange trading. The Eurozone is actually a larger economy than the United States so it makes sense that the wobbles of its periphery – Ireland, Greece, Portugal and Spain – were enough to throw the world markets into panic on several occasions over the last three or four years. Closer to the core, Italy and France have struggled and continue to labor while Germany, which undertook reforms well before the Global Financial Crisis, powers ahead. Like the US, Europe’s stock markets are dominated by Global Companies which rely on global markets for revenues and earnings. And, with the global economy in a moderate growth pattern, the corporate outlook has been reasonably good for most of the name brand companies listed in London and Frankfurt, the two major markets.

Moving over to Asia, we have a fast growing economy, China, which may be succumbing to the “law of large numbers” at best or perhaps getting ready to pop a major bubble at worst, a former giant, Japan, appears to be emerging from two decades of stagnation and India which has experienced some good growth on the back of economic reforms in recent times but has stalled of late. The rest of Asia has become dependent to a greater or lesser extent on the Great China Supply Chain. Most countries in the Asian Region (including Australia and New Zealand) have seen China become the number one trading partner in the last 10 years. So, until Japan pulls another economic miracle, we can focus on China for now as the leading indicator for the economy and financial markets in this region.

Africa and South America can be overlooked for the moment. Good things are happening in Africa while Latin America appears to be offering a mixed bag of tricks after some solid improvement in the last two decades. For now, we will note that there is nothing surprisingly positive or negative that might impinge on our observations taken elsewhere.

The observations, from this quick spin around the globe, are of reasonable optimism. The bull markets which have raged since the depths of 2009 may be a bit long in the tooth, the commodities Super Cycle appears to have taken extended leave and China may be building empty cities in the desert but the numbers point to growth and profitability for now.

We will refine these observations as we run through the OODA Loop. The important thing here is not to pass judgements but to gather observations and baselines that can serve to help us build the mental constructs that will help us make sense of the observable reality. The judgments and decisions come in the Orientation and Decision phases.

Also note that we have left out most of the political rumblings both domestic and international. We will add them in during later cycles through the loop to spice up the picture. But for now, we will start with the large bits that are easily observable.

Orientation – The Second O in the OODA Loop

Next, we will look at the Orientation part of the cycle. This will allow us to start to make judgments about the facts that we have observed. So, rather than coming to a judgement and finding facts to support our opinion, we are looking at the broad world with neutral eyes first and drawing conclusions later. Hopefully, this will allow us to see the investment landscape as clearly and as close to reality as it is, rather than as we would wish it to be.

Decoupling: Markets and Politics

BarryBen Decoupling: Markets and PoliticsSince the start of the Global Financial Crisis, markets have taken their cues from government policies, political crises and Central Bank interventions. According to the classic Keynesian thinking, this is to be expected as government steps in to make up for failing private sector demand. But also according to Keynesian logic, we should start looking for the government to withdraw as the private sector picks up the slack in a recovery.

Although equity markets still managed a swoon for the messy outcome of the Italian elections, the relatively quiet passing of the “Sequester” is one of the early signs that market participants are starting to look beyond the Beltway for future earnings. Despite all the dire warnings from the politicians, investors decided that they have seen this movie before.

On the S&P500, as represented here by SPY, the markets have basically been flat for the month.

SPXFlat Decoupling: Markets and Politics
Source: Yahoo Finance

Gold, represented here by GLD has been drooping down with only a slight flutter for the Italian election debacle.

GLDSliding Decoupling: Markets and Politics
Source: Yahoo Finance

The markets are saying…

To Washington: that they like the idea of some fiscal restraint and can see through the blatant attempts to make the spending cuts as politically painful as possible.

To the Italians and Europeans: that the Italian election is not the worst thing we have seen come out of Europe in the last 5 years. Germany will foot most of the bill for Europe’s financial reconstruction and it will drive the long, slow agenda to put the Euro back on a sustainable course. Nothing to see here, folks, move along…

Meanwhile over at the Federal Reserve…

Although I personally missed the release of the Federal Reserve’s 2012 unaudited annual report, the Mises Institute put out a readable analysis of the changes. Not all is good news (the Fed is loading up on Mortgage Backed Securities), but overall it appears that the tide is changing. The balance sheet actually shrunk slightly year over year and the FED’s holdings of Treasuries has fallen slightly. The author even finds evidence that the banks are starting to lend more to actual customers rather than simply moving electronic pots of money around the various servers at the FED.

Moderately bullish markets call for moderately risky weightings

Wall Street’s top strategists are calling for a tight range on this year’s performance for the S&P500 (-6% to +7%). In general, the big bears are hedging after being wrong last year while the bulls are struggling to come up with the massive earnings growth figures that their models need to support a big run. What most of them are missing is that the decreasing anxiety amongst investors is raising the appetite for risk assets (primarily equities) over safe assets (like Treasuries). The shift will not be dramatic in terms of percentage points of portfolios reallocated but it will be enough to boost stocks into double digit gains for the year. Risk has not gone away but investors are becoming more comfortable with the risks that are in the market and are willing to pay up a bit to capture more potential growth.

The FundLogik portfolios are still leaning towards riskier assets and investors are still climbing a “Wall of Worry,” a healthy sign in a moderately bullish market: Maintain current weightings.

The “Great Rotation” and Risk

The FundLogik Application continues to point towards a risk weighting. For most portfolios, that means a shift towards equities and away from fixed income.

Last week, we looked at one of the main currents of money flow which drives global financial markets. This week, we look at the factors which drive the money flows into one of the key asset classes available to investors: Equities.

How Wall Street views Equities

According to the collective judgement of investors on Wall Street, a dollar of earnings this year will cost $15 if you select the average Blue Chip stock from the S&P 500. And, for the optimists in the room, that $15 dollar figure for stocks falls to $12.30 if one looks forward to 2014 earnings rather than backwards to 2012 numbers. That same dollar of earnings will cost you $50 if your tastes run to 10 Year US Treasury Bonds. As bond interest is fixed, there is no need to calculate a rosy scenario.

To Wall Street strategists, this big price difference between equities and fixed income suggests an imminent “Great Rotation” from bonds to stocks as rational investors rebalance between relatively expensive bonds and cheaper equities.

Three Factors

3factors The “Great Rotation” and RiskAre they right? The answer is yes but probably not for the reason usually pushed to the front of the research report (stocks are cheap, bonds are expensive). There are three factors which drive stocks and stock markets: Earnings, Interest Rates and Risk.

Earnings: Supportive of Equities

If you limit your focus to quarterly earnings and consensus forecasts, you will see an exciting jump in expectations at the beginning of this year. The numbers that go into the overall S&P 500 estimate are important because most institutional money is benchmarked to the index or a close derivative thereof. If you are interested in some of the key biases which drive the consensus forecast process, ZeroHedge has an insightful article on the subject.

SPX Earnings The “Great Rotation” and Risk
Source: Bloomberg

Before one gets too excited, let’s step back and view a couple of years at once. The phenomenon highlighted with the small red arrows is known as “earnings roll.” Analysts, who are employed by brokerage firms in the business of selling stocks to clients, push their numbers up in the beginning of the year and then adjust them as quarterly reports come out.

SPX Earnings1 The “Great Rotation” and Risk
Source: Bloomberg

So, if you look at the red line on the second chart (which charts the running 12 month forward forecast), earnings are moving in a positive direction but not dramatically. This is supportive of the market but not enough to make the case for a “Great Rotation” on its own.

Interest Rates: Neutral for Equities

This is an easy call because all the Central Banks are working in concert to keep a lid on interest rates. These generational lows in US dollar interest rates have hardly spurred the borrowing and investment boom that some Keynesians had expected. But with debt levels reaching what some consider dangerous levels relative to GDP, few G-20 countries want to think about servicing their debts at high single digit interest rate levels. Rising rates are bad for stocks, falling rates are good. Interestingly, there are new studies suggesting that low and steady levels of interest rates do not correspond to above average stock market returns while high and steady do not necessarily mean poor performance. With no movement expected up or down, this part of the equation is neutral.

Risk: Positive for Equities

The Chicago Board of Options Exchange has an excellent index for measuring the level of risk in the short term (ie. a matter of a month or two) called the VIX. Although this is often cited as The Fear Index in the market, it is important to remember what it is actually used for on a day-to-day basis: pricing options. A high reading certainly does reveal high anxiety in the market and a low reading, relative calm but the measure is by design a short term one.

The risk we are trying to measure is the certainty of forecasts. To give a simple example, the range of expectations for a consumer products company like Proctor and Gamble are much narrower than they might be for United Continental. While the former may stumble in an emerging market or be subject to margin squeeze, the latter can see profits quickly turn to losses with an adverse move in jet fuel prices. Broadly speaking, the tighter range of expectations command higher Price/Earnings ratios (P/E) while the broader range means the company (or the market) is accorded a lower P/E.

Macro factors can also be measured in a similar fashion. When the range of possibilities are uncertain (think some of the hyperbolic commentary ahead of the “Fiscal Cliff”), investors respond with caution and P/E ratios tend to fall. When uncertainties drop away, investors are willing to bid up asset prices and P/E multiples expand.

With the European Central Bank commitment to support the Euro at almost all costs, the passing of the “Fiscal Cliff” and the realization that the trajectory of US Government Debt issuance is likely to pursue a more sedate upward trajectory while the underlying economy continues to grow at a lower but sustained pace, some of the big worries in the market are being calmed.

If one wants a proxy (rather than anecdotal assurances), a reasonable measure of longer term anxiety is the spot gold price. With the arrivals of ETFs, gold is certainly cheaper to hold but the shiny metal still provides no income. Investors buy gold because they are willing to forego income to hedge against the risks they perceive in other asset classes. The FundLogik application and just a cursory look at the charts show that the upward trajectory of gold has cooled dramatically.

Conclusion

The FundLogik application has been flashing “Buy Riskier Assets” since November last year. Now we are starting to see that the market has been a good leading indicator as the conditions for better earnings and a less volatile environment shape up.

Keep holding onto the riskier end of your watch lists…and as they say on the airplane, “sit back, relax and enjoy the ride.”

US Trade Deficit and the “Great Rotation”

Now that we have milked “January Effect” for a nice return, it is time to look forward to the medium term. This idea will take two letters to flesh out. This first part will set up the conditions; the next will describe the catalyst.

Weather and Markets

As the Northeast digs out of its blizzard, it is hard to resist a reference to the weather and its causes.

Growing up in New York, one is introduced to the concept of the Gulf Stream Current in grade school with a few interesting facts:

  1. New York City is roughly on the same latitude as Madrid and Naples.
  2. London’s latitude would put it on the southern shore of Hudson Bay in Canada.
  3. There are palm trees sprouting near the southwest tip of Ireland.
>irishpalms US Trade Deficit and the “Great Rotation”I cannot vouch for the palm trees but the other checkable datapoints suggest that the Gulf Stream is a critical part of what makes Western and Northern Europe quite a bit warmer than one might expect. With an estimated 100x the total global energy demand contained in this “river through the Atlantic”, the Gulf Stream has energy to spare for generating and feeding hurricanes that we give names like Katrina and Sandy.

Ocean currents are both powerful and not immediately obvious to the observer on or near the water. The first map of the Gulf Stream was published by our ambassador to France, Ben Franklin, who gathered data from American captains. When he tried to clue the British in on his findings, he was rebuffed. As a result, American shippers were able to beat the leading global maritime power by a significant margin on trips from England to the US for a number of years in the early days of the Republic.

FranklinGS US Trade Deficit and the “Great Rotation”
Source: Wikipedia

What do currents have to do with the market?

Moving from weather and shipping to the market, the markets also have a current which is known but largely overlooked by the financial media. The largest and most powerful single part of the global economic engine is the US Trade Deficit, currently running at $40bn a month. When US consumers purchase more oil and widgets from other nations than they export, a stream of US dollars are sent overseas to settle the balance. That’s about an Apple Inc. a year ($450bn market cap).

USTradeDeficit US Trade Deficit and the “Great Rotation”
Source: Bloomberg

Exported dollars become imported capital

Those US dollars must return to the US to purchase assets. Sometimes the actual recipient will invest directly but mostly the dollars end up with larger government and sovereign wealth sized entities as exporters turn in their excess dollars for local currency to pay running costs. Those US dollars are aggregated and used to purchase a combination of deposits in banks, property, debt instruments or equity. There have been some fads and there have been some constants. US Treasuries and Agencies have always been a popular choice, particularly for the managers of “foreign exchange reserves” (Central Banks or Sovereign Wealth Funds).

Why Treasuries are always popular

The US Treasury market remains the most liquid of the financial markets. Even after S&P’s downgrade, the question of security has never been a serious issue. In addition to the policy demand from the Federal Reserve, Treasuries have remained the most popular choice for the foreign currency reserve manager. Those two sources of demand have pushed Treasury prices up to what some consider bubble levels and interest rates down to generational lows.

Property and Equity (M&A)

But there have been other bouts of enthusiasm. Large Japanese companies went for property and corporate buying sprees in the late 80’s and early 90’s (remember Pebble Beach and Rockefeller Center?). European corporates have not been shy about snapping up large US rivals when the opportunity has arisen (who makes Bud Light?). And more recently, Chinese State Owned Enterprises have been deploying some of the Chinese cash pile into corporate projects.

The Mortgage Boom

Even though US Agencies like Freddy Mac and Fanny Mae have always been on the shopping list, the biggest boom in recent times has to be the Securitized Mortgage Boom from 2000 to 2008. For those few years, the demand for CMOs and their alphabetic siblings was nearly bottomless as Sovereign Wealth Funds called their bankers in New York and London to put money to work. Mortgages were no longer a cottage industry run by Savings and Loan officers in towns across the US whose banks wore the risk on their books. The loan officers were turned into buyers for the mass production lines run out of the money center banks and investment banks to feed the demand for homogenous, commoditized product. We all know how that ended.

Continuation of the Treasury Bull market

Since 2008, the weight of funds has been towards the short and medium portions of the US Treasury market. Foreign Reserve Managers have not been terribly interested in the long end of the market which is why “Operation Twist” was deemed necessary by the Federal Reserve. There was plenty of demand for the bills and notes that the FED swapped out of to buy the longer term bonds. The FED’s goal was to flatten the yield curve but it would have inverted (short rates higher than long rates) if the underlying demand for the securities the FED was swapping out of had not been there.

Where do we go now? Great Rotation?

Now that we have identified the strongest current of capital flow in the ocean of money that forms the Global Financial markets, will there be any asset class shifts this year which might lead to relative outperformance?

One potential change being touted is the “Great Rotation” into equities by some analysts on Wall Street. From the equity side of the equation, it would not take a massive shift of funds to have an outsized impact on equity prices.

In the 80’s and 90’s there was some equity participation by offshore investors but as we can see from the charts, the total amounts ($10bn monthly deficits) were smaller. Now we are talking about a much larger “river” of capital which needs to be invested. Until the maturation of the ETF product, which allow investors to efficiently and anonymously buy entire indices, it would be difficult to argue that Sovereign Wealth Funds could participate meaningfully in equities because of liquidity constraints.

Means and Opportunity

The funds are in the market as a result of the US Trade Deficit and the opportunity to invest in other asset classes exists with the mass adoption of ETFs. But, as any seasoned investor knows, the necessary conditions are only part of the equation. The investors will need a catalyst to shift their asset allocation assumptions.

And now for Motive

Are we on the cusp of that asset allocation shift or has January been a temporary blip of enthusiasm? In our next newsletter, we will explore the one factor that may tilt the balance in favour of equities. If we are right, what has been termed a “melt up” could become a full fledged bull market move.

Stay with the “risk on” trade for now.

A Good Apple or a Bad One

One of the most common questions we get is whether a particular asset is “good” or “bad”. Usually, the investor has been looking at an asset and wants to know if now is the time to buy or sell. We tend to view assets that are going up as “good” and those that are going down as “bad”. That is, unless we are buying things from a store. In that case, a deep discount sale is definitely to be regarded as “good”…but we digress.

It is hard to know how to answer the good/bad question because assets are neither good nor bad. They are merely the building blocks for an investment strategy. Also, one can rarely assess an asset in isolation. And finally, the price one pays for a particular asset goes a long way towards determining whether it represents good value to the buyer.

So the black and white question has quickly morphed into three separate considerations, two of them strategic and the final one tactical.

  1. Does the asset make sense as a candidate for a particular investor’s investment strategy?
  2. If yes, are there other assets that could do the job just as well or better?
  3. At current prices, is the investor over or underpaying for the asset?

Since we are already talking about good apples or bad ones, let’s look at the company which has filled my house with iProducts. Is Apple a good company? Most reasonable people would answer yes. This is a company which has changed and in several cases invented several categories of consumer electronics and made buckets of money in the process.

But let’s look at it through our three questions.

  1. Should you consider Apple Inc’s common equity as a potential investment for your long term investment strategy? What is your risk profile? What is your investment time horizon? Is this a company that has staying power like Microsoft, Intel and Google? Or is it a Dell, HP or perhaps a Yahoo? Will it continue to lead or could it lose its way. Will it reward you as a shareholder? And if so, how?
  2. Are there other companies (singular or in combination) that give you exposure to the same market segment or investment opportunity as Apple? Are they better? Worse? Up and coming? Or fading? Do you need to pick one company or is there a fund or ETF that gives you exposure to the thematic risk without exposing you to too much individual company risk?
  3. Is Apple a good value at these prices? Well, what are you looking for? Are you looking for bold M&A strategies, new must have products and explosive growth? Or are you looking at low relative P/E ratios and strong cashflows to support a healthy and growing dividend. Are there better opportunities?

As you can see, even for one simple equity the question of whether it is good or bad is not as simple as this modified 1 year chart.
apple1year A Good Apple or a Bad One
Source: Bloomberg

What should an investor do?

Approach investing from a broad perspective. If you start from too narrow a perspective, you run the risk of asking the wrong questions. The risk is that the person who answers that question may not take the time to work through all the strategic and tactical considerations before giving you the proverbial thumbs up or thumbs down. If you ask the wrong question, your chance of getting the wrong answer increases. And more importantly, you may not even understand why the answer is wrong.

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