Rebalancing vs. Buy & Hold

In these tumultuous times, one wonders what sort of investment strategy to adopt. The modern portfolio theory rule of thumb would be to "stick to one's guns" by remaining thoroughly diversified and keeping a disciplined approach to rebalancing the portfolio when asset class weights deviate "too far away" from a defined optimal value.

Rebalancing can actually be tricky in times of high volatility not only because it may require quick action to counter large sways in the market but also because of the additional transaction costs that frequent "adjustment" trading could entail.

There is, however, an optimal level of rebalancing that can be implemented, depending on market volatility conditions. Studies show, for example, that rebalancing (adjusted for transaction costs) outperforms buy and hold strategies in periods of high volatility where markets experience sharp reversals. The opposite occurs in bull or bear market conditions, where the markets follow a clear trend. In this environment, buy and hold strategies tend to outperform rebalancing.

An optimal portfolio allocation strategy would therefore be one that is a function of the volatility levels of the markets. When volatility levels spike, as they have over the last couple of weeks, it would trigger a rebalancing signal for the portfolio. This could be in the form of a tightening of the rebalancing band limits of the respective asset classes. In contrast, when volatility levels are subdued, those same band limits should widen, reducing the probability of rebalancing but not eliminating them altogether, which would be risky, especially in transition periods from low volatility to high volatility.

A double dip?

According to the latest remarks from the Fed, the stimulative policy that began soon after the sub-prime crisis began in 2007 is likely to remain for some time to come. If we read between the lines, this would basically mean that the Fed is becoming increasingly pessimistic on the growth prospects of the economy and rightly so, considering the growing deficits that the U.S. and Europe are facing. In fact, as we have been saying since the end of 2008, this crisis is likely to remain with us for at least another couple of years. There is no quick way out of it, unless a very aggressive form of "financial repression" combined with hard core austerity is forcibly implemented, but if the U.K. riots are any sign of how ugly things can get, there doesnt seem to be much that can be done in the short run.
Market sentiment in this environment has become risk averse to such a degree that even treasuries, that recently lost their triple-A rating, have actually been rallying. This would be the second time in four years that "pundits" have gotten the direction of interest rates seriously wrong.
In summary we should be embracing ourselves for a global "double dip" as the U.S. increasingly embarks into what looks like an austerity program in disguise!

A revised Big Mac Index...

One fascinating index that has gained in popularity through the years is the Big Mac Index that is published by the Economist newspaper. It is interesting because it provides a very different approach to measuring the over or under valuation of exchange rates, based on the Purchasing Power Parity (PPP) theory which states that in the long run, the exchange rates between countries should adjust themselves to bring about parity in prices.
As the "Big Mac" is a commodity that is readily available in most parts of the world and because its price is very easy to obtain prices, it is very suitable for making cross comparisons.
One large drawback with the measure, however, has been that it does not adjust for differences in productivity which means that for emerging markets with cheaper labor, it will tend to introduce an underweighting bias to the figures. This bias is confirmed by a simple regression of the price of a Big Mac to GDP per capita. There is a clear positive correlation between the two.
In order to account for this, the Economist recalculated its figures by adjusting for differences in productivity. The end results are very different from the original calculations. China, for example, which was thought to have a currency that was undervalued to the dollar, according to the original figures, now finds itself slightly overvalued with the new calculations! It is also interesting to note the substantial overvaluation of the Brazilian Real and the continued overvaluation of both the Swiss Franc and the Euro.
In these times of growing uncertainty and rumors that official CPI figures may be rigged, the Big Mac index provides a more reliable measure of the PPP adjusted currency exchanges.

Playing with fire...

...describes well the dangerous games of partisan politics in the U.S.

Postponing a deal on the debt ceiling which is scheduled to expire in the beginning of August to the last minute is akin to playing with fire not because they will not strike a deal before the set deadline (they most likely will) but because the markets are right now at arms length of entering panic mode as tensions continue to build up. Our June newsletter outlines the so called "clear and present dangers" that are on the sidelines, waiting for that as yet unidentified catalyst that could trigger another dreaded crisis on the markets.

It should be noted that the U.S. debt debacle is taking place on the backdrop of a clearly worsening debt crisis in Europe, which is now showing signs of spreading to the bigger peripheral country economies of Italy and Spain. The reason why investors have become so jittery is because both Spain and Italy happen to be just too big to rescue.

Although stock market volatility rates remain subdued there is a clear "flight to quality" momentum that is building up as gold, the Swiss Franc and government bonds of countries perceived to be less affected by the debt debacle break records.

So what is one to do when the threat levels are just one notch before panic mode? Well, for one you should stick to the old adage of ensuring a sufficient degree of diversification. But you also run the risk of losing more through diversification if things suddenly improve. That is because the probability that things are going to get worse currently have a greater weight in the market pricing of assets than the probability that things will improve, so if things do improve and you are diversified into investments that are meant to protect the portfolio in bad times, those are the ones that will suffer the most. It is always easier to construct a portfolio in stable rather than unstable market conditions because the risk premium component of the value of an asset will be a smaller percentage of the total. So there is a timing element to diversification but that should matter less over the longer term.

On the horns of a dilemma...

At each cry of help, the powers that be are injecting a potent but short lived dose of life sustaining matter into the system, but this is unfortunately just another case of too little too late. The political setup of this European "experiment" is their "Achilles heel" that impedes them from doing what is needed to avoid a train wreck. With the record erosion of the Euro against the Swiss franc and European stock markets now firmly in negative territory there is little that can be done to stop contagion from spreading. Default is still in the cards but the more time passes the less likely that it can be conducted in an orderly manner.
Mind you, the U.S. is in its own mess too, still recovering from a colossal debt burden and no way out of it, other than to print more money to buy more time. Still, the fact that the U.S. enjoys both economic and political integration puts it at a major advantage to Europe, and right about now, the markets seem to agree with this.

Distrust with a slump...

The steady rise in the value of gold to a large extent reflects the eroding trust in the monetary authorities of the world, most notably those of the U.S. and Europe. Commodity prices have been following the same pattern until very recently. The price of oil, for example, has been surging on the back of speculation related to a potential constraint on the supply side, reflecting the ongoing conflicts in the Middle East. This speculation has also appeared on the demand side, reflecting the anticipation of more demand from emerging markets and, at a more distant future, greater demand from developed markets as their respective economies recover.

More recently, the price of oil has seen a sharp drop in value reflecting the economic turmoil that is brewing across Europe and the U.S. In the speculators mind, two things have changed on the demand side of the equation. Emerging markets, battling a surge in inflation are applying the monetary brakes more aggressively whilst the economic conundrum in Europe and the U.S. that seems to be showing signs of worsening is likely to postpone any sustainable recovery to a more distant future.

In summary, what these two indicators are telling us at this point in time is that the distrust in monetary authorities continues but that the global recovery is in peril.

Gold, the pseudo commodity...

Asset managers and investors typically classify gold as a commodity. After all it shares characteristics of commodities such as the fact that it is tangible, can be traded and is used in the production of goods.

Gold also has certain characteristics that is highly specific to it that really put it in a class of its own. The price of gold, for example, is not impacted by changes in demand and supply, unlike commodities. This is because annual demand and supply are only a fraction of the outstanding gold in circulation. This characteristic makes it curiously similar to paper money or stocks, with the big difference that gold does not produce any revenue or cash flow streams and therefore does not have an intrinsic value. The price of commodities, on the other hand, are very much impacted by current and expected demand and supply dynamics. Almost all of the supply of a commodity will be consumed in one form or another, only a small portion is stored indefinitely. In the case of food, this is pretty obvious whilst in the case of hard metals, it is converted to become part of something else in a production chain somewhere around the globe.

So what is it that influences the value of gold? There are several factors that have an impact on the price of gold. Amongst the most important is sentiment, more specifically how much confidence an investor has on monetary authorities. If confidence is being eroded, the price of gold is likely to go up as it serves as a refuge investment in the event of uncertainty in the financial system. This is also the reason why the price of gold rises when there is "money inflation", which is exactly what is happening in the U.S. today.

Gold is not only a surrogate for money, it is a powerful diversifier that softens the blow when monetary authorities get it so very wrong. This makes it a rather unique investment which is why any sound portfolio should contain some.

Paving the way for QE3?

Things are not looking good on the housing front in the U.S. The latest figures show that prices slumped yet again in March, dragging the closely watched Case-Shiller index to its lowest point since the start of the downturn (see graph above).
Sure, there is still some distance to go before the housing bubble is completely burst, but any further drop in prices will be a drag on the economy as it widens the already dire "negative" equity situation for a large number of households.
Quantitative easing is a critical tool in maintaining a floor on housing prices because of its influence on the 10 year maturity yield. A large number of market participants including mortgages, pension funds and the good old dividend discount model (DDM) use it as a benchmark to set their rates. In other words, the latest housing price figures are likely to put additional pressure on the Fed to do something post QE2 which will end very soon.