Vanity of Vanities

Vanity of Vanities

Market Shadows Newsletter, Vanity of Vanities (11/5)

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Event Horizons

Storm of the Century, Fibonacci Spirals and No Silver Lining

The Storm of the Century was a painful reminder of how fragile life is. We have been taking many things for granted, such as our ability to harness nature. Although we can, sometimes, gain control and outsmart natural forces, Mother Nature likes to remind us that she is more powerful than we are. The rule of unintended consequences is always a step (or many) ahead of any plans we may construct in its opposition.

An interesting article in the Atlantic Cities illustrated this point and revisited the forgotten dangers of building too close to the shore lines.

The coasts we live on are not natural phenomena, but human phenomena,” [John R. Gillis] says. In his book [The Human Shore: Seacoasts in History], Gillis writes about how beginning in the 18th century, Western cultures began to re-imagine and rebuild the shoreline to suit their commercial purposes, creating hard boundaries where tidal areas and marshlands once blurred the edge between sea and land…

Gillis sees the destruction brought by Sandy as the inevitable result of a pattern of development that disregards all that history tells us about the ocean and its role in daily human life. ‘We’ve built right up to the edge in the most foolish way,’ he says. ‘The whole coast is now an extended suburb.’…

‘The sensible long-term thing is to think in terms of retreat,’ he says. Only by regaining our respectful distance from the water’s edge, says Gillis, can we truly protect ourselves from the cost – both human and financial – of living on the margin where sea meets land. (‘We’ve Built Right Up to the Edge in the Most Foolish Way’)

We cannot quantify the human costs of Hurricane Sandy, but the financial costs have been estimated as running somewhere between $30 billion and $100 billion.

Taking a numerical look at our recent natural disaster, the hurricane pattern fits nicely into the Fibonacci spiral. In so many ways, life traces out ubiquitous mathematical patterns. Books have been written, and trading systems designed, based on applying the Fibonacci sequence to a myriad of diverse phenomena. (For more read, Fibonacci in Nature: The Golden Ratio and the Golden Spiral.)

 

Screen Shot 2012 11 03 at 11.09.21 PM Vanity of Vanities: Event Horizons

(Picture credit: SHEA GUNTHER)

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Last week,  took on the Keynesians in his essay “Hurricanes do not have a silver lining.” He concluded that GDP is a flawed measure of wealth, and that natural disasters, such as earthquakes, storms, and disease, and wars, are economically (and humanly!) very destructive. Below are highlights from Pater’s excellent article, Hurricanes Do Not Have a ‘Silver Lining’.

Breaking Windows isn’t Good for the Economy… 
It didn’t take long for mainstream economists to provide us with some inane commentary regarding the latest natural catastrophe. Allegedly, the massive destruction of wealth hurricane ‘Sandy’ will leave behind has a ‘silver lining’.

The WSJ for instance reports (under the heading ‘Hurricane Sandy could boost GDP growth’):

“While natural disasters take a large initial toll on the economy, they usually generate some extra activity afterward,” Moody’s Analytics economist Ryan Sweet wrote on the firm’s website Monday. “We expect any lost output this week from Hurricane Sandy will be made up in subsequent weeks, minimizing the effect on fourth quarter GDP.”

Jason Schenker of Texas-based Prestige Economics said hurricanes like Sandy usually lead to a bump in economic growth, mainly through stronger retail sales. In a note to clients, he cited to “the last minute run to hardware stores and supermarkets, or after-the-storm replacement of furniture, windows, cars, and other damaged durable and non-durable goods.” He said that, barring major damage to infrastructure in the mid-Atlantic region, Sandy will likely help retail sales in November.

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The loss of wealth the hurricane has inflicted is very real; the wealth destroyed by it is most definitely gone. GDP does however not measure the existing stock of wealth and the impact the hurricane has on it. It measures the annual flow of wealth creation (although we must stress that the statistic nonetheless remains deeply flawed and can definitely not be accepted at face value), but it tells us nothing about existing wealth or its destruction. Maybe they should at least have mentioned that?

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Market-Moving Forces

The fiscal cliff – a conundrum that our government backed itself into – has been receiving attention because it begins in 2013.  It comprises the end certain tax breaks and the introduction of new taxes…

As certain tax breaks end, spending cuts agreed to as part of the debt ceiling deal of 2011 will begin to take effect. According to Barron’s, over 1,000 government programs – including the defense budget and Medicare – are in line for “deep, automatic cuts” ($98B).”  It is estimated that the economic drag produced by the effects would be in the range of 3.5%. The debt ceiling is also coming into play again, as we are ‘only’ $133B away from that magical number where we hit it!

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Mutual Fund Flows

Mutual funds have seen an outflow from their coffers over the entire year, with up to $100B being withdrawn and either spent paying bills, or moved into bond funds or savings accounts that earn nothing.

According to Investor’s Business Daily, in September, investors pulled $24.36 billion from stock funds despite a rising market!  Bond funds, year to date, have taken in a $238.27 billion vs. $83.61 billion last year.

 

Source: Chris Kimble (http://blog.kimblechartingsolutions.com/wp-content/uploads/2012/10/bondstockflowsandresultsoct161.gif)

 

Nevertheless, investors are starved for yield, and the Federal Reserves’s QE is shifting the curve to riskier fixed income assets, which is driving down yields. Investors are soaking up bonds that pay small spreads over the artificially propped up Treasuries. (In last week’s Value in the Eye of the Storm, Paul Price argued that bonds are in bubble territory.)

According to Sober Look, “New issue investment grade corporate bond market continues to run hot… investors are chasing quality paper and willing to accept historically low rates… Current treasury yield investors are taking Caterpillar risk for 5 years to receive about 1.35% per year in total coupon. This is below some 5-year FDIC-guaranteed CDs (Barclays will pay 1.7% on a 5yr CD). CAT is a strong company, but most individual investors would generally prefer FDIC risk, particularly at a higher rate. The point is that 1.35% is just ridiculous.” (Investment grade spread touching multi-year support level as CAT issues 5y notes at T+60)

The chart below shows the spread between the corporate yields (higher risk) and those of the treasuries. On the y-axis is the percent spread between corporate (junk/risk) and treasury yields – i.e. the difference between yields on corporate bonds and yields on treasuries. During the 2008-09 recession, people were dumping corporate bonds – driving yields way up. The difference between the corporate bond yields and government bond yields spiked up.

Now, the situation is different. Investors are dumping their money into bonds, and also chasing yield (they don’t earn anything in their savings and money market accounts). Investors are accepting more risk for a smaller difference between corporate yields and treasury yields. This is reflected in the chart below.

 

 

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Building a Portfolio from the Ground Up – Part One

Courtesy of Dr. Paul Price of Beating Buffett

Most people are rather haphazard in their stock-buying approach. They get ideas from various sources and then simply buy 100 shares of whatever sounds promising. This can leave them poorly diversified, with very unbalanced positions when measured by dollar values.

After thirty four years of putting together portfolios, I’d like to share my common-sense way of starting an equity account.

In the late 1970’s a full service commission was about $90 – $100, and discount brokers like Schwab were charging $29.95 a trade. Odd-lot trading added an eight (remember those) to the price of amounts less than 100 shares.

Today you can trade for as little as $1 per 100 – 200 shares at TradeStation or Interactive Brokers. Many other online brokers charge from $3 – $9 per trade regardless of size. Commissions should no longer be an influence in deciding whether to make a trade.

When starting out, one important consideration is the amount of money you have available to work with. If you have just a few thousand dollars, you’d probably be better off in a mutual fund or ETF (exchange traded fund). This article will deal with how best to allocate amounts of $20,000 or more.

I’m going to use a $100,000 model, but the same technique applies with other investment sizes. I think we need at least 10 different stocks spread over varied industry groups to achieve proper diversification…

My biggest mistakes over the decades have been due to putting too much of my total net worth into stocks I absolutely loved. Those over-weighted positions rarely did well (until right after I reduced my holdings or completely sold out).

Murphy ’s Law: Outsized positions will underperform.

Corollary: Whatever you just nibble at (dollar-wise), will double first.

My rule has evolved into using equal dollar purchases when setting up new portfolios

Now, it’s time to prepare a wish list of companies we’d like to own. Last week’s issue of Market Shadows, Value in the eye of the storm, provided a list of stocks that I thought were worth buying at their then-current prices.

Read the full article for the list of stocks with their prices updated as of the close last Friday.

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The Election Cycle – What to Expect in Stocks & Bond Prices

Courtesy of Chris Vermeulen

DIA – Dow Jones Industrial Average – Daily Chart

DowStocksElection The Election Cycle – What to Expect in Stocks & Bond Prices

 

Looking at the chart of Dow DIA Index fund you can see a 5-6 month cycle in the market which has a positive skew. A positive skew is when the market is trending up making a series of higher highs and higher lows. During a bull market, each cycle upswing lasts longer then when the cycle turns down. So there are longer rallies which send our secondary indicators (stochastics, volatility, put/call ratios, advance decline line etc…)  into the overbought levels for extended periods of time. Those trying to pick a top continually get their head handed to them. The focus must be on buying the pullbacks. Volatility tends to be higher. In the long run, we stand a better chance of making money trading with the trend than trying counter trend trades (picking a top).

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This article is adapted from Chris Vermeulen’s recent article for the Market Shadows newsletter, Vanity of Vanities (11/5).  For more by Chris, follow his Daily Trading Analysis & Trade Setups at: www.TheGoldAndOilGuy.com.

Read the full newsletter: Vanity of Vanities (11/5).

Last week’s newsletter, introduction to the work of Dr. Paul Price: Value in the eye of the storm (10/28). 

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