Brighton Perspective

FinancialAdvisorMatch :An Alternative to Traditional Asset Allocation

FinancialAdvisorMatch :An Alternative to Traditional Asset Allocation.

Article written by me published yesterday.

What Should a Financial Advisor Do for You?

I've seen a number of articles lately on the role of the financial advisor. I've also been asked lately where do I think the markets are headed. Both thoughts dovetail nicely I think.

The financial advisor's role is to help protect and build your asset base. You have worked hard over the years to build up a 401k balance, own a nice home and build, hopefully, a taxable investment portfolio as well. You have also tried to save money for college, for retirement and for future generations. You want to retire earlier than your parents did and enjoy the "fruits of your labor". This is where the advisor comes in.

Most of us do not have the ability to forecast the future with precision. Thus, our objective is to forecast as best as possible and hedge the potential risks we expect to encounter along the way. We will attempt to protect your assets via financial and estate planning techniques so that you keep as much as possible of what you have earned and have the best opportunities to pass on a legacy to future generations of your family. A number of risks are encountered in this process - legal and regulatory changes, economic cycles, etc. Not all can be forecast with certainty and the advisor should account for that uncertainty.

With regard to investments, I believe advisors should be focused on constructing portfolios that attempt to meet basic goals - generate an absolute return that exceeds inflation plus a spending percentage and hedge against potential downside risks. These are competing goals and thus require constant examination. Asset allocation is not dead but does need to be revisited conceptually. I believe that rather than regarding asset allocation as an equity/fixed/other combination, advisors should be viewing asset allocation as core-satellite or on a risk basis. The allocation decision is driven by risk targets first, then by return. So the objective is to properly allocate risk among various assets. In this assessment, lower risk strategies are considered core strategies and can be fixed income, equity or other assets. Same goes for riskier assets (satellite). This does involve a degree of tactical asset allocation which involves trading more the riskier assets more frequently. I'm not trying to time the perfect entry and exit, rather, I'm trying to take advantage of volatility to provide excess return when assets are moving up and hedge downside risk when assets are declining. It's not perfect but I think better addresses my primary objectives than the traditional asset allocation approach.

So the financial advisor is attempting to preserve and grow what you've acquired. We should be more conservative than you most of the time and should be the "voice inside your head" attempting to reason you out of more aggressive decisions. We're not perfect, but if we successful one more time than we're not, we should do well for you.

As to where the markets are going, I don't know. I'm always skeptical (never truly a bull or a bear) and always more comfortable with a portfolio that has some "insurance" against a market decline. I think the "premium" paid to hedge some of the downside volatility is worthwhile.

Weekly Update

The Markets   Financial markets were mostly flat for the week as investors took advantage of continued better than expected earnings reports to take profits built up over the past 6 months. Treasury yields moved higher ahead of record note sales planned for the coming week. Economic data was uneventful as chain store sales were slightly positive, consumer sentiment fell slightly, the Fed suggested the economy was stabilizing in some areas and recovering in others and the index of leading indicators improved. Market/Index 2008 Close Prior Week As of 10/18/09 Week Change YTD Change DJIA 8776.39 9995.91 9972.18 -0.24% 13.63% S&P 500 903.25 1087.68 1079.60 -0.11% 19.52% MSCI World 920.226 1170.638 1153.422 -0.02% 26.65% Russell 2000 499.45 616.18 600.86 -2.49% 20.30% Fed. Funds .25% .25% .25% 0 bps 0 bps 10-year Treasuries 2.24% 3.42% 3.48% 6 bps 124 bps Last Week's Headlines ·      Consumer confidence fell suggesting consumer spending will not lead the nascent recovery ·       The index of leading indicators rose for the sixth consecutive month to a 2 year high ·       Sales of previously owned homes improved to a 2 year high     Upcoming Items of Interest Earnings season has ended and investors will now focus on holiday retail sales for evidence that consumers will be contributing to the economic recovery via holiday spending. Investors will also note the 10 year note sales, durable goods orders, GDP growth, jobless claims and personal income and outlays reports. Data source: All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results. The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2000 U.S. small-cap common stocks. The MSCI World Index is a free-float adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.

The 60% Rally In Perspective | zero hedge

The 60% Rally In Perspective | zero hedge.

The stats in the this post clearly show that this rally isn't as well supported by fundamentals as past rallies have been. The bond market appears to agree as pricing in that market seems to indicate much less enthusiasm for the strength of the economic recovery.

Investors, particularly equity, can be irrational for much longer than a rational investor would expect. Hence, hedging equity exposure rather than moving to all cash could make sense. Eventually, fundamentals will catch up with prices, which I believe, means prices will need to correct. Yet, given past irrationality, one can't forecast with any precision, when that will happen. I still have a target of 950 on the S&P 500 (roughly a 16% correction from current levels). I can't say when it'll happen however, as reasonably good news seems to continue to feed the monster. Let's see what the Christmas retail shopping season delivers.

Weekly Update

The Markets   Equity markets moved sharply higher during the week thanks to several rounds of positive news including continued better than expected earnings. The weight of the evidence continued to suggest to market participants that the rate of recovery for the economy could support higher equity prices. Market/Index 2008 Close Prior Week As of 10/9/09 Week Change YTD Change DJIA 8776.39 9864.94 9995.91 1.33% 13.90% S&P 500 903.25 1071.49 1087.68 1.51% 20.42% MSCI World 920.226 1139.844 1170.638 2.70% 27.21% Russell 2000 499.45 614.92 616.18 0.20% 23.37% Fed. Funds .25% .25% .25% 0 bps 0 bps 10-year Treasuries 2.24% 3.38% 3.42% 4 bps 118 bps Last Week's Headlines ·       Inflation remained sanguine, up 0.2% in September but down 1.3% from last year. ·       Oil and gold continue to rise while the dollar continued to fall suggesting investors are looking for a dollar alternative. ·       The ISM index rose above 50% for the first time in a year. An index reading over 50 suggests the economy is growing.     Upcoming Items of Interest Earnings reports continue this week along with updates on housing starts, wholesale inflation, leading economic indicators and existing home sales. Earnings will continue to be of particular importance as investors look for top-line growth to improve. Top line improvement could be seen as strong evidence that the economic recovery is sustainable.   Data source: All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results. The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2000 U.S. small-cap common stocks. The MSCI World Index is a free-float adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.

Planadviser.com

Planadviser.com. The link is to a survey which states that Americans want more financial education. Unfortunately, the majority still do not intend to use a financial advisor. Obviously, I'm biased, but a good financial advisor who lives and breathes investing, financial planning, etc. can offer tremendous value to investors willing to tap into this knowledge.

If you're working with an advisor and haven't discussed educational topics, considering doing so. You'll increase your comfort level with your advisor and with the discussions you make as you'll increase your personal knowledge and your comfort level with your advisor's knowledge.

If you're not working with an advisor, give it some thought. If you're already a sophisticated investor then an advisor could be a sounding board. If you're less sophisticated, an advisor can help improve your financial situation while also increasing your financial acumen.

Risk Appetite Hits Highest Level in Over Three Years - Morningstar - Market Update

Risk Appetite Hits Highest Level in Over Three Years - Morningstar - Market Update.

Mutual fund cash levels have often been used as a contrarian indicator. Cash levels are now at their lowest levels since 2004. That was in the middle of good run that didn't end until 2007. As we've seen many times in financial markets, investors can remain irrational for longer than would seem reasonable.

I agree with most of the sentiments though - I think developed markets x U.S.  are looking more attractive than emerging markets (equity at least) and the U.S. I think the dollar is probably undervalued but don't believe that will change any time soon. Devaluing the dollar is, I believe, part of the government's approach to economic recovery, so not much, if anything, will be done to offer support until the economy's growth appears self-sustaining. At present, that doesn't appear to be the case.

Calculated Risk: Fed's Kohn: Economic Outlook

Calculated Risk: Fed's Kohn: Economic Outlook.

Excellent analysis of near-term economic prospects (though I continue to expect inflation as the bulk of the 1st stimulus hits the growing economy - a 2nd stimulus will almost ensure it).

Assuming Kohn is correct, what investment strategies should be considered?

1) Consider reducing equity exposure - prices are ahead of fundamentals most likely on improving optimism of a V-shaped recovery. If Kohn is correct, evidence will prove this optimism misplaced and prices will correct.

2) Consider reducing commodities exposure - commodities should still do well as demand from growing emerging markets increases but the near-term inflation worry will prevent significant price increases.

3) Consider increasing non U.S. exposure - emerging markets equities may be overpriced yet may still offer more upside than the U.S. in the near term. Emerging markets debt should be attractive as well.

4) Consider alternatives - lack of clarity suggests hedged strategies could be beneficial - you still participate in the upside but hopefully mitigate some of the downside risk. Other event driven strategies, such as merger arbitrage, could be attractive as well. Weaker companies facing prolonged challenges may sell out to companies with stronger balance sheets and better cash flow.

Just things to consider. Make your own decisions based on your own analysis, risk tolerance and return expectations.

Greg Mankiw's Blog

Greg Mankiw's Blog.

More on a consumption tax.

Taxes Are Not Created Equal « Donald Marron

Taxes Are Not Created Equal « Donald Marron.

I believe I agree with Mr. Marron. It makes sense to have a broad base and low rates, a tax on consumption rather than income and taxes on "bads" rather than "goods". I'm not an expert on taxation but it seems logical that a consumption based tax would be progressive and beneficial as those that earn more tend to spend more. Couple a flat consumption tax with a constitutional amendment requiring a national referendum on any additional taxes and maybe we have something.

Unfortunately, the reality of special interests precludes the simple answers. Any reform that takes away a preferential perk will be fought just as any attempt to cut an "entitlement" will be fought.

Weekly Update

The Markets   Equity markets moved sharply higher during the week thanks to several rounds of positive news including better than expected earnings from Alcoa, smaller than expected trade deficit, falling mortgage rates and slightly better than expected employment data. The weight of the evidence suggested to market participants that the rate of recovery for the economy could support higher equity prices. Market/Index 2008 Close Prior Week As of 10/9/09 Week Change YTD Change DJIA 8776.39 9487.67 9864.94 3.98% 12.40% S&P 500 903.25 1025.21 1071.49 4.51% 18.63% MSCI World 920.226 1088.903 1139.844 4.68% 23.87% Russell 2000 499.45 580.20 614.92 5.98% 23.12% Fed. Funds .25% .25% .25% 0 bps 0 bps 10-year Treasuries 2.24% 3.22% 3.38% 16 bps 114 bps Last Week's Headlines ·       U.S. mortgage applications surged to highs last seen in May as rates fell to a 4 month low. ·       U.S. trade gap narrowed to $30.7 billion which was roughly 10% lower than expected. ·       The ISM index rose above 50% for the first time in a year. An index reading over 50 suggests the economy is growing.     Upcoming Items of Interest Earnings reports continue this week along with updates on retail sales, business inventories, the consumer price index, jobless claims and consumer sentiment. Earnings will be of particular importance as investors look for top-line growth to improve. Top line improvement could be seen as strong evidence that the economic recovery is sustainable.   Data source: All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results. The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2000 U.S. small-cap common stocks. The MSCI World Index is a free-float adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.

Go Global for True Fixed-Income Diversification - Morningstar - Fund Spy

Go Global for True Fixed-Income Diversification - Morningstar - Fund Spy.

I believe fixed income offers better near-term performance than equities and believe non-U.S. sovereign debt offers excellent potential total return. Look for managers actively managing currency exposure as well.

Alcoa Earnings: Alcoa Reports Surprise Profit; Sales Also Beat Expectations - Companies * US * News * Story - CNBC.com

Alcoa Earnings: Alcoa Reports Surprise Profit; Sales Also Beat Expectations - Companies * US * News * Story - CNBC.com.

This is an interesting start to earnings season. It's a positive to see both earnings and revenues exceeding expectations, BUT, keep in mind that revenues were roughly 36% BELOW 3Q08.

We need to see meaningful top line growth to sustain and advance current valuations. Alcoa's statement does highlight the global recovery, or at least strength in China. The global economy could be the lift the U.S. needs to overcome U.S. consumer spending weakness.

Watch this earnings season closely - 73% of S&P 500 companies beat expectations for 2Q earnings but did so mostly by squeezing costs. That can't continue and this is probably the quarter that signals the turning point in expectations. IF top line improvement fails to meet expectations we could see the correction many have forecast lately. 

Rational Expectations

An excellent article in Canada's National Post today by Terrence Corcoran regarding the current dispute between economists such as Krugman & Posner, favoring Keynesian economics, and most everyone else, favoring rational expectations.

The jist of the dispute is that Krugman and Posner believe we need a return to classical Keynesian economics with significant government involvement to ensure that market and economic participants who would not otherwise act "rationally" do so. The rational expectations side argues that participants will act rationally on their own with the information they have at that moment. Given that the information is not perfect, decisions will not always be perfect. Importantly, participants cannot be fooled for acting "rationally" as determined by the government.

To me the argument is for more government involvement because "the government knows best what is good for participants" vs less government involvement because market participants "know best" what is good for them. I'm on the side of participants.

Weekly Update

The Markets

Major equity markets turned south for the week as much of the economic data was negative. The Dow fell 84 points, the S&P 500 fell 12 and NASDAQ fell by almost 18. Not to be left out, the MSCI World index also declined by more than 2%. Overall, not a great week for financial markets worldwide.

Market/Index	2008 Close	Prior Week	As of 10/2/09	Week Change	YTD Change
DJIA	8776.39	9820.20	9487.67	-3.06%	7.66%
S&P 500	903.25	1044.38	1025.21	-1.84%	13.50%
MSCI World	920.226	1115.398	1088.903	-2.38%	18.33%
Russell 2000	499.45	598.94	580.20	-3.13%	16.17%
Fed. Funds	.25%	.25%	.25%	0 bps	0 bps
10-year Treasuries	2.24%	3.33%	3.22%	-11 bps	98 bps

Last Week's Headlines

·       U.S. unemployment hits 9.8%. This was a 26 year high. The drop in payrolls was greater than predicted by economists.

·       U.S. factory orders dropped for the first time since March giving investors additional reasons to wonder if the nascent recovery is sustainable.

·       U.S. consumer spending surged in August likely boosted by the “cash for clunkers” program which expired at the end of August.

·       U.S. 2^nd quarter GDP was revised to a smaller decline than had been forecast by most economists.

 

Upcoming Items of Interest

Light on news this week but a few items of interest will be released. First up is the ISM Non-Manufacturing Index. Investors will be looking for a number greater than 50 which would indicate economic improvement. On Wednesday, the latest data on consumer credit will be announced. Current consensus is for a contraction of approximately $8.5 billion. Outstanding debt has been falling steadily since late 2007.  On Thursday, the latest jobless claims data will be released. Current consensus is 540,000 new claims which would continue a relative decline in claims. The four week average should also show a decline which would be indicative of continued economic recovery.

Data source: All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results. The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2000 U.S. small-cap common stocks. The MSCI World Index is a free-float adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.

Felix Salmon » Blog Archive » Chart of the day, hours-worked edition | Blogs |

Felix Salmon » Blog Archive » Chart of the day, hours-worked edition | Blogs |.

I'm not overly optimistic about near-term economic growth but the contrarian in me wonders if this is a sign of a bottom. When the media turns negative, the worst is usually over.

I'm still skeptical and do expect a correction before year-end but I don't see the square-root path here. I see a long, slow process of recovery.

Robert J. Barro: Stimulus Spending Doesn't Work - WSJ.com

Robert J. Barro: Stimulus Spending Doesn't Work - WSJ.com.

As someone who is not a fan on increased government spending, I appreciate the empirical analysis in this article. A related article by Nick Gillespie highlights Barro's claims about government spending increasing with GDP. To wit, total government receipts in 1950 were $39.4 billion and in 2008 were $2,524 billion yet we're still running deficits. Government spending expanded to spend the money it collected. This is what worries me - last year's spending becomes the baseline for growth of this year's spending. Thus spending continually increases. I can't confirm it empirically, but wouldn't be surprised if the 9 budget surpluses of the last 60 years were the result of unexpected increases in tax receipts and NOT the result of cuts in government outlays.

Andrew Lo on the wisdom of crowds

FT.com / Markets / Insight - Insight: When the wisdom of crowds becomes the madness of mobs.

I have been a fan of Andrew Lo for a number of years. I appreciate his comments here regarding tactical asset allocation to manage risk. As a proponent of a core/satellite approach to portfolio mangement, this is consistent with my reasoning. The satellite component is comprised of higher volatility strategies which should and are managed tactically. The core is comprised of lower volatility strategies which can be managed strategically. The objective is to manage risk and maximize expected return given the target risk level.

This inverts the traditional approach which focused on maximizing return while attempting to minimize risk given that target return. I think 2008 demonstrated that the traditional approach of relegating risk management to a secondary issue invites rather dramatic draw-downs and is awfully painful to endure. For my clients, and myself, I'd rather give up upside to protect downside through better risk management and a better understanding of risk tolerance. The "insurance" is worth the premium.