Something’s Gotta Give

February 19, 2010

Andy had a nice blog piece the other day about municipal bond issuers flirting with bankruptcy. But even larger government entities like states are having trouble because of growing pension obligations. According to a February 18 Bloomberg story,

U.S. states must contend with a more than $1 trillion gap between what they have saved and what they have promised to retired workers for pension and health-care benefits, the Pew Center on the States said in a report today.

Even by congressional standards, $1 trillion is a lot of money. Some states (Illinois, Connecticut, New Jersey, California) are in more trouble than others, but this part of the story was completely shocking to me:

Twenty states have saved nothing for future obligations for health care and other benefits.

How can this happen? Very simply, governments are not held to the same accounting standards as corporations, which is more than a little scary when you contemplate how much latitude even corporations have.

Corporations are legally required to use accrual accounting. That means if you have an anticipated expense-like your corporate pension obligation-you must reserve for it. Governments are allowed to use cash accounting. They are allowed to pretend that their future contractual obligations do not exist. The only thing they have to show is how much cash came in and how much cash went out. The potential for financial chicanery is significant-and has been fully exploited by government entities large and small all over the U.S. (If you understand only this much about the debt crisis, you will know more than 90% of American taxpayers.)

As the bulge of baby boomers begins to retire, there’s going to be big pressure on budgets due to pension obligations. Something’s got to give. It’s never clear when or how the bond market will react as the budget pressure becomes apparent, but it’s something to keep in the back of your mind. Having an income portfolio focused on municipal bonds, without the flexibility to go elsewhere for income or capital gains, could end up being a problem. More assets and more options might turn out to be a necessity in the future.

Leave a Comment » | Markets, Tactical Asset Alloc | Permalink
Posted by Mike Moody

Zut Alors!

February 19, 2010

If you need another reason to hate the French, besides envy of their excellent cuisine, it turns out that a bevy of winemakers were fined and given suspended sentences for foisting cheap, lousy wine on American consumers and charging them premium prices for it.

On the other hand, it shows that cognitive biases are everywhere. Neither the American company the wine was shipped to nor consumers drinking it ever complained! Because the wine was labeled as premium pinot noir, wine enthusiasts apparently thought it tasted great. In fact, it turns out that wine drinkers think expensive wine tastes better, even when you trick them and give them two glasses of wine from the same bottle.

This behavior is not unknown in the stock market, where cognitive biases run unbridled down Wall Street. Ten years ago, everyone was in love with General Electic. It, too, was high-priced and tasted great. Ten years later, GE is considered cheap swill that leaves a bitter taste in the mouths of investors.

The moral of the story is that you can’t fall in love with your stocks or your wine. You have to like it on its own merits. In the case of our Systematic RS accounts, we like a stock only as long as it has high relative strength. When it becomes weaker and drops in its ranking-indicating that other, stronger stocks are available-we sell it and move on to a better class of grape. (We’ve been known to break a bottle here and there, but the idea is to adapt as tastes change.) In this way, we strive to keep our wine cellar stocked with the best vintages all the time.

Leave a Comment » | Investor Behavior, Just for Fun, Markets, Thought Process | Permalink
Posted by Mike Moody

Building a Winning Team

February 19, 2010

Our partners at Arrow Funds have just released their latest newsletter in which they have included a nice analogy on relative strength:

In a sports tournament, a team’s ultimate goal is to win. Likewise, a relative strength portfolio manager uses a tournament approach to narrow a portfolio to a group of the strongest securities. In the first round of the tournament, securities are grouped and compared by asset classes.

Relative strength of individual securities can be used to measure within their asset class to identify the top-performing representatives. In the second round, relative strength is used to compare the strength of each asset class against the asset class universe that was established by the manager.

A portfolio manager uses this process to allocate larger (strong relative strength) and smaller (weak relative strength) positions to these asset classes within the portfolio. The ultimate goal is to put together a team with exposure to the strongest asset classes and securities.

In sports, a tournament ends with a winning team as the champion. That champion will remain until the next season’s tournament. A relative strength tournament in investing also repeats. However, the manager has the ability to alter the frequency of the tournament based on the time frames being used to measure the securities.

Leave a Comment » | Thought Process | Permalink
Posted by Andy Hyer

Sector and Capitalization Performance

February 19, 2010

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s). Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong. Performance updated through 2/18/2010.

Leave a Comment » | Markets | Permalink
Posted by Andy Hyer