Frankenstein - It's Alive!

Henry Frankenstein: Look! It's moving. It's alive. It's alive... It's alive, it's moving, it's alive, it's alive, it's alive, it's alive, IT'S ALIVE!
Victor Moritz: Henry - In the name of God!
Henry Frankenstein: Oh, in the name of God! Now I know what it feels like to be God! 

Enjoy one of the great rock instrumentals of all time...Edgar Winter Group - Frankenstein

There has been a lot of talk lately about High Frequency Trading (HFT), and its impact on the volatility of the markets. While I'm no expert on the subject, I have been investing/trading for nearly 30 years so I thought I would share my observations.

First HFT does not analyze company fundamentals, they analyze data patterns. The goal is to extrapolate what they are seeing in one set of data to other markets before the crowd gets there. They hire the brightest mathematical brains to develop algorithms that identify these patterns. Speed is a key weapon. Many HFT shops locate their servers close to the exchange where they trade to cut down on the time it takes to execute a trade. The average holding period is between 10 milliseconds and 10 seconds. By some estimates HFT accounts for anywhere from 40% to 70% of average daily volume, and even more on extremely volatile days. (The following link gives a good wonkish explanation of HFT  High-frequency trading )

While its hard to dispute the fact that HFT increases liquidity, it's a different kind of liquidity, a fake liquidity that generally moves all in one direction. Also, when the computers step away volume can dry up in a flash, hence the term "Flash Crash". 

One of the more interesting outcomes of HFT and it's increased liquidity is that it hasn't increased market efficiency. What has happened instead is that stocks are more correlated than ever before. Some of this increased correlation is a result of exchange traded funds, and leveraged exchange traded funds, which buy and sell baskets of stocks in particular sectors. This has caused individual stocks valuations (P/E ratios, P/S ratios, etc) to converge, regardless of their fundamentals. How else do you explain a company with the growth prospects of Apple trading at 11 times earnings (9 times ex-cash)? 

Many market players have simply reverted to asset allocation and sector allocation, and have given up on picking individual names. This is what I do through my Global Tactical Asset Allocation model, I'm not trying to fight the markets/machines, I'm just trying to participate on the upside, and protect on the downside. But this increased inefficiency also creates opportunities for individual stock picking. If every stock in a sector is going down in unison regardless of their fundamentals, then the best stocks in that sector may become very attractive. I say "may" because they all might move back up in unison. In my personal trading account I have been able to take advantage of some of these short-term pricing inefficiencies, but I emphasize the word short-term. 

Investing has changed, as everything has changed. Some for the good, some for the bad. Only time will tell if HFT does more harm than good. We as investors have to learn to adjust and adapt.

One of the things that endears us to Dr. Frankenstein is his willingness to push the envelope...

Henry Frankenstein: Dangerous? Poor old Waldman. Have you never wanted to do anything that was dangerous? Where should we be if no one tried to find out what lies beyond? Have your never wanted to look beyond the clouds and the stars, or to know what causes the trees to bud? And what changes the darkness into light? But if you talk like that, people call you crazy. Well, if I could discover just one of these things, what eternity is, for example, I wouldn't care if they did think I was crazy. 

 

What makes mankind great is our desire to learn, to push boundaries, and to grow. This is the dominate theme of all of human history. Of course, this pushing of the envelop is not without risk, especially in finance. We all remember the "financial innovation" that gave us, portfolio insurance, credit default swaps, and securitized bundles of mortgages. These inventions were extremely profitable, for a while. But costs and unintended consequences were ignored along the way, and eventually we paid a very dear price. 

It is important that we ask tough questions of our innovators, but equally important that we don't stifle that innovation. Maybe that's why we sympathize with Dr. Frankenstein, we know that we'll be repeating his mistakes for hundreds of years. 

We don't know if HFT is good or bad, time will tell. As investors we have to find a way to adapt to our current environment, and hopefully prosper.

Be careful out there, and keep the lights on,

Chris Wiles, CFA

412-260-7917

www.rockhavencapital.com

For prior Rockhaven Views visit:

www.rockhavencapmgmt.blogspot.com

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Teach Your Children Well

Teach your children well, their father's hell did slowly go by,

And feed them on your dreams, the one you picked, the one you're known by.

Crosby, Stills, Nash & Young - Teach Your Children

As we prepare our little ones to go back to school I started to think about money, not just about how much I'm spending, but about how to teach them about money.

When I was a kid I had a piggy bank (shaped like a rocket), and a savings account at the bank. The piggy bank got most of my loose change (other than the funds needed for the penny candy), while the bank received my earnings from grass cutting and house painting. I loved feeling the weight of that rocket as it filled with change. I still remember dreaming about what I would buy; a frisbee, or new ball. Small dreams.

I didn't realize it at the time, but I think the clink, clink of coins falling into the bank somehow encouraged responsible behavior, and made me a life long saver.

My girls don't think much about saving. They have banks, but rarely does a coin find the bottom. They have savings accounts for college/life, but those were entirely funded by us. Mostly they have their purses, where money and gift cards accumulate just long enough to make it to the mall. My girls are spenders, not savers.

This really used to bother me, but not so much any more.

Times are different today. Our central bankers have proven that savers are saps, or sheep to be fleeced. With the constant devaluation of the dollar, and our ongoing zero interest rate policy (ZIRP), savers are losers.

Ben Bernanke recently announced that interest rates would stay at zero for the next two years. This is great news for those who have to borrow, but horrible news for any savers. Savers get zero from the bank, and then get to watch the value of their dollar based savings devalue by 5% - 7% per year. Losers.

Maybe my daughters are right, spend it before it devalues.

US Dollar priced in gold. Relatively stable until it was devalued in Great Depression, and then totally devalued after Nixon ended the gold standard.

A child of the world today has a much different relationship to money than when I grew up fifty odd years ago. Look at the lessons the world has taught them:

- Debt is wealth.

- Living beyond your means is not only acceptable, but encouraged.

- If you can't pay your debts walk away, its someone else's problem.

- The government is there to bail you out.

- We are entitled to things that we didn't work for.

- Getting rich quick is preferable to long-term saving, especially when we're not held accountable for our actions.

The world is such a different place. The dollar has not been a stable source of value for decades. The US dollar is not risk free. Everyone needs to understand that the rules have changed. For decades our governments have promised much more than they can deliver. Our governments have lived beyond their means, and have encouraged their citizens to do the same. 

During the last 30 years, our government has attempted to use a combination of fiscal and monetary policy to manage the natural flow of business cycles. This was done for the noble goal of full employment. In the 25 years between 1957 and 1982 (300 months), there were 64 months that the economy was in recession. In the 25 years between 1982 and 2007 (again 300 months), there were only two shallow recessions, each lasting 8 months. On the surface it appeared that this manipulation was working, but underneath it was clear that a significant cost was being accumulated. Total Debt to GDP exploded. In other words we've been borrowing like crazy to try and mitigate natural economic declines. The problem today is that we've finally hit the end of this monetary experiment.

Source: Ned Davis Research

I'm not sure what to tell my girls about money. At the risk of being labeled a sap, I guess I'll tell them:

- To be responsible for their actions.

- Make good on your promises, even your financial promises.

- Don't trust the government to be there to bail you out. (And Dad won't always be there either).

- Save, but think really hard about where you put your savings. (Banks should be way down that list).

- Spend some too. Life is short and you might as well have some fun.

Teach your parents well, their children's hell will slowly go by,

And feed them on your dreams, the one they picked, the one you're known by.

Don't ever ask them why, if they told you, you would cry,

So just look at them and sigh and know they love you.

Be careful out there, and keep the lights on,

Chris Wiles, CFA

412-260-7917

www.rockhavencapital.com

For prior Rockhaven Views visit:

www.rockhavencapmgmt.blogspot.com

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

The Questions Run Too Deep

When I was young, it seemed that life was so wonderful,

a miracle, oh it was beautiful, magical.

And all the birds in the trees, well they'd be singing so happily,

oh joyfully, oh playfully watching me.

Two pretty good videos that will take you back...   The Logical Song by Roger Hodgson (former Supertramp singer songwriter)     The Logical Song Roger Hodgson w Orchestra

I instantly thought of this Supertramp song when I saw the following graphic in today's WSJ. A pictorial of my first fifty years, as seen through the lens of the ten-year treasury note. So many memories, good, bad, and not fit for a family newsletter. Wow, what a wild ride...wonder what the next fifty years will look like?

Yesterday the 10-year Treasury yield fell below 2% for the first time since April 1950. 

Could it go lower? Of course, just look at Japan. 

Could it stay at this level for an extended period? Of course, again look at Japan, and remember that Bernanke said short-term rates would be at zero for the next two years. 

Could they go higher? Of course, if foreigners (our good friends in China, Russia, & the Middle East) decide that they no longer want to buy them and no longer accept the dollar as the worlds global currency.

If we only knew the answer to those questions we wouldn't have to worry about working for the next fifty years.

There are times when all the world's asleep,

the questions run too deep

for such a simple man.

As investors though we still have to invest knowing that we don't know. "Knowing that you don't know" is clearly better than "not knowing that you don't know", which is significantly superior to "thinking that you know". Follow? 

Investing in a world of unknowns has never been easy, but one thing most investors do agree on is the need to diversify. For me diversification is not defined as owning different securities, for me diversification is only useful when you are diversifying your risk exposures. Risk diversification, not asset diversification. To diversify risk you need to look for inflation hedges, deflation hedges, currency devaluation hedges, sovereign debt default hedges, and corporate debt default hedges.

Once you've identified the best securities to hold for proper diversification, the next step is determining what exposure you should have to each risk at any given time. This is tactical asset allocation, this is not "buy-and-hold (hope)" investing.

We've had a lot of volatility in the last several weeks, and our Global Tactical Asset Allocation portfolio has had some significant changes. Here's where we stand today:

US Equities -- 5% Bearish,

 we are now at our minimum US equity weight.

Int'l Equities -- 5% 

Bearish, we are now at our minimum International equity weight. 

US REITs --  4% 

Neutral, but very near our minimum target of 3%.

Int'l REITs -- 2% Bearish

. The sell-off in Europe has knocked these stocks down.

Gold --10% Bullish, clearly being viewed as a fiat currency substitute. 

Commodities -- 6% Neutral, but very near our minimum target of 5%

.

US Fixed Income -- 18% Bullish, with the Fed all but guaranteeing that rates will be kept low for the next two years.

Int'l Fixed Income -- 12% Bullish, but risk has increased with the European bank problems.

Cash Equivalents & Currencies --38%, divided between the US at 23%, and 5% each in China, Australia, and Brazil.

While defensive, this is very different than what happened in 2008, in 2008 everything went negative, equities, gold, bonds, etc. Today money has run to gold and fixed income. 

While corporate earnings continue to be OK, we are seeing some early warning signs that the second half might be a bit weak. Clearly we still have the issues with insolvent governments in Europe and here in the US.

But then they sent me away to teach me how to be sensible,

logical, oh responsible, practical.

And then they showed me a world where I could be so dependable,

oh clinical, oh intellectual, cynical.

I thought this was a great segment from Jon Stewart's Daily Show this week. I'm a fiscal conservative, social liberal, which means I generally agree with 80%+ of what the Libertarian Party stands for. I think it's amazing how the media totally ignores a Republican candidate that a huge segment of the population agrees with. 

Enjoy...

Indecision 2012 - Corn Polled Edition - Ron Paul & the Top Tier

I've had a couple of people take me up on my offer to speak to their groups, if anyone else has a need for a speaker to talk about investing (I have a pretty cool presentation on Controlling Your Lizard Brain), please give me a call.

Be careful out there, and keep the lights on,

Chris Wiles, CFA

412-260-7917

www.rockhavencapital.com

For prior Rockhaven Views visit:

www.rockhavencapmgmt.blogspot.com

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.