A More Sophisticated Approach to Portfolio Construction

I don't think this article is as novel as the author and the blogger are making out. All it really says is build a balanced portfolio out of uncorrelated assets and then lever it up. Modern Portfolio Theory allows for that. But it is a more sophisticated approach to constructing an efficient portfolio than you will hear about in articles geared to the small investor that appear in the mainstream financial press. But you don't want to use very high margin lending rates to achieve this. You can achieve similar results by investing the stock portion of the portfolio in leveraged mutual funds, stock index futures etc. This means that less of your capital needs to be devoted to investing in stocks and more will be directed to real estate, bonds etc. The end result is a leveraged balanced portfolio. It will probably have lower volatility for a similar level of returns as an unlevered all stock portfolio.

This isn't far from the way my portfolio is currently constructed with a balanced mix of stocks, bonds, real estate funds etc. and then using leverage to trade stock index futures and ETFs. In the long run, I want to have a core of more hedge fund like investments for perhaps 50% of the portfolio, about 40% in funds which I will change the mix of over the 4 year stock cycle to have more stocks or more bonds and about 10% as capital for leveraged trading. Or up to 100% invested and then borrowing using low margin rates for the cash needed for trading. Currently Ameritrade are charging my account size a 10.5% margin rate which is ridiculous. CommSec in Australia are charging 8.9% (and interest rates are higher in Aus!). Interactive Brokers rate is less than 7%. The latter is economically viable.

Merger Mania

Two of my stocks are now in merger talks: Powertel - a small Aussie telecom firm - and Symbion Health - an Aussie healthcare firm (what else?). Powertel is in talks with Telecom NZ, which I really shouldn't have sold. It has gone up around 10% since I sold it! Talk is that Telecom NZ will acquire Powertel and merge it into its underperforming Aussie subsidiary, AAPT. AAPT was one of the first stocks I bought - I bought it at the IPO and sold when Telecom NZ acquired it. Symbion is one half of the former Mayne conglomerate that remained after Mayne Pharma was spun off in a demerger. Yup, Mayne Pharma was acquired too. An advantage of investing in mid and small cap stocks is that they are more likely to be acquired than mega-cap stocks are. That's one reason I made my disastrous investment in Croesus Mining. Sometimes it works out and sometimes it doesn't...

There is a global wave of mergers, acquisitions, and privatization buyouts going on that rivals the previous peak of such activity in 2000. In theory this suggests that shares are cheap as most of the acquisitions are being made with cash or borrowed money, not other shares. But I don't think the evidence is that acquirers are actually that smart and the high level of such activity could be seen as a sign of an overheated stock market instead.

P.S. Tuesday, 30 January

Telecom NZ is offering $A2.30 per share for Powertel. I paid $A1.20. The stock is trading at that level. The only issue is I bought on 6 May 2006. So I need to hold on till this 6th of May to get the long-term capital gains rate. This is worthwhile when considering the tax saving vs. interest paid in the meantime. Only question is whether I'll be able to hold on till then. The news release talks about Powertel shareholders voting on the deal in late April. If the acquisition (for cash) proceeds immediatately there is going to be no point in waiting till then - unless a better deal comes through. I'm skeptical about that, because one potential bidder already dropped out earlier saying that the price of Powertel was already too high then!

Indexing vs. Active Management Again

New research attempts to do a better job at assessing whether indexing or active management performs better for long-only mutual funds. They examine each capitalization class (small cap, mid cap, large cap etc.) for both active and passive funds. The bottom line is that there appears to be some gain to active management in the mid-cap sector. I recently blogged about the advantages of small funds. This new research also confirms that active management has some advantage in periods of market underperformance though they found that active management just underperformed less in that time period.

I would be very skeptical about buying a long-only actively managed large cap fund. I don't own any currently unless you count Colonial First State's Global Resources Fund. But actually it's not a large-cap only fund. In the past I have owned Colonial First State's Geared Share Fund. It is a large cap long-only Australian stockmarket fund that uses leverage. Of course most Australian large cap stocks would be mid-caps in the US. And the real reason to use the fund is for the built in borrowing at a very low interest rate.

I get large cap exposure in the short-term using futures and ETFs. If you want to get large cap exposure in a buy and hold fashion it probably does make sense to buy an index fund. But does it make sense to buy and hold large cap stocks anyway?

Don't Worry So Much About Saving Enough for Retirement

The NY Times discusses something I have commented on from time to time. Most people in the US end up saving enough for retirement. Poverty is concentrated in fact among families with children rather than seniors. The retirement planning tools provided by brokerages and funds management firms tend to over-exaggerate how much you need to save. As Lawrence Kotlikoff comments in this article - you could end up squandering your youth rather than your money which you will likely come to regret. My mother has a high net worth but hardly at all touches the income from these investments. She primarily lives on government and employer pensions (the employer pension from my father's employer is very low). She gets free government health care and owns her own apartment. Sometimes I try to persuade her to spend more. The main point is that the research also shows that the old spend less than the young. You only need to replace what you spend and that spending shouldn't include things like mortgage principle payments, spending on children etc....

I'll probably end up with "too much saved" (even though I had nothing in a retirement account till age 31, and a negative net worth for most of my 20s) but I am still saving rapidly now because I don't plan on retiring at 60-65 but becoming financially independent long before that. IMO my $1million goal is more than sufficient for achieving that as long as after I reach the goal I at least maintain the inflation-adjusted value of the money.

Overnight Trading Proving its Worth

I'd credit a signficant portion of the rising profits I blogged about in yesterday's post to adoption of the overnight trading tactic. And today proves the point. I closed my short position early yesterday but didn't go long till late in the day when the market had risen considerably. I bought 3 QQQQ call options in my Roth IRA account (300 QQQQ shares equivalent). This morning the market started up and then began to fall. I then bought 500 QQQQ in my Ameritrade account and after that 1 NQ contract (800 QQQQ) @ 1810.75. But the market kept falling all day... late in the day I bought another 2 NQ contracts @ 1791.75. Using the overnight trading approach I should have either dumped my 3 options contracts for about breakeven early in the session today or kept them and suffered a small loss and then gone more significantly long late in the day after prices had fallen. Trying to position myself in line with the model during the session resulted in significant losses - even though the market had already fallen when I started buying. The model is still long, which is why I bought two more contracts late in the day. They are now a little in the money but my earlier buys are underwater. I also should have put in place a hard stop at a 1-1.25% loss in the index for the day.

The overnight trading strategy does seem to work well for part-time traders who can't sit and watch the market all day. At least it works well with my psychological makeup. Today showed what happens when I deviate from it. Living and learning :)

IB Account Profit and Loss Curve

The chart shows the cumulative profit in my Interactive Brokers account since I opened it in late October 2006 trade by trade. All closed trades are shown here. Initially, things were a bit erratic and then an Aussie Dollar trade went very bad. I shorted 3 contracts and the AUD rose 1 US cent against me... that resulted in a loss of $US3000. Since then I have had a pretty smooth ride along an ascending profit curve. As I blogged, yesterday, that might make me a bit too complacent. In fact I made a new short AUD trade yesterday - but only 1 contract - and again the AUD rose against me. But this evening, on the release of the SPI report in Australia the Aussie plummeted and that trade (now closed) turned out OK.

The chart also shows the importance of cutting losses. If I just halved the size of those two big losses the track record would look very different.

I did one of these reports before for non-futures trading. It also looked pretty erratic. I am still waiting for the decisive breakthrough where my trading looks consistently profitable.

Cushion of Profits

I've managed to build my Interactive Brokers account which I use for trading futures up to $12,000. I originally put $10k into the account. After the Aussie Dollar trading debacle in early December the account had fallen to $7,000. So at this point I am achieving the first part of my second goal for 2007 by bringing one of the three accounts back to profit. As I begin to rebuild profits I start to feel less anxious about losing money in trades. This doesn't make a lot of sense economically. $2000 is about 1/2 per cent of my net worth and shouldn't make much difference to my decision making if I was really a neoclassical rational optimiser. It shouldn't matter that the $2000 is the profits in a specific account. This is a classic example of behavioral economics.

Anyway, I'm not sure if this is good or bad. On the one hand, I am likely to be less jittery and more likely to let profits run etc. On the other hand, I might start to take unreasonable risks. Need to remain dsciplined.

Small Caps and Small Funds

Following up from the discussion about mutual fund costs, Friday's WSJ had an article about top performing small cap funds (pointed out to me by Rich Gates - sorry no link as it is subscription only - I read the hardcopy at the office - I subscribe online to Barrons but not the WSJ). This showed that not only have small cap stocks outperformed large cap stocks in recent years but many of the top-performing small cap stock mutual funds are very small in terms of assets under management. TFS Capital's own analysis showed something very similar. It is well known that large mutual funds can have a hard time in getting high returns compared to small funds. This is especially likely to be true if they try to invest in smaller stocks. These small funds tend to also often have high expense ratios. 2% of $50million say is only $1million and from that you have to pay all overheads and several salaries.

The only really large cap stock I own is Berkshire Hathaway. I was thinking about making a post about the market caps of each stock and funds under management of each mutual fund I own. The biggest mutual fund that I have shares in is the Hussman Strategic Growth Fund. But the size of some of my other mutual and closed end funds could be misleading as those are in some cases products of management firms that also have other similar products. For example, Colonial First State runs very similar funds, under retail, retirement (superannuation), and wholesale labels. These are really different share classes of a single fund. They also have direct institutional mandates that may well be managed in the same fund pools. So this was just getting too hard, when I started thinking about all this!

Five Things You Probably Don't Know About Me

I finally got tagged by Clifford with this so-called "meme" that is all over the blogosphere. So here goes:

1. I was born on the same day as my mother. 33 years apart that is.

2. I've lived on four continents - at least five years on each. I guess that leaves Africa, South America, and Antarctica to go.

3. I rode my bike from Lands End to John O'Groats - the southwestern tip of England to the northeastern tip of Scotland and from London to Nice - across France.

4. I can read the Old Testament in the original language.

5. I hate mashed potatoes.

OK, who can I pick - most personal finance bloggers seem to have done this already. Here's a new idea - please comment on this post and either volunteer yourself or nominate someone else :) Like one of those committee meetings where everyone decides to nominate the member who didn't show up :P

Blame it on the Nucleus Accumbens

My insula must be very active!

Mutual Fund Costs are not Important!

I'm fed up with hearing how people should look at the expense ratios of mutual funds when deciding which to invest in as if that was the most important factor. I just turned off a radio show I was listening to because the host was going on about this again. There is so much propaganda out there that I think a lot of people think that these costs are deducted from the reported mutual fund returns. This is not the case. Mutual fund returns are always reported after all costs. Therefore, what is of first order importance is the return not the cost. Vanguard use the line "if you don't get to keep it is it really yours" to try to get people to believe otherwise.

The argument that costs are important is based on the unproven theory that the market is totally efficient and no managers add any value. In such a world the best fund would be the one with the lowest expenses. But that isn't the world we live in. Managers can add value but most don't on average add more than their fee which is what we would expect from economic theory. However, there are some managers that do add a lot more value than their fees. On the other hand, the average individual investor won't have the neccessary insights to pick these out.

Index type funds do have an advantage of being very tax efficient relative to most actively managed funds. This is irrelevant, however, in US retirement accounts (not in Australia though where retirement account earnings are taxed at 15% at source - but a levered managed fund can end up being even more tax efficient under Australian tax rules!).

Even when choosing among index funds, the expense ratio isn't the most important thing. A fund which charges high expenses should lag the index. Looking at the reported returns is good enough. Perhaps the higher cost fund manages to offset those costs by slightly outperforming the index before costs.

Loads - the entry fees into funds are another matter. These are there in order to provide commissions for brokers. The very high rates are a throwback to the times when the cost of trading stocks were also very high (though never that high) just like trading property still costs several percent. I would try to avoid paying a load unless a fund was very interesting and there was no way around it. For example, the Australian fund manager Colonial First State charges a load of 4% on its equity funds. If you make an application direct to the firm you pay that fee and they just pocket it. If you apply through a full service broker the broker gets the fee. If you buy it through a discount broker like CommSec the broker rebates the fee to you and you pay no load! (I have accounts with both these firms).

The Croesus Mining Saga Continues

It now looks like Croesus mining shares will again be traded on the Australian Stock Exchange. A reverse split of 1 for 15 and a new capital raising is being proposed subject to approvals, though the details are a bit fuzzy to me. The Sydney Morning Herald reports:

"IN A development that has stunned the mining industry, the gold assets of collapsed Croesus Mining have been sold to a little-known UK second-board company for $71 million. Perth explorer Avoca Resources had been considered the hands-down favourite to pick up the Norseman goldmine, 50 kilometres south of the Trident mine it is developing in Western Australia. But administrators for Croesus, which collapsed due to poor hedging last year, said yesterday that an offer from Perth-based AIM-listed Davos Resources was significantly higher than two other final offers. Eight parties conducted due diligence, but the final bidders were Davos, Avoca and an overseas syndicate. Avoca shares, which had risen earlier this week on speculation the company would win the Norseman assets, fell 13.5c, or 9 per cent, to $1.355 yesterday. Croesus administrator Vincent Smith said the deal with Davos was signed a week ago but was not announced until the company lodged an $8 million deposit on Tuesday. Avoca managing director Rohan Williams said he was not informed of the winner until just before Croesus announced the deal to the stock exchange yesterday. "It was all pretty well kept under wraps," he said. "We were outbid. That's what happens in administration processes. I'm OK with that." Avoca has been tagged the "market darling" of the WA mining industry in recent months, due to its promising Trident project and expectations it would acquire the Croesus assets capable of producing about 100,000 ounces a year. "Trident is an excellent project and it's got lots of exploration upside ... but Croesus was a bonus on top of that," Hartleys analyst Andrew Muir said. "It was a bit of a shock to the market that they didn't [get Norseman]." Davos chairman David Steinepreis said his company would raise the necessary financing to complete the acquisition in London but that it intended to pursue a dual-listing on the Australian exchange in the future. Norseman mine manager Barry Cahill will be appointed the new chief executive of Davos, which might make further acquisitions. "I think there is an opportunity to rationalise the smaller goldmines in Australia," Mr Steinepreis said. Davos will re-inject money into Croesus, which will be left as a shell company with barely any assets after the Norseman sale. Croesus would then buy other exploration opportunities, offering its long-suffering shareholders the chance to recoup at least some of their funds."

Nobody Ever Went Broke by Taking a Profit, or Should you Let Your Winners Run?

Beginning (and more experienced traders too) are often confused by the conflicting advice they get from different sources. Some argue that because losses are inevitable you should let any winning trade run and close any losing trade fast so that you can generate a good ratio of the size of the profits of winning trades to the losses of losing trades. Others argue that you should take some profits if you are shown to be correct about a trade. Maybe you won't be correct for long...

I think this largely depends on the nature of the system or model you are using to trade with. Here is a nice diagram that lays out the two most important parameters: How often your trades win, and how much they win when they win relative to how much they lose when they lose. If your system is only right slightly more often than it is wrong or maybe even is right less than it is wrong, then you need to let winners run in order to be profitable. However, if most of your trades are correct the amount you win when you win versus what you lose when you lose is less important. My formal trading model is right most of the time. The winning profit/losing profit ratio though is close to one. Profitability doesn't depend on letting winners run. But if this is the case, letting winners turn into losers is very detrimental to results. Therefore, it might make sense to take some profits when we can. Does this make sense?

So far in January on my IB account I have 11 winning trades and 2 losing trades. The profit to loss ratio is more than 6. So no problems on either score here. But in December I had a couple of big losses than brought my profit to loss ratio down to 0.21! I won 24 times and lost 10 times. So cutting losses is also extremely critical. In December I let losers run and took profits too fast. Even with being right much more often than I am wrong this results in losing money.

Annual Report 2006: Part V

I promised that yesterday's post would be the last in this series, but then I came up with a new idea: the contribution of each security or fund to my annual investment result for 2006:



It's too much hassle to compute rates of return and so these are just total contributions in US Dollars. Gaining investments outweigh losing investments 4.5:1 in dollar terms. Not surprisingly the CFS Conservative Fund contributes about a quarter of the gains as it is more than half my net worth in value. Forex contributed even more. All other is the net of interest received and interest and fees paid. Interestingly investments dominate the gainers at the top of the table and trades dominate the losers at the bottom of the table. Investments that lost money are: Ansell, Telecom NZ, and Croesus. All of these are the single industrial firm stocks I wrote about yesterday. Now you can see why I'm not enthusiastic about them. On the other hand, Ansell has generated significant profits in previous years and Mayne/Symbion and Powertel made great contributions this year. But all the mutual funds, closed end funds, fund management companies, and hedge fund investments made money. These are the main patterns I can see.

As far as learning from this record in order to improve my trading in 2007, the main lesson is that avoiding the losses on my two worst trades (each is actually the sum of several trades in that security) would significantly have improved my results - adding about 1.75% to the annual return on investment. I'd like to think I can now avoid the kind of mistake that generated the losses in trading News Corp. That is the whole point of developing a trading model, though money management is a big part of it too. On the investment side the loss on Croesus was unexpected, I really believed the company was turning around, sorting out production problems, and making significant new gold discoveries. I didn't realize the size of the hedging book and how that was going to bring down the company. The lesson is to be very wary of individual stocks of companies that seem to be experiencing any kind of problem.

Annual Report 2006: Part IV

This is the final part of the annual report where I review my current investment allocation and strategy:



This is a screen shot of part of the allocation spreasheet I set up each month to keep tabs on my investment strategy. 2/3 of my net assets are in Australian Dollar related investments. Australian based international investments that aren't hedged into the Australian Dollar are listed in the "Other" column. Yes, over half my net worth is in the CFS Conservative Fund - this fund is 30% invested in equities with the remainder in bonds and cash. I've listed it under Australian Bonds even though it also includes foreign bonds and equities and Australian shares. I have 1-2% of net worth allocated to any individual stock investment. Larger shares can be allocated to closed end funds or trading positions (e.g. 15% allocated to a SPY trade). Unlike the majority of PF Bloggers I don't have any index funds as investments. I use ETFs as trading vehicles.

Here is a different view of the portfolio:



My strategy is to invest 100% of my net worth and borrow against this to fund trading. At the end of 2006 my net trading position was long. The beta exposure column shows how much each category adds to the portfolio's beta (which measures its sensitivity to the S&P 500 index). The investment portfolio contributes a beta of 0.45. My trading positions added a beta of 0.553. So currently I have a very conservative investment portfolio. The overall portfolio's beta can range from 0.9 when I have long trading positions to -0.1 when I have short trading positions. IMO this is a much better approach to market timing than trying to swing an entire portfolio for and against the market. I developed this philosophy from Soros' approach as described in "The Alchemy of Finance".

The overall investment portfolio is conservative at the moment because the yield curve is inverted and there is a strong risk of a recession. Bonds do well in economic slow downs and recessions when the Fed cuts interest rates. So I do adjust the investment portfolio but over the course of years, trying to only incur long-term capital gains taxes. When I am bullish on the economy the beta of the investment portfolio will be above 1.

Breaking down the investment portfolio I have the following kinds of investments:

Core Investments (22%): Loftus Capital, Clime, EBB, EBI, Challenger Infrastructure, Berkshire Hathaway, HCBK, TFS Market Neutral Fund, Hussman Strategic Growth Fund, TIAA Real Estate, Newcastle, Platinum Capital. I don't intend to change these investments with changes in the economy. The investments are a mix of hedge funds, real estate funds, and investment management companies. I would like to have more of this type of investment.

Market Related Mutual Funds (71%): The four Colonial First State Funds, and CREF Bond Market Fund. In fact I have never adjusted the CFS Global Resources Fund since I bought it many years ago, but often wonder if I should. So maybe that too is a core investment. I hold onto positions in the CFS Future Leaders and Developing Company Funds because they are closed to new investors. In order to expand my holdings in the future I need to remain in them. I used to hold a much higher percentage in these funds. My holdings in these funds will change dramatically when I get bullish on the economy.

Industrial Stocks (9%): Ansell, Croesus, Symbion, Powertel, Telecom NZ. Croesus is probably worth nothing in fact (but has not been delisted). I have subsequently sold Telecom NZ. Ansell and Symbion are in the health related field and so I think will not be affected much by recession. Powertel is a small Australian telecom that has done very well and recently reached profitability. I will sell these when I think future gains don't look promising. I may buy new single stock investments when I see opportunities.

Weak Economy, Low Inflation, Record Low Bond Yields?

John Mauldin forwarded his subscribers (subscription is free) an interesting article by Hoisington and Hunt today. They point to low inflation and low growth this year rather than an outright recession but also what they describe as "record low bond yields". A continuing fall in interest rates has been one of my themes for a long time and the reason I hold so many bonds (in mutual funds). Falling interest rates mean rising bond values. Periods like this are when bonds perform well and tend to outperform stocks if the reason for falling rates is economic weakness.

Annual Report 2006: Part III

The following table compares my rates of return on investment to the MSCI World Index and the S&P 500 Total Return Index:



Both those indices include reinvested dividends and in the former case tax credits too. The MSCI World Index covers all countries indexed by MSCI is expressed in US Dollars. I consider the MSCI index the benchmark I measure my performance against. This post has a chart comparing my USD Total Asset Return to the MSCI World Index.

Anyway, getting back to the table - it is divided into four sections:

The first two columns of figures only cover non-retirement assets. I give the return in Australian Dollar and US Dollar terms. The latter look a lot better due to the rise in the Australian dollar from 2001. The returns are the total gain over the relevant period - not annualized rates of return.

The next two columns also include retirement accounts. In the long-term these returns are a lot better with a 123% gain over ten years but are poorer for 2006 itself. Recently, my retirement accounts have been invested more conservatively than non-retirement accounts. In earlier years this wasn't the case and I chose some very successful funds including Colonial First State's Geared Share Fund.

Columns 5 and 6 present the same data for the two stock indices. Over 1, 2, 3, and 5 years the MSCI has outperformed the S&P 500. I have just about matched the S&P 500 over 10 years and outperformed it on all the shorter horizons. I outperformed the MSCI over 3, 5, and 10 years but not over 1 or 2 years. My 2005 rate of return was particularly low.

The final three columns give the same information in terms of annual rates of return. This shows that my rates of return have been extremely strong over 3 and 5 years. The S&P 500 performed poorly over the 5 year horizon. The fall in the US Dollar is one reason that both I and the MSCI outperformed the S&P 500 - foreign stock markets have also performed better in terms of local currencies during this period. So are my returns just luck? I could have moved all my non-retirement assets to the US in 2002 when I moved here from Australia. I deliberately chose not to do so. I also chose to invest most of my Australian retirement account in Australian shares rather than other alternatives. These were deliberate choices based on my view of the value of the currencies. I now see the Euro, Pound, and Aussie Dollar as fully valued and so will focus on accumulating US Dollars. Only time will tell if I am right.

Sold Telecom NZ

I sold all my shares in Telecom NZ. I've owned this stock since 2000 when they took over AAPT - an Australian telecom start-up which I bought at the IPO. I've bought in and out over time, so this final sale registered a loss for tax purposes. The stock fell sharply in mid-2006 after the New Zealand government tightened the regulatory regime to encourage more competition. The stock price has recovered since then, but the high dividend yield has been cut and the company is struggling to gain traction IMO. Neither the company nor analysts are forecasting any earnings growth. The five analysts who track the company each have a different opinion ranging from strong buy to strong sell! The bottom line was I asked myself if this investment will return more than the margin loan interest I am paying to maintain it and my answer was no. I hold very few individual stocks of non-financial companies. After selling this, my remaining such investments are: Powertel, Ansell, Symbion, and Croesus Mining. I don't believe I have any edge in choosing these investments. But, occasionally there are situations which look favorable to me and turn out well and sometimes very badly.

Annual Report 2006: Part II

A focus of many who seek financial independence is building passive income. Payments that come without you having to do any work for them. My passive income in dividends, interest, and mutual fund distributions was about $13,000. Short-term capital gains from trading - which isn't passive income - generated about $6,000, but I spent about $4,000 on investment interest (mostly margin interest). If I wanted to maxmimize capital appreciation I could gear up a lot more and have the cash-flow to cover the interest payments. I've really been very conservative in this regard, though the vast majority of investors in the stock market do not borrow to invest at all. On the other hand, margin loan rates I am paying are actually very expensive relative to other sources of leverage (futures, options, levered mutual funds). Taxwise, in the US it is optimal to not exceed the sum of short-term capital gains, interest, and US non-qualified dividends in margin interest payments. For example, if tax is with-held on foreign dividends you can't claim it as a foreign tax credit and simultaneously deduct margin interest against the income. The built-in interest component of futures, options, and levered mutual funds is at a much lower rate - close to the risk-free rate - than most brokers lend at to small accounts.

Again, I need to at least double the combination of passive income and short-term active trading gains. The cash flow would then cover my expenses and price appreciation (this year around $20,000) would more than cover the effects of inflation in eroding the value of my taxable accounts. Given that my retirement accounts would continue to grow undisturbed, running down the value of the taxable accounts a little wouldn't really be a problem, but it is better to have rising rather than falling income!

Annual Report 2006: Part I

This is my first annual report. I covered some basics a few days ago. Here are the more or less final numbers for income, expenditure, and saving:



The format is the same as my usual monthly reports. Current income is actual cash received from salary, tax refunds, and other sources including inheritance. Retirement other income is total employer and employee retirement contributions to my 403(b). I note the transfer of money from current savings to my Roth IRA account separately. Total retirement contributions were, therefore, $15,432. Total income and realized and unrealized investment gains summed to $53,429. About 2/3 of the gains were in non-retirement accounts which have been more aggressively invested on the whole. About a quarter of the US Dollar gain was due to the rise in the Australian Dollar ($12,092).

It is exciting to see investment gains begin to rival income from employment and exceed saving from current other income and retirement contributions that totalled $42,430. Current investment income ($34,728) exceeded spending ($25,676). There is no guarantee that this will continue in the future. But as assets increase the chances are higher that it will. Investment returns on current accounts for this year are close to long-run expectations based on an alpha-beta analysis. I would like to double this income stream - so that it would be close to my current pre-tax salary - before quitting my current job and looking to make a living from trading and investing. If I can achieve the same rate of return this year I would yield $50k in current investment income.

Net worth grew by $94,675 with about 2/3 of the gain in non-retirement accounts. This imbalance is an additional factor that lead me to start maxing-out my 403(b) contributions.

Changing Distribution Method

I've decided to stop reinvesting the distributions from my non-retirement Australian mutual funds managed by Colonial First State and receive cash distributions instead. These funds constitute 35% of my net worth. The reasons for this decision are as follows:

1. After maxing out my 403(b) contributions investable cash flow from salary is much reduced. Last year these funds distributed $A13,200 (USD 10,400). This cash will largely replace the funds now diverted to my 403(b). Cash is needed to take advantage of emerging investment opportunities and from 2008 onwards I will probably need cash to make tax payments - up till now salary with-holding has been sufficient. This year I will exhaust carried forward capital losses.

2. Tax is payable whether a cash payout is received or not. So using this money to invest in new investments is more tax efficient than selling existing investments.

3. There is no discount for reinvesting the distributions and no load for new fund investments so no actual costs to this choice.

4. The Australian Dollar is currently strong and the US Dollar weak. I want to increase US Dollar investments. I can easily transfer this money back to the US for investment. In fact, that is what I plan to do. Up till now I have been using Australian dividends received to reduce my margin loan with Commonwealth Securities.

I need to send my request in writing. The next distribution is at the end of March - some funds have quarterly and some half-yearly distributions. I am still reinvesting my dividends from Telecom New Zealand and distributions from Everest Brown and Babcock, the TFS Market Neutral Fund and the Hussman Strategic Growth Fund. My other Australian investments do not allow dividend reinvestment by foreign investors. I'm not planning on changing these instructions at the moment.

December Report

Got back Friday from a long trip to Vermont and am getting up to speed - the coming week will be spent mainly on preparations for teaching the next semester. Good news is that Thursday I got an e-mail from my lawyer that she has received the documents to go to the next stage in my green card application - the actual application for the visa itself. The process started in 2003 and looks like being finally concluded this year. With a green card I will have much more freedom of employment and location than I do now as an H1-B holder.

Income and Expenditure



The monthly report for February explained the basic layout of these monthly statements. This month there is a new line for "tax credits". The current (non-retirement) investment returns are reported on a pre-tax basis. Part of the total return on investment includes foreign (mainly Australian taxes) paid on dividends. I get to claim these back on my annual US tax return. The "current other income" includes my net tax refunds (this category is mainly salary). If it wasn't for these credits my reported "other income" would be lower as my tax bill would be higher. Up till now I have been doing a kind of double-counting on these reports and slightly exaggerating my actual saving and income. For the moment I've chosen to compute saving by deducting both expenditure and tax credits from total income. I guess I should report all income on a pre-tax basis and then include a line for taxes. This would mean changing my accounting systems to actually record gross income monthly and then include stuff like health insurance in spending. At the moment my reported salary figures are take home pay after all deductions. So my expenditure is also somewhat under-reported too I guess...

Anyway, getting to this months results:

Expenditure was $US2,092 - $500 more than last month partly due to travel and spending on my trip to visit my girlfriend in Vermont - 64% of take home pay ($3,290) which is much reduced due to maxing out my 403(b) contributions from this month forward. Only one of my two new higher retirement contributions posted to my account and so expect to see retirement contributions ($1,180) higher next month. Non-retirement invesment returns were very strong this month ($6,564) and were the most significant factor in increasing net worth by $10,149.

Net Worth Performance

Net worth rose by $US10,149 to $US364,714 and in Australian Dollars gained $A13,322 to $A462,366. A net worth of half a million Aussie Dollars is now clearly in sight but one never knows what fluctuations could occur on the way there...

Investment Performance
Investment return in US Dollars was 2.21% vs. a 2.26% gain in the MSCI World Index, which I use as my overall benchmark and a 1.40% gain in the S&P 500. Non-retirement accounts gained 3.51%. The contributions of the different investments and trades is as follows:



The returns on all the individual investments are net of foreign exchange movements. Foreign currency losses appears at the bottom of the table together with the sum of all other investment income and expenses - mainly margin interest. Powertel again had one of the best percentage gains. The Everest Brown and Babcock entry covers returns on a listed fund of hedge funds and the management company itself which are both listed on the Australian Stock Exchange.

Asset Allocation
At the end of the month the portfolio had a beta of 0.90. 58% of the portfolio was in stocks, 45% in bonds, 7% in cash, and loans totalled -21%. The remainder was in the hedge fund type and real estate investments, futures value etc.

Accounts Restatement

As I am tidying up my accounting spreadsheets for the end of 2006 I am also fixing some issues from the last several years. The major issue was loans I made to friends in 2002-3 which I then cancelled in July 2004. I have now restated the loan payments to those friends as consumption expenditure for those periods. This results in lower net worth and higher expenditure in the 2002-4 period but also higher estimated investment returns as a given investment return is now attributed to a smaller capital base. I've gone back and updated all my NetWorthIQ entries. The following chart shows the MSCI World Index vs. an equivalent index for my own investment portfolio over the last decade:



Initially I was conservative and underperformed the index and then in recent years have generally outperformed the index - catching up to the MSCI index and then tracking it more or less. This pattern is also shown in the next chart which displays estimates of the alpha and beta of my portfolio over the last several years:



Each alpha and beta pair is estimated on 3 years of monthly returns data. Generally, my alpha - my excess risk-adjusted return - has tracked upwards. In earlier years I subtracted value while in recent years I have added 10-24% return above the market rate of return while taking relative risk into account. The linear regression line tracks this learning curve.

The final picture shows rolling twelve month totals for earning (salary etc. plus all investment returns on non-retirement and retirement accounts) and spending for the last 17 years:



The main feature is the lack of correlation between my earning and spending. I don't spend a lot more now than I did when I was a graduate student in 1990-93. And, these data are NOT adjusted for inflation. I spent much more than I earned in that period. The two big bumps in the spending profile are the periods when I moved to Australia from the US (1996) and then back to the US (2002). From October 2001 to August 2002 I was dependent on investment returns which at first were positive and then very negative. This combined with rising expenditure - including two round the world trips in three months in January and March 2002 resulted in the big fall in net worth in that period.

Missing Retirement Contribution

My missing retirement contribution is now showing up on TIAA-CREF's website. But it's been parked in a money market fund despite my instructions in the application forms. Well, I'll move it and change the instructions online for future contributions. Just a reminder to make sure that your instructions are carried out as requested.

TFS Capital Distribution

So far I am very happy with my investment in TFS Capital's Market Neutral Fund. The fund distribution for 2006 has just been announced:

Short term capital gains: 0.0895
Long term capital gains: 0.1272

After my discussion on this blog with one of the portfolio managers I had been a bit concerned that the distribution might impose a big tax burden, which is one of the downsides of actively managed open-ended mutual funds held in taxable accounts. Recent investors have to pay taxes on investment gains from the past which they haven't benefited from income wise. But this distribution is not bad. It is only a 1.6% yield and the short-term long-term CGT composition is close to the 40/60 mix of futures trading. And my gain so far in just over a month of holding the fund is 5.3% (pre-tax)!

Initial Assessment for December and 2006

It will take quite a while it seems till I have final figures for December and 2006. One reason is that my supplemental 403b plan isn't showing up on TIAA-CREF's website - I e-mailed them to query this. I guess I should at least get a paper statement for the end of the quarter some time but that will take a long time. As of today I am at a net worth of around $365k which represents a gain of $95k in net worth - 95% of my goal for the year. Total after tax earning including salary, investment gains, retirement contributions totalled around $121k with around $26k of spending. Of that income. $69k came from non-investment sources and net income tax paid and $52k from investments. Changes in exchange rates contributed about $12k of the latter. Net realized short-term capital gains on stocks (not counting mutual fund distributions) were around $8k. Trading the NDX added just $2300 for the year with December adding $60. But at least the losing streak of the last few months has ended. The rate of return on investment (pre-tax) was about 18% and 23% on non-retirement accounts as my retirement accounts have been quite conservatively invested.

As numbers are finalized over the next few weeks I will present a lot of reports on the different factors and how they contributed to the results for the year. The main thing though is I am now at a stage where investment earnings are covering living expenses though there is no guarantee that that will continue. In 2005 my investment return was only 3.4%. On the other hand I continue to learn and improve (as objectively measured by indicators such as my portfolio alpha). Over the last three years my alpha is 10% p.a. relative to the MSCI and 14% relative to the S&P 500. Beta is 0.6-0.7. That means in an average 10% year for the indices I should return between 18-22%. If the indices fall 10% I should return on average more than 12% in theory... But I can have a bad year too unrelated to index performance. Is this enough yet to consider myself "financially free"? Obviously I need to manage my money actively and a bad year could have very significant impact. So I consider myself on the verge of being able to make a living as a trader/investor but still need to accumulate more assets and show a more consistent and better trading performance.

December alone added about $10k to net worth with a 2% investment return and about $2000 of spending. If I could keep that up I would easily meet next year's goals :)

Hedged Trading

Another new idea. Seem to be a lot of these as I struggle to find a method that fits my psychology well and uses the model signals. Trade 1 NQ and 200 SPY (S&P500 ETF) in opposite directions. So say I am short 1 NQ then buy 200 SPY. This is equivalent to trading a position of $20 times the NDX and the opposite direction $20 times the SPX. Here is a chart of NDX/SPX:



Reasons to use SPY rather than a futures contract as the hedge:

1. I don't have enough money in my futures account to trade 5 NQ and 2 ES which is the correct ratio of futures contracts and I can trade the SPY part in my Ameritrade account.

2. The tax deduction on stocks is greater for a loss than on futures. As the hedge is expected to lose it makes sense to use stocks for this side of the position.

3. The leverage for stocks is lower and an apparent reduction in leverage is psychologically beneficial.

I've done some simulations and over the last year a fully levered (initial margin for NQ of $3750 and 50% margin for stocks) 1 NQ - 200 SPY position behaves pretty much the same as an unlevered 800 QQQQ position. The strongest gaining days are bigger in terms of percentage gain though - the worst losing days are about the same. So I am now experimenting with this idea live. Of course, if the trend is clear I can remove the hedge and even keep the hedge in the same direction and reverse the main position when the trend reverses. Not sure if I will just use the hedge when I am unclear on direction or all the time.

Last night I watched the movie "Pi". Really crazy movie. Anyway, I'm not like that guy though I am looking for patterns in the stockmarket and have studied the Talmud etc in the past :) One example - he didn't actually trade :P

Buy Signal?

NDX stock futures ran up a lot overnight but are now retreating. NDX needs to be about +5 from the close to trigger a crossing of the moving average and a buy signal. It was +11 at around 6 am but now is back to +4.75. Think I will wait for the new housing number at 10am to make a decision whether to go long.

Pair Trade Update

Just checking how the "pair trade" is working out. The concept was fine but if I think of just NCT and IYR in isolation I shorted too much IYR. So far I lost $251 on IYR and gained $259 on NCT. My IYR short position is worth -$8228 and my long NCT $3229. I should have shorted fewer IYR and if I had the trade would be nicely profitable despite the fact that IYR rose. NCT has turned out to be much stronger than the average actual property owning REIT.

NQ Chart

A possible Elliott-Wave interpretation of the market action of the last month (using the NQ futures chart) ... we would be currently in wave 4 of the final downwave of the correction with just wave 5 down to go to complete this month long correction. Then expect a rally to exceed the 2006 highs. Up till wave b of B it had looked like we were in a triangular correction... but soon the breakout from the triangle failed and a larger corrective pattern developed. This happens all the time with E-Wave which is why it is such a hard tool to really use for trading.

Oversold!

I just realized that in fact we are now in "oversold" conditions - the stochastic oscillator is below 20. This hasn't happened for so long I wasn't paying attention. According to the trading rules one ought to be short here not long! I entered a long trade this morning with just one contract. Now will look to exit it.

How Could I Add $105k to Net Worth?

2006's results (to be reported in detail after January 1) were helped by foreign exchange gain and a small ($6-7k) inheritance amount. I doubt foreign exchange will add much this year and it may even take away unless I successfully trade foreign currency. The Australian Dollar is close to 80 US cents and it is hard to imagine it going much higher. The US Dollar could be bottoming. The second part of the inheritance could come this year or not. Legal procedures are extremely slow. I expect it would be about twice the value of the first one but we don't really know. So let's assume all these factors are zero. I also assume that my tax bill in April will be zero - I have been over-withholding and I think it is sufficient to meet the required tax.

I can expect the following - my employer contributes 8% of my salary to my 403b and I am now contributing the maximum allowed contribution. Combined these come in at $1750 per month. If I spend at the same rate as this year, I should still be able to save $1000 a month after tax. Total from "contributions" would, therefore, be $33k for the year. In my previous post I stated a goal of making $19k from trading. That would be a 46% return on those accounts mentioned. This year I only gained $3k from QQQQ/NQ trading. So it seems like a lot. If I can succeed in adhering to my model it isn't though a very high goal. Viewed another way, it is about 1/2 the average US salary and only a step on the way to becoming a succcessful trader. If we assume that I do achieve this then the required return on my investment portfolio is 14%. This also is high, but not impossible. This year the S&P 500 exceeded that. Of course returns could be much lower and my spending much higher. But this is a goal, not a forecast, and the point is that it should be hard but not impossible to achieve.

2007 Net Worth Goal

Though we haven't yet completed 2006 I have added my 2007 net worth goal to the sidebar. $470,000. At this point I look like reaching $365k for 2006 - an addition of $95k to my net worth. $5k short of my goal but far above the amount I wrote I would be happy with. So next year's goal is to add a little more to net worth than this year - $105k. Also at a constant growth rate, $470k is on the growth path to $1 million at the end of 2010. My second goal is to end the year with as much in my three self directed US investment/trading accounts - at Ameritrade and IB as I put into them ( I also have a 403b and an account with TFS Capital - those are doing fine). Currently my net investment has been $60k, but there is only about $41k in the three accounts. I've added that goal to thje sidebar with the amount achieved in parentheses - I'll update it periodically. If I add or withdraw money to the accounts the goal will shift. These two goals are pretty simple I think. A "stretch goal" as people say is pretty obvious - reaching a net worth of half a million dollars :)

Overnight Trading

I'm struggling to develop a trading strategy which won't involve me staring at the market all day. The idea behind developing the "model"... But seems it is psychologically hard to just follow the model directions and leave a position on all the time until I have a reasonable cushion of profits from trading the model. This doesn't make any sense from the point of view of traditional neoclassical economics, but does make sense from the perspective of behavioral economics. Noting that overnight moves in the stockmarket tend to be much smaller than intraday ones (a well-known economic anomaly) I think I may have an alternative trading strategy:

1. At the close of each day place a trade as directed by the model.

2. In the morning observe the direction of the market from the 8:30am timing of most major U.S. macroeconomic announcements to about 11am.

3. If the market is moving in the direction forecast by the model take profits after a substantial move is made.

4. If the market seems to be going in the opposite direction get out fast.

For example, this morning the market was up slightly before the open but nothing significant. Then came the big fall after the open. Around 9:45am was the ideal time to cover the position. Or just where I decided to go long, a little later. This trade would have made around 13-14 points or $260-280 per contract. The clue that this is doable is that I decided to go long at NQ = 1775. So I'm capable of making the right decision in principle and just need to build that into a strategy.

Making a trade every day also makes it easier to take time out from trading. The psychological difficulty of this strategy is being disciplined to ignore the market for the rest of the day once I've closed the overnight trade. I'll call this strategy "overnight trading" as opposed to "day trading" :)

Of course if the market appears to be in a very strong trend it would make sense to place a stop and let the trade run after observing the morning conditions. This might be easier if I trade say 2 contracts and close one in the morning and let one run if conditions look favorable.

Santa Rally?

The market has been going up since July so maybe it is rather late in the day to talk about the "traditional" year-end "Santa Rally" in the stock market. But this period from the day before Christmas till a few days after is also a time of seasonal strength in the market. The model was still short going into this morning, but only marginally so and will probably be long by the end of the day. So I went long at NQ = 1775.00. Still trying to work out if that was the right move. More ominously for bulls is that at this turning point we are now clearly out of the persistently overbought conditions that have prevailed in the last few months. All my indicators are now coinciding and indicating a turn here. This isn't the case in the overbought state. So after this short rally be on the look out for a significant downtrend to develop.

12:14pm

Stopped out at 1771.25. I put the stop at the low of the day so far and it was taken out. If I'd just stuck with the model, which was still short, I would have been up... Not sure, may wait till after Christmas to place another trade.

Don't Add to Successful Positions?

Brett Steenbarger writes in his blog to take some profits when a trade works out. This seems to run counter to the idea of letting winners run. Figuring out when to take some profits and when to let the trade run is a very tricky judgement. What I've learnt to my expense in the last couple of days is that when a trade works out well don't add to it even when there looks like plenty of upside left in theory. That's a less extreme version. Rather look to see if you should reverse direction and if so, then think of making a larger trade when you reverse direction. The market opened down yesterday and so dumbly I added to my short position and then the market ran up all day. Turning my winning trade into a losing trade. I covered some and then more this afternoon when the market finally began to reverse down again. Took some losses and left some of the position on the table to see if my original concept will work out.

Volatile Weather and Markets and the Demise of Mutual Funds?

This morning there was snow on the ground here in Burlington, VT and there were occasionally snow showers throughout the day. The markets opened steeply lower following a 15% plunge in the Thai stock market and the housing and PPI reports. The US Dollar fell a bit and the markets recovered, with the Dow and S&P 500 ending up on the day. The wave does look corrective on the NDX and the late day sell-off came pretty much where one would expect. The original model forecast was for Wednesday to be the first down day, so I am still expecting a down move tomorrow (which might rescue some of the bad intra-day trades I did today :)).

An interesting article about the potential demise of active mutual funds. Seems that the PF community is on board with the beta part of the story (buy index funds, ETFs, or futures) but doesn't recognize that some managers actually do add value (beta). The question is why pay a manager of a mutual fund or hedge fund to generate both alpha and beta returns when the beta can be bought very cheaply elsewhere. Maybe hedge funds as well will be forced to move to a model where managers are only rewarded for supplying alpha. Contrary to what the author writes, hedge fund managers are in most cases currently rewarded for both alpha and beta.

Closing the Australian Beta Trade

As the model has now switched to sell, I closed out the Australian positions I opened to increase my portfolio's beta. The results are as follows:



This is a margin account and so all the money to buy the shares was borrowed and the cost of interest needs to be figured into the profit. All the numbers are in Australian Dollars (1 AUD = 0.78 USD).

Overall I am happy with the result of this experiment :) But the after tax profit is a small fraction of the gross profit. Trading 2 NDX E-Mini (NQ) contracts is a similar size trade in terms of the underlying value of shares traded. Here is an imaginary NQ trade on Interactive Brokers which generates the same pre-tax profit of AUD 900. The results (in USD) would be as follows:



This trade actually provides more beta than the Australian trade I actually did. Fees are dramatically lower and the tax rate is lower too. The after tax profit on the Australian trade was USD 284. By the way, trading a single stock in Aus would only have lowered the combined fees by AUD 40 over what I paid to trade 3 different stocks as for this size trade CommSec charge 0.12% of the trade value (+ an AUD 10 fee for each trade on a margin account).

Early Reversal

Today's action resulted in a new downtrend starting earlier than expected.... though my old acquaintance Ground Zero was already short... the fluctuations in the market seem to be getting shorter in frequency. The breakout from the supposed symmetrical triangle failed as a result - it worked - but now we have fallen back into the triangle zone before making a new high on NDX. I'll close all the long trading positions and then look if I will actually take the short with a limited size.

I spent most of today travelling to Burlington, VT. Amazing how mild it was and how green the landscape sometimes looked on the way up here.... Definitely nothing like a Vermont winter here.

SEC Plans to Increase Net Worth Required to Invest in Hedge Funds

To $2.5million. I don't understand why the U.S. authorities want to keep hedge funds as a club only for the rich, which is the opposite of the trend in other countries. It is especially ridiculous given the increasing number of long-short mutual funds. Anyway, it is much easier to lose your money playing with options, borrowing to buy high-priced houses at the peak of the housing market, and in any number of other ways. Maybe some big hedge funds who won't be affected by the rule want to reduce the competition?

Perfect Storm

This morning's CPI and wage data. Stocks and bonds soared and the US Dollar dropped on the news. Perfect for more my portfolio. But will the massive opening gap hold, or should I sell my stock positions. QQQQ was $44.40 before the news and now is at $44.78 a few minutes later. There is a potential for $45 being an attractor today as it is options expiry day....

12:39pm

The NDX gap pretty much did fill in the end and $44.50 is looking like more of an attractor than $45. I should just trust the model and stay long through Tuesday I guess... The Aussie and 10 year bonds retraced a lot of their surge too.

Two More Australian Positions

Just bought 1000 shares of NWS.AX and WDC.AX. The former - the News Corporation - is one of my favorite trading vehicles and it was down at the open today. The latter - Westfield - was on my shopping list yesterday and today was recommended by Clime Capital's CEO Roger Montgomery in his monthly letter to shareholders. Westfield is a huge owner and developer of shopping malls in Australia and the United States. It was founded and still run by the Lowy family. Frank Lowy is one of Australia's billionaires. Both these firms are family companies in a way though publicly traded. Still, I'm not planning an investment here really just a short term trade. Beta of the portfolio is now 1.31 and borrowing 41% of net worth.

The triangle set-up I talked about yesterday worked out and the rally on the NASDAQ does not seem complete yet. The model is signalling that the rally should last through the end of Tuesday at this point. I might be selling a lot of stuff Monday night (Tuesday in Australia) through Tuesday :)

Bullish?

After the market managed to close up slightly and stay within the triangle the model is still forecasting upside for the next several days. Actually, a higher close would have made the model bring forward the next downtrend to start sooner. If the NASDAQ manages to break out of the triangle to the upside we could expect a significant rally. So I decided to start increasing my beta further. The plan was to buy 4-5 large cap high beta stocks in Australia. So far I only bought 3000 shares of AMP ($A9.58). If the trend is confirmed I will add more positions. What gives me pause and made me put the question mark in the title is that already the All Ordinaries index's rise so far this evening has resulted in a sell signal using my older "autoregressive model". But that model is rather unreliable and this could simply mean that a strong trend is underway.... Anyway best to be cautious. This move takes my portfolio beta up to 1.17 and total borrowing to 28% of net worth. Another of the stocks I was thinking about buying - Wesfarmers - has, of course, run up sharply since I decided not to buy it today :)

Surprisingly Strong Retail Sales

U.S. retail sales were up 1.1% in November. The consensus forecast was 0.2%. As a result, stocks and the U.S. dollar are up and bonds down. NQ futures are up 7.75 points at the moment (my positions bought yesterday are now in the money). I was actually worried the retail sales number might be low and sold out of a QQQQ position I bought yesterday afternoon just before the number came out and then bought back in just after for a loss of 3 cents per share (I sold the shares for an 11 cent profit - 3 cents is the difference between my buy and sell prices). Yes, I'm still very jittery.

10:28am

Oh well, the market closed the opening gap... and then some. Sometimes the gap closing trade works and sometimes not. I don't have a good theory about this yet. A lot of traders are watching this triangle:



I think it should break upwards, but at this point we are close to testing the downside.

FOMC Day

And I gingerly stepped back into the market... So far, just one NQ Mar 07 contract @ 1805.50. If an uptrend takes hold I may add to it. Though it was announced this morning that the US trade deficit narrowed significantly the USD is weak (AUD = 0.7864). Bonds are up slightly and stocks are down. I am a bit apprehensive of getting too bold before the FOMC announcement at 2:15pm. Bernanke is in China, so don't expect any surprises. The most significant thing that could happen I am thinking is if Jeffrey Lacker doesn't dissent from the decision and state that he thinks interest rates should be raised as he has at recent meetings. That could be bullish for stocks (or maybe not - my TA is pointing up in the stockmarket so I suspect it would be read bullishly - rather than a sign that the economy is even weaker). It would certainly be bullish for bonds and bad for the USD.

3:17pm

It's been a catching falling knives kind of day. The model was forecasting a slightly down day (after the level I mentioned yesterday didn't hold). So when the market opened down I thought that was a good time to buy. The market fell much more before the FOMC announcement though... Lacker dissented again. Apparently he is rotating off the FOMC after this meeting. At least the model is forecasting an uptrend now for the near future as I'm underwater on the two contracts I ended up buying (there was a third which I sold for a small gain). Bonds are up and the USD down after the announcement while stocks are up though very volatile.

I Know What's Going to Happen...

but don't do anything about it.... same story as last week. The model forecast today as a down day, but my read of the intraday (and daily) charts came to the opposite conclusion. So I was hesitant to do anything. If the market stays up near it's current level (13-14 NDX points) the model forecasts Tuesday as an upday. Basically the market is forecasting a favorable FOMC report tomorrow afternoon. I'm pretty sure I can make money from trading on a full time basis but letting my attention drift can be fatal. And I can't fully focus on it. So that's why I'm not acting. I guess that is better than making more losing trades. And losing money makes me nervous and do dumb things.

This upcoming rally seems likely to be very short-lived though. I think it highly likely we are in an ending diagonal or some other topping action that will last much of this month.

On the foreign exchange front, my guess is that the US Dollar has just completed a fourth wave since October and new wave down is getting underway. This wave if it materializes will take the dollar to the support level that has held in the last couple of decades of 80 or so. Some kind of rally would seem likely from that point even if ultimately the support fails, even though I actually think that unlikely. Prices are already very high in Europe relative to the United States. In the end I believe that relative purchasing power will limit moves in currencies. If this is the case, the US Dollar can only keep on falling relative to the Pound and Euro if there is significantly higher inflation in the US than in Europe.

Hyperopia

Interesting academic article which I found from today's New York Times Magazine. I've pondered whether some PF bloggers, particularly those in their 20's are being over-responsible and self-denying. At least based on what they write publicly. I don't regret not saving money during that period of my life and going into debt in order to study, travel, and enjoy life. Nowadays, I am pretty frugal but mainly because I have only gradually increased my material standard of living over time. I am not in any kind of struggle to avoid spending money. I just don't want a lot of "stuff". My saving also isn't directed at some distant "retirement" but rather at achieving "financial freedom" as soon as possible.

Anyway, the point of the article is to test the idea that over time feelings of guilt about not being responsible and overindulging oneself tend to decline, while feelings of regret about missing out on life's pleasures tend to intensify over time. The authors believe that their experimental results support these hypotheses.

Risk Aversion

Seems I've become very risk averse. That's why I set such a tight stop yesterday morning. But that resulted in me losing money on a day when I had predicted the market direction correctly and should have been making money. I thought about getting short around lunchtime. But was scared the market would run up again. It didn't. The market fell more in the afternoon. I'm still out of the market this morning and am watching the big employment reported. My guess was the market would move up in reaction. So far it has, but I didn't place a trade. Maybe there are times when you should just take a break from trading, like from all things. I'll think about getting into the market again next week (of course I am always 100% invested in a mix of stocks, bonds, funds etc., I am talking about short-term trading. Today is the last class of this semester. I've set my schedule for next semester to make it easier for me to trade. Teaching 4 days a week from 12-2. Plan on heavy market data days to get to campus fairly early and watch the pre-market, market, prepare class etc. Major action in terms of setting a direction in the market tends to be over by 11am I find... setting a stop after that is a lot safer than before 10am which is when my first class is at the moment.

The model trend should remain down over the weekend even if today is something of a rebound day. It is too early to tell if the initial uptrend will hold. Bonds are down and the dollar and stocks are up at this point. As often is the case, it is hard to see what in the report generated the spike in interest rates.

9:17am

Now stocks are down, the dollar is down, and bonds are off a little. Glad I didn't put a long trade on.

12:09pm

Got back from class and NDX is up 20+ points! Now the long trade is looking very good.... glad I'm just not trading :) Bonds are off quite a bit and the US Dollar is rallying strongly.

Ouch - Stopped Out!

So far it looks like I predicted the direction of the market correctly yesterday. Had a meeting from 9-11 this morning and I set a stop. The stop was set at NQ (December) = 1808 which was the point where the stochastic would rise above 80 and negate the sell signal from the day before. The stop was hit and then the market dived. Lost $140 on the trade - guess it could be worse. But even when I'm right I am losing money which is discouraging. I'll wait for a bounce and re-evaluate whether to go short again.

Model Switches to Sell

The model switched to sell at today's close. If the NDX had closed above 1802 the model would have remained on buy. This is a rather negative omen for bulls given that the high yesterday (c) did not exceed the previous high around Thanksgiving. As I mentioned, the move down from the top looked like an impulse wave in Elliott Wave terminology. The move up since then (a), (b) , (c) now looks like a corrective wave. So the coming wave down is a wave 3 or wave C.

November Report

Investment Performance
Investment return in US Dollars was 2.67% vs. a 2.88% gain in the MSCI World Index, which I use as my overall benchmark and a 1.90% gain in the S&P 500. The trading accounts lost money again... The contributions of the different investments and trades is as follows:



The returns on all the individual investments are net of foreign exchange movements. The biggest single contribution to US Dollar returns was the foreign currency gains, which appears at the bottom of the table. Powertel made a nice gain this month.

Asset Allocation
At the end of the month the portfolio had a beta of 0.89 (a 1% rise in the market would result in a 0.89% increase in the portfolio). 58% of the portfolio was in stocks, 46% in bonds, 7% in cash, and loans totalled -22%. The remainder was in the hedge fund type and real estate investments, futures value etc.

Net Worth Performance

Net worth rose by $US12,188 to $US354,596 and in Australian Dollars gained $A6809 to $A449,083.

Income and Expenditure



Core investment income is total investment gains before taking into account the change in exchange rates. Other income is salary and retirement contributions. Expenditure was $US1592 - almost exactly the same as last month - only 38% of take home pay ($4125).

Model Forecasts - Trading Diary

At this point the NDX futures are up 5. If this holds or even if the index were to fall 12 points or so today the model is calling for a change of trend from Thursday. If we fall more than 12 points today then Thursday would open with oversold conditions if the index was unchanged from today's close. So that's the roadmap. Cover short positions today unless there is a huge selloff. Everything will depend on the economic data and Fed Beige Book published today.

Update: 10:47am

I did some NQ daytrading and am now holding the short positions with stops in around the day's highs. One theory is that the high today is the top of the B-Wave (in Elliott Wave Theory) of the correction that started on Friday. The big decline on Monday looks impulsive rather than a complete correction and the wave since then looks like an ABC formation. On the other hand, unless things reverse sharply here and the market ends down (which at the moment looks unlikely unless they totally hate the Fed Beige Book at 2pm) the model is saying to get long at today's close. So wait and see for the moment.

Update: 11:49am

The stops were hit while I was commuting and now I am flat. Though the market is off from the level of the stops (always annoying) I will remain flat till nearer 2pm. Have a meeting coming shortly for the next 1 hour or so. NDX could be making an ending diagonal formation intraday and if so it isn't complete.

Update: 2:34pm

Tha market doesn't hate the beige book, but so far it doesn't seem to like it either. I got long - waiting to see if that is the right stance.

Update: 8:29pm

In retrospect I would have been much better off without the stops.... I always have mixed feelings about stops. Sometimes I wish I had them and other times wish I didn't. I sold out of both long positions (QQQQ and NQ) by the end of the day. Will re-establish in the morning.

Tuesday Update

The market rebounded a little today. Friday remains the likely timing for a more substantial upswing. That is unless we get to oversold conditions (stochastic less than 20) before that. For that to happen we need to get another serious selloff in the next couple of days. The Aussie Dollar rallied against me. My futures position is partially hedging the underlying exposure to the AUD so actually my USD net worth rose still due to this rally in the AUD, but much less than it could have. The "autoregressive model" is now giving a more emphatic sell signal today for the Aussie. Bonds rose too, which is good for me. So all in all today was probably a wash. I did a couple of NDX daytrades the losing one lost a little less than the winning one made so I guess that is OK too :)

Tomorrow we get a bunch more macro news including preliminary GDP, new home sales and the Fed's Beige Book. Today existing home sales were up, but as expected there was a year on year price decline again.

Trading Update

I've been short NDX for a while and losing money. In strongly overbought situations it is hard to use "the model". Each time it seems to show that the overbought situation is ending there has been a quick reversal back to overbought conditions. A nimble trader could have played these intraday "buy the dip" situations we have been having. Today's down move brings me to about breakeven on the month. The model is now clearly short. Expect more downside. Friday though could be the beginning of a new uptrend. It could get going on Thursday already. Overall though my portfolio is up about 2% so far this month and now beating the market. I fully expect to lose money in Australia in the next few days, though.

Forex Update

I've been successful so far trading the Aussie Dollar on the long side - making $US814 so far (this is just futures contracts not gains on my actual Australian investments due to the rise in the AUD) - and now I have switched to the short side. I was long one contract and am now short one contract. So I have gone from almost 100% in Australian Dollars portfolio wide to about 50/50 Aussies and Greenbacks. The reason is because my "autoregressive model" gave a sell signal on the Friday close. I don't know how far the down move will go. It seems reasonable that the sharp fall in the US Dollar last week will correct somewhat even if the USD is headed down further after that. And the Aussie does look relatively weak. I've also relabeled my posts about currency trading as "Forex" instead of "Trading" so that they will be easier to find.

P.S. Noon Monday

I sold another AUD contract, taking my AUD exposure down to 23% and USD up to 67% (the rest is in funds exposed to other currencies).

Thanksgiving Conversation

As many other bloggers mention, we often find ourselves having conversations about finances with people we don't usually talk to about finances at occasions like Thanksgiving. And it is always amazing what people don't know. We were talking about looking for other jobs and relocating and someone mentioned: "It's a pity that retirement accounts are set up in America so that it makes it difficult to move jobs". With a bit of prodding it sounds like the guy has a 403(b) defined contribution account with TIAA-CREF just like I do. I told him that it probably isn't a barrier to moving but he should check with his HR people if he is thinking of moving so he knows what to do. I said anyway he could roll it over into an IRA even if he couldn't keep the account or transfer it to his new employer and then he could just start a new account with his new employer. Our host (early 50s, actually with a PhD in economics) then said: "how do you know if you have a defined benefit or defined contribution?" I explained, looks like she has defined benefit with state government and that could be an impediment to moving. If you stay with the state more than 20 years they up the benefit level and she's only been 16 years. That's what she said anyway. Then everyone commented that they hate thinking about this stuff and dealing with money... I didn't investigate why.

The first guy though did know how much was in his 403(b), how much he contributed each month, and had shifted some of the money to more aggressive options in the previous year. The host had an FSA (something I don't do because I think it's too much hassle) and knew all these things came out pre-tax. We also discussed the percentages my employer and I put into my 403(b).

Investment Decisions

I have made the three investment decisions I've been discussing recently:

1. I am investing $7000 in the Hussman Strategic Growth Fund in my Roth IRA.

2. After my discussion with one of the portfolio managers, and reading up on their funds and approach to investing, I have decided to make an initial investment of $5000 (the minimum) in the TFS Market Neutral Fund. Currently, this fund is the top performer in Morningstar's long-short category. The fund's track record is short but over this time it shows strong upward movement, but short-term movements tend to be against the market. This indicates the fund has a low beta and high alpha which are desirable for a market neutral fund. This chart shows the fund's performance relative to the S&P 500:



The fund was particularly strong during the mid-year market meltdown and has beaten the market for the last 12 months and year to date. Other factors that I like are that the managers invest in the fund and also manage hedge funds through the same firm and that they have a particularly interesting compensation structure on a new fund they have launched, which includes an incentive fee, but could result in them receiving no compensation for the year. This suggests they are very confident of beating the market of course. Finally, they focus on quantitative investment and trading strategies.

3. I will max out my 403(b) contributions to my TIAA-CREF account, starting on December 1st.

The reason behind these moves is I don't want to add money to my U.S. trading accounts until they breakeven. I also don't want to devote more money to short-term trading until I can prove I can make profits consistently.

The Hussman and TFS Funds essentially give you a hedge fund without high hedge fund fees, high minimum investments, high net worth requirements, or low liquidity. These and other such funds are well worth considering as an alternative to traditional long-only mutual funds. I already invest in two hedge fund vehicles in Australia - one a fund of funds, and one a closed end fund that is similar to these two funds.

The two new funds add to my existing core investments. These are intended to be investments that do not need adjustment over the stock or business cycle. Eventually, I'd like to have around 50% of net worth in investments of this type I think.