Risk Assessments

I have spoken to a lot of people over the last few months regarding our Fixed Rate Deposits (http://www.fixedratedeposits.com/) and it is apparent that there is a clear case of poor analysis when it comes to determining the risk of a product.  Assessing risk is difficult at best and sometimes almost impossible, but in the main it is relatively easy to compare products and get a clear sense of whether the added return validates the increase in risk.

A risk assessment starts with the least risky asset of all the United States T-Bill.  This is a highly liquid note and has the full faith of the United States Treasury behind it.  At present that is worth something and as long as the perceived security is there then it holds its place as the least risky of all assets.  At present the one month T-Bill is yielding 0.03% or basically nothing.

From this low level rates start to increase with risk.  For an indication the 10-year T-Bond is currently yielding 3.18%, so a lot higher return for a lot longer term.  As the longer term means a higher probability of not being paid back the risk is higher.  Some may argue that there is still no risk as the investment has the full faith backing of the US government, but we have seen just how much of a mess can be created in just a few years, so I would say that there is a higher risk associated with the longer term and this is reflected in the increased rate.

So the higher the risk the higher the return?  Not in all cases.  There are many cases where the risk is far higher than the return and other cases where the return is far higher than the commensurate risk.  The latter investment is what every investor strives to find and what I strive to create.  So with the basis of the above two rates from the US Treasury we will now go to the next step of risk analysis - a comparison of four products and our Fixed Rate Deposit.

The first comparison is to a bank Certificate of Deposit.  The bank rate for a two year CD is around 1.50%.  Compare this to our current two year rate of 4.00% and it would appear that the risk should be a lot higher for the Fixed Rate Deposit.  The bank comes with FDIC insurance to $250,000 ($500,000 if you are a couple or a trust) and the backing of the financial institution itself.  The Fixed Rate Deposit has the backing of the schools and the funds protecting it.  I would argue that the risk profiles are similar as the Fixed Rate Deposits has never had a default in over 8 years while banks are failing left and right and the FDIC is pretty much insolvent.  Furthermore I would contend that most banks are insolvent as they are not required to mark the assets on their balance sheets to market.  Hence a mortgage that is current but attached to a house that is worth less than the mortgage is considered a performing loan and listed at par.  If the mortgage was marked to market it would have to be written down to the value of the property and this would instantly (in my opinion) make most US banks insolvent instantly.  The Fixed Rate Deposit investment has the backing of very solvent and highly profitable institutions.

International banks are offering higher rates than those on-shore.  Banks in the Philippines and other emerging economies can offer rates of 2.5%.  While these banks are US based they are still subject to sovereign risk.  So while the investment may be held in dollars, if there is a coup or a nationalization of the the banking system these assets could be lost.  Certainly countries such as Australia and New Zealand are considered safe bets, but I would steer away from the South East Asian rim, South America, the Middle East and Africa.  Once you strip those away you are back to poor rates of return in developed countries.

Now on to another comparison.  I have had money managers mention that they receive higher rates than the rates on the Fixed Rate Deposits.  One investment is an exchange traded fund (ETF) with the ticker CEW.  CEW is made up of a basket of emerging country currencies.  This basket of currencies has provided a return to investors of roughly 5% per year.  As it is an ETF there is daily liquidity but you are really dealing with fire here.  Remember 1997?  Contagion spread throughout the world and emerging country currencies fell like stones.  If this ever happens again (and I predict that it will) these investors will all run for the exit at the same time and will drive the value of this ETF through the floor.  Is this huge risk worth 1% more?  I think not and certainly it is not an investment that I would consider for my safe money.

The final comparison is structured note products that are in vogue at present.  These investments yield around 7 to 8% however there are a lot of caveats.  First is the underlying collateral of the asset.  These notes sell puts against various markets.  Typically the puts are sold way out of the money but the product is open to risk.  As you now know a put is an option that allows the seller to sell their position in a stock or an index at a preset price.  If the market falls below that price then the seller of the put transfers ownership of that index across to the buyer and the buyer is on the hook for the asset at the preset price.  Now these options are sold well below the market but should the market collapse the owners of the structured note could get wiped out.  Second are the large commissions that are paid to the brokers of the structured notes.  No wonder they peddle them so hard and even sell them as "risk-free".  This is hardly a risk free investment especially when you consider that the term of the note.  These notes typically have a relatively long term hold on them.  If you wish to exit there are fees and penalties that will eat up any gains, so the owner of the note has to sit and wait for 6 to 12 months and hope that the market continues higher or risk losing their entire investment.  Certainly a much greater risk than anything I have to offer and in my opinion not worth the extra 3%.

These are just four examples of different styled investments. Each has a different risk profile and each has a different rate of return.  As an investor you need to carefully analyze the risk of the investment before committing to the investment based on the sales pitch.  If after careful analysis you are comfortable with the investment then proceed, but make sure that you compare your proposed investment with other investments to really understand the risk of each and the proposed return and strive to invest in those with the least risk and the greatest return.

A Headline

Yesterday was not a good day for stocks.  At the time I began writing this the market was down more than a percent for the day but one headline really caught my attention, "Noted earlier that the Dollar Index was flirting with its 50 ema/sma near midday.  The Dollar paused allowing for a midday reprieve in equities but new highs in the Dollar in recent trade has led to fresh session lows for the major indices.  If the Dollar Index can't hold above these averages (75.24/75.28) it could relieve some of the downside pressure on stocks."

So what does that mean? The Dollar strengthened causing it to rise up to the 50 day moving average line.  This line is merely a summation of the previous 50 days of the index divided by 50.  The line represents a technical indicator and something that market technicians watch and use to determine the strength or weakness of the market.  In this case the Dollar had been getting pounded and was finally bouncing off its lows.  This rise in the Dollar was the cause of the correction in the stock market.

The part that is disturbing is that the headline called for a continued crash in the Dollar in order to support stocks by saying that "if the Dollar Index can't hold above these averages (75.24/75.28) it could relieve some of the downside pressure on stocks."  Essentially the stock market rise is a factor of the Dollar weakness.  Now I do not disagree with this statement in the least, in fact I agree that the weak Dollar caused by the Federal Reserve policies and money printing has benefited the stock market.  If and when the money printing stops the market will crater.  The sad part to the article is that market participants filled with greed and fear are hoping that this line in the sand (the 50 day moving average) holds and pushes the Dollar down again so that they can temporarily benefit from a continued rise in the price of their stocks.

This is about as short sighted as I have ever witnessed and highlights the fickleness of human nature.  We are wired to win regardless of the consequences.  Small short-term victories with serious long-term consequences are more desirable than short-term pain with a long-term outcome that is very favorable.  This is highlighted by this headline.  Let the Dollar burn so that we can make a few more bucks! The long-term consequences of this strategy are dire.

Inflation is already here and is starting to feed into even the Federal Reserve's measure of inflation the core inflation rate which strips out the increase in the price of food and energy.  A continued decline in the Dollar will continue to feed the inflation level and this will result in pain at the household level.  Already spending on retail items is falling as consumers cut spending on discretionary items in order to pay for groceries and gasoline.  Driving the Dollar lower will raise these prices even more and will cut consumer spending further. 

It is impossible to have a recovery in housing until the consumer can save, get out of debt and get a loan.  They need jobs and a low rate of inflation to be able to acquire these assets and the current policies are making it all but impossible.  The consumer is madly trying to pay off excess debt, save, get a job, find financing and earn enough money to keep up with the rise in prices.  All in all the short-term vision of propping up the stock market at the expense of everything else is going to end in far more pain than letting the market correct now.

Stop the printing, work on the actual problem of getting people employed by creating a fundamentally strong economy with a strong currency.  Earn the trust of the world again by running an austere government with a fiscally responsible and independent reserve bank that looks upon the strength of the Dollar as part of its policy rather than as the scape goat.  Change these policies and I believe that we can once again have a strong economy with long-term prosperity.  Implementing this would come at the cost of severe pain in the stock market as the security blanket of money printing has to be removed however, right now we have the ability to remove it ourselves in a controlled manner.  If we continue the current policies at some point in the not too distant future the market will loose its footing and will crater on its own in an uncontrolled manner creating far more havoc than what we have had to deal with up to now.

As it is almost guaranteed that there will not be a change in these policies until the inevitable happens, protect your investments with put option or sell your winners but whatever you do add some level of caution to your investments.  For those of you with cash looking for great rates of return with minimal risk give me a call or review our website on www.fixedratedeposits.com.

Sell in May and Go Away

The old trader's adage of sell in May and go away looks like it will be a good axiom to follow this month.  Although the market continues to spiral ever higher there are some serious headwinds and these are going to have to be dealt with during the lowest trading volume months of the year.

Typically when summer arrives trading volumes on the major exchanges diminishes.  Traders tend to take holidays and relax more and overall trading volume becomes lighter and volatility picks up.  Stocks can gyrate madly about with little or no reason other than there is little volume in the market or the stock.  This is a dangerous time to trade as moves in any direction can be magnified hence the axiom to go away and wait for a more "normal" market to return later in the year.

For those of you with substantial gains in your portfolio thus far this year I would definitely take some profit and even think about locking down the positions with put options or covered call contracts.  My reasons are many but following I will delve into just a couple.

1. Banking Index (BKX) is showing signs of rolling over.  When the banks start to trend down that is normally an early signal that there are problems in the overall market.  On a more granular level it is often said that as goes Goldman Sachs so goes the market and a review of the GS chart shows that the market could be in trouble.
2. Global growth is slowing.  Two of the metrics that I look to for a clue as to the strength of the global markets are copper and the Baltic freight rates.  Copper is a base material that is used throughout the world.  As copper prices are determined by demand and supply, a weak copper price shows weak demand.  Weak demand points to slower economic growth on a macro-economic basis.  For a graphical view of this click on the following link to see the current monthly futures chart http://www.danielstrading.com/resources/quotes-and-charts/quotes.php?page=chart&sym=HGK11
3. Tied to this indicator is the demand for shipping as indicated by the Baltic Freight Rates.  This shows the level of demand for dry bulk shippers around the globe.  These boats transport the raw materials needed to keep economies going and so a lower Baltic Freight Rate points to weaker demand for all raw materials.  For a clear view of how this rate has performed click on the following link but needless to say it is not looking very promising. http://investmenttools.com/futures/bdi_baltic_dry_index.htm
4. Finally the Federal Reserve has stated that they will end their open market purchases on time and will not extend their purchases for the time being.  How long they actually stop is anyone's guess, but without the support of the Federal Reserve I would think that the market rolls over.  A lot of people seem to already be buying treasuries expecting some sort of market draw down in the near future.  The support for treasuries seems to be stronger than what the Federal Reserve can provide on their own.  A look at the chart of the ten year T-Bill shows the support for treasuries over the last few weeks http://www.danielstrading.com/resources/quotes-and-charts/quotes.php?page=chart&sym=ZNM11

For all of these reasons I would advise that the market is looking far weaker than it appears on the surface.  May is typically a month that signals the beginning of slower volume days and this can lead to an exacerbation of market moves.  If the market rolls over I would think that it will go farther and faster than during "normal" market periods.  Do yourself and your portfolio a favor and protect your profits by selling some or all of your positions and move into cash.  Once you have a cash build-up contact me and I will provide you a fantastic rate of return for virtually no risk while you wait for the dust to settle.

One last thing to think about when you are planning your next investment - how much longer will the rest of the world support these levels of debt?