March 8, 2013
By Steve Blumenthal

What a market – up over 8% in 2013 in just 9 weeks!  “Switch my investments – get me in,” says the client.  It is the annual dance; rebalancing out of underperforming assets and into outperforming assets.  Disciplined removed, memory gone as emotion rules reason.

While ill-advised, the temptation is too strong and the average investor sets his plate for his next disappointment.  This behavior two-step is detailed in the following Dalbar 20-year Performance Study.  The results are sub-par.

It was tech in 1999, housing and financials in 2007 and the crowding in bonds today.  Once again, placing our trust in the great and powerful Fed, we move forward and choose to close our eyes.

However, let’s move in a different direction today and take a pass on discussing France’s problems, the EU distress that remains, the global debt and entitlement mess, Japan’s new era, the brewing currency wars and talk in detail about building two kinds of portfolios.  One concentrated on big bets (“get rich quick”) and the other a balanced broad-based investment approach favored by endowments and seasoned investors that is an approach aligned with the principles of Modern Portfolio Theory.  

Let’s first swing for the fences and talk about several ideas that could be home runs, “concentrated get rich bets” and then let’s take a look at how you might weave some of the ideas into a well thought-out and broadly diversified portfolio structure I call the 33/33/34 Enhanced Modern Portfolio Theory approach.

A quick aside: I talk about investments as “risks”.  Each producing a different risk stream.  Some risk streams are highly correlated (meaning they go up and down together) and some are not.  It is also important to note that risk exists in every investment (your bank CD, your money market, your insurance company, the cash under your mattress, your brokerage account, in everything).  You simply need to take risks.  There is no other way.  Concentrated risks may produce great wealth or may take away your wealth.  It is for this reason that diversification is important.

This is why I favor 33/33/34 that combines a diverse set of non-correlating risks as I believe  compounding money over time is a far better investment approach than swinging for the fences; however, hitting home runs is fun so let’s swing hard at what I believe are the fattest and most probable pitches to hit and then talk about how to weave them into a well thought-out portfolio.  Important: this is not a recommendation for you and offered for discussion purposes only.  I encourage you to discuss with your advisor.

Concentrated Get Rich Bets

  • Long Gold (inflation and currency protection)
  • Short Yen (inflation and currency destruction – the bet is yen gets hurt most against the major developed world currencies)
  • Short 30-year U.S. Government Bonds (just not quite yet – trade likely late 2013)*
  • Long Japanese stocks (big inflation play but couple the trade with short yen to preserve currency loss)
  • Long Agriculture (food inflation and demand vs. supply imbalance)
  • Long Emerging Markets (they are in better financial shape than the developed world and their currencies should benefit relative to the U.S. dollar)
  • Others to consider: Long Natural Gas, Long Coal, Long Water

If I were to be a home run hitting type of guy, I’d go with the following:

25% Gold ETF
25% Short Yen (short yen recommended in the 11-30-12 Viewpoint)
25% Long Japan Index
25% Long Agribusiness ETF

*I really like the short government bond trade but still think it is just a bit too early.  I’ll be looking at investing in an inverse government bond ETF later in the year. See next chart on supply and demand for 2013.  There is nearly twice the demand vs. supply, providing support to the bond market… for now.  Note that the very large buyer is the Fed.  Carefully read all fund prospectuses.

The fat pitch here is that the global central banks have planted the seed for significant inflation.  The total market capitalization of the global equity markets is $55 trillion, up 10% or so in the last few months.  The total amount of new currency units the global central banks have created is $15 trillion, the majority of which has been printed in the last five years.  That’s a super “wow” number.  Can you say, “It’s a wonderful day in the neighborhood children?”  Maybe – until inflation steals the show.  This is unprecedented and, unfortunately, history has taught us that such manipulation ends badly.

The Fed and the balance of the developed world are printing massive amounts of money.  They are forcing people into the markets.  This kind of rigging and manipulation has its consequences. One of the biggest that we see on a daily basis is a huge miss on asset allocation.

A more sensible approach is to weave some of the big bets into a broader portfolio game plan. If I am correct in my forward view, those risk bets should help your overall return.  If I’m incorrect, they are sized in such a way as to not hurt too much.  Forget 60/40 and move to 33/33/34.  It is risk focused and highly diversified and I believe can put you in position to take advantage of the great buying opportunity that will present itself at the next crisis low.

Until then I like the following endowment-like approach:

33/33/34 – Enhanced Modern Portfolio Theory

Endowments and experienced investment managers favor Modern Portfolio Theory, which is defined as “a mathematical formulation of the concept of diversification in investing, with the aim of seeking a collection of investment assets that has collectively lower risk than any individual asset.”

33/33/34

33% Equities:

  • 6%  Vanguard Total Stock Fund (hedged periodically with covered calls and put options – see Trade Signals for ideas around hedging)
  • 6%  Vanguard International Stock Market Fund (hedged as above)
  • 6%  CMG Tactical Rotation Strategy (a tactical risk management focused strategy)
  • 15% CMG Opportunistic All Asset Strategy (a tactical risk management focused strategy)

33% Fixed Income:

  • 33% CMG Managed High Yield Bond Program (a tactical risk management focused strategy.  Note that I am biased here as I have managed this strategy for more than 20 years. You may want other flexible bond funds in your mix. Simply, traditional fixed income at historic lows yields is far too risky relative to the potential return.  Think tactically on fixed income until rates reset higher.)

34% Trading Strategies – Alternatives

  • 7% Gold (a hedge against inflation, currency play and a directional risk bet)
  • 4% Agriculture (both a hedge against inflation and a directional risk bet)
  • 4% Vanguard REIT (both a hedge against inflation and a directional risk bet)
  • 5% PE Investments Currency Trading Strategy (tactically long or short G10 currencies)
  • 4% Short Yen ETF (both a hedge against inflation and a directional risk bet)
  • 5% CMG Scotia Growth S&P Plus Program (tactical long or short S&P 500 Index exposure)
  • 5% CMG SR Treasury Bond Program (tactical long or short government bonds)

*Please carefully read all prospectuses before investing.

Over time, this portfolio averaged 11.09% per year vs. 2.14% per year for the S&P 500 Index and 6.20% for the Barclays Aggregate Bond Index. More importantly, the max drawdown was just -11.88% vs. -50.95% for the S&P 500 Index.  Its standard deviation was 7.87 vs. 15.91 for the S&P 500 Index and produced a sharp ratio of 1.  The blue line below represents the portfolio and the goal we are trying to achieve.


To be crystal clear, the performance is hypothetical as the data set combines various investments into one portfolio at the above referenced percentage weightings.  See important disclosure information at the bottom of this email.

The idea I’d like to leave you with is how you might weave together a diversified set of risks to create a portfolio aligned with the principles of modern portfolio theory.  In order to put it all together, I believe it is important to look at how two risks correlate with each other.

In the portfolio creation process, ideally we are looking to combine risks that do not correlate with the stock market and/or the bond market and we are looking for risks that have the ability to profit in both up and down markets.  Once we have identified the various risks, we are additionally looking for risks that don’t correlate to each other, thus, furthering diversification.  I’m not saying don’t own the Vanguard fund, I’m saying own it together with something that is uniquely diversified and together they are better than either is alone.

When I look to include a new asset or investment strategy into a portfolio, I first look at its correlation to the S&P 500 Index.  As you look at the correlation chart that follows, take a look at how each asset correlated with each other (specifically look at 2 through 15).  As you look at each compared to each other you are looking for numbers between -0.5 and +0.5 to represent non-correlation.  In this way, we are looking to combine a set of risks that do not rise and fall together at the same time. 1.00 is fully correlated while -1.00 is completely un-correlated.  We want -0.5 to +0.5.

Please give me and my team a call if you have any questions.  It is a lot of data to take in and I understand it might look like a foreign language to you.  We are happy to help.

I would also like to offer you a sincere apology.  I received a number of emails after last week’s On My Radar from some justifiably upset friends.  I shared a Bloomberg article/video link that featured Stan Druckenmiller (famed hedge fund manager and former chief strategist for George Soros) titled “Druckenmiller Sees Storm Worse Than ’08 as Retirees Steal”.

Stan talked about our seniors stealing from our young people and went on to share some of the math behind the demographic crisis that lies ahead.  While the crisis is real, I don’t believe that throwing the seniors, who have paid into the system for years, under the bus was the right approach.  Frankly, I’m not sure if he intended to strike out at seniors or if in a short interview just focused on quick sound bites.  Either way, it came across that way.

I believe his intent was to wake us up to the crisis ahead; however, I’m sorry that by extension, if in any way, I offended you.  That certainly is not my way.  As I read the Bloomberg piece, I gave little attention to his comment and focused on the bigger issue ahead.  To which end I agree.  My baby boom generation is aging and last I remember, we represent two-thirds of the U.S. population.  There is not enough money, nor will there be enough workers paying into the system, to cover the entitlement promises given to us.  The math simply will not work.  The imbalances are too great – one way or another something will give.

On a better note, I just returned from Bend, Oregon where I and my senior team spent four days in strategic planning with my personal business coach, Jim Ruff.  Jim is happily retired from Oppenheimer Funds and has grown to be a great friend.  We skied, huddled for hours in a closed board room, ate well and had some terrific beers.  The micro brewery business is alive and well in Bend.

As I set business and personal goals and think about them often, Jim frequently comes to mind as a wonderful example of how to continually create great things and, most importantly, how to celebrate life to its fullest.  Jim, I’m raising my Crux IPA to simply say how grateful I am.

Bend, Oregon is spectacular – look it up and go for a visit.      

Video Links, articles and charts:

Here is a link to an important 9:11 minute video clip from CNBC this past week.  Well worth the review.  Ken Langone, co-founder of Home Depot; Stanley Druckenmiller, former chairman & CEO of Duquesne Capital Management; Kevin Warsh, Hoover Institution and Geoffrey Canada, Harlem Children’s Zone CEO, share their strategies on investing for the future.

Note: I have posted a number of articles and video links on this subject up on our web site as well as the above demographic chart and a powerful chart showing 10-year forward expected 60/40 returns.  Here is the link: http://www.cmgwealth.com/research-insight/  click on the News link.

If you have any questions or comments, please feel free to email info@cmgwealth.com or simply reply to this email.  Wishing you the very best.

With kind regards,

Steve

Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Suburban Philadelphia
1000 Continental Drive, Suite 570
King of Prussia, PA 19406
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax

Quote sources:

1)       http://www.msnbc.msn.com/id/27335454/ns/business-stocks_and_economy/t/greenspan
2)       http://www.ft.com/intl/cms/s/0/ebfb0d8e-32eb-11df-bf5f-00144feabdc0.html#axzz2IiLVLuO2.
3)       http://www.reuters.com/article/2013/01/18/us-usa-fed-idUSBRE90H13Q20130118
4)       http://en.wikiquote.org/wiki/Alan_Greenspan
5)       http://en.wikiquote.org/wiki/Alan_Greenspan


IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk.   Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc (or any of its related entities-together “CMG”) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.

Certain portions of the content may contain a discussion of, and/or provide access to, opinions and/or recommendations of CMG (and those of other investment and non-investment professionals) as of a specific prior date.  Due to various factors, including changing market conditions, such discussion may no longer be reflective of current recommendations or opinions.  Derivatives and options strategies are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Moreover, you should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from CMG or the professional advisors of your choosing. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisors of his/her choosing.  CMG is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.

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Hypothetical Presentations:  To the extent that any portion of the content reflects  hypothetical results that were achieved by means of the retroactive application of a back-tested model, such results have inherent limitations, including: (1) the model results do not reflect the results of actual trading using client assets, but were achieved by means of the retroactive application of the referenced models, certain aspects of which may have been designed with the benefit of hindsight; (2) back-tested performance may not reflect the impact that any material market or economic factors might have had on the adviser’s use of the model if the model had been used during the period to actually mange client assets; and,  (3) CMG’s clients may have experienced investment results during the corresponding time periods that were materially different from those portrayed in the model.  Please Also Note: Past performance may not be indicative of future results.  Therefore, no current or prospective client should assume that future performance will be profitable, or equal to any corresponding historical index. (i.e. S&P 500 Total Return or Dow Jones Wilshire U.S. 5000 Total Market Index) is also disclosed. For example, the S&P 500 Composite Total Return Index (the “S&P”) is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the stock market.  Standard & Poor’s chooses the member companies for the S&P based on market size, liquidity, and industry group representation.  Included are the common stocks of industrial, financial, utility, and transportation companies.   The historical performance results of the S&P (and those of or all indices) and the model results do not reflect the deduction of transaction and custodial charges, nor the deduction of an investment management fee, the incurrence of which would have the effect of decreasing indicated historical performance results. For example, the deduction combined annual advisory and transaction fees of 1.00% over a 10 year period would decrease a 10% gross return to an 8.9% net return. The S&P is not an index into which an investor can directly invest. The historical S&P performance results (and those of all other indices) are provided exclusively for comparison purposes only, so as to provide general comparative information to assist an individual in determining whether the performance of a specific portfolio or model  meets, or continues to meet, his/her investment objective(s).  A corresponding description of the other comparative indices, are available from CMG upon request. It should not be assumed that any CMG holdings will correspond directly to any such comparative index. The model and indices performance results do not reflect the impact of taxes. CMG portfolios may be more or less volatile than the reflective indices and/or models.

In the event that there has been a change in an individual’s investment objective or financial situation, he/she is encouraged to consult with his/her investment professionals.

Written Disclosure Statement. CMG is an SEC registered investment adviser principally located in King of Prussia, PA. Stephen B. Blumenthal is CMG’s founder and CEO. Please note:  The above views are those of CMG and its CEO, Stephen Blumenthal, and do not reflect those of any sub-advisor that CMG may engage to manage any CMG strategy.  A copy of CMG’s current written disclosure statement discussing advisory services and fees is available upon request or via CMG’s internet web site at (http://www.cmgwealth.com/disclosures/advs).