Increase in ETF Trading = Increase in Correlation??

I saw this article in Reuters today and was somewhat surprised by this comment:

The rise of ETF trading has increased market correlation. According to Bespoke Investment Group of Harrison, New York, the market is on pace for 42 days when at least 80 percent of S&P 500 stocks move in the same direction, which would be second only to the 52 days in 2008.

 Is this correlation or causation?

CIVETS

Investors are starting to look beyond the BRICs and into the next class of emerging countries, now being termed the CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa).  This article  contains a good overview of the CIVETS.  I have been bullish on Turkey for some time and continue to recommend iShares MSCI Turkey Index Fund (TUR) for exposure to Turkey.

The iShares MSCI Turkey Index (TUR) provides broad exposure to the Turkish economy via an ETF.  There are approximately 90 holdings in the cap-weighted index, with Financials comprising over 50%.  The average market cap is around $6 billion, so TUR falls in the Mid Cap category.  Expenses are fairly low at 0.65%.

This investment thesis revolves around the strength of the Turkish banking system in comparison to its neighbors and other emerging economies.  Turkey had its own financial crisis in 2001, which was caused by a growing trade deficit and a weak banking sector.  The result was a massive consolidation, as the number of banks decreased from 80 to 50.  This crisis resulted in a stricter regulatory framework and puts Turkey in a position to benefit from the current market environment.  Turkish banks are the least-leveraged in Eastern Europe, with few toxic assets and a low amount of mortgage exposure. 

The biggest position in the Turkey Index is Turkiye Garanti Bankasi at 15% of the index.  This bank saw revenue growth of 49% and profit growth of 69% in 2009.  They opened 46 new branches in Q4, and I expect this growth to continue.

Additionally, from a demographic standpoint, Turkey has a very young population which is cause for higher growth prospects.

Obviously, there are risks to this strategy.  There is still a good deal of political instability in the region and the government is heavily involved in the economy.  Additionally, inflation is near 10%, and the country’s credit is still below investment grade. 

I would suggest holding TUR as no more than 5-10% of an investor’s overall portfolio as this is meant to be used as a compliment to other International Equity holdings.

Support for Income Argument

David Rosenberg, of Gluskin Sheff, and I are on the same page... at least in terms of this income theme.  He writes today:



"Well, despite a huge amount cash on corporate balance sheets ($837 billion for
the S&P 500 nonfinancial sector – 26% higher than a year ago), it seems
obvious by now that this is only leading to a moderate cycle in capital spending –
and it looks like growth in business outlays may have already peaked.
This cash hoard plays nicely into “income” strategies. First, the tremendous
amount of liquidity helps bolster the balance sheet and mitigate the risk of
default – hence our constructive stand on credit and in particular, at this point in
time with regards to risk-reward ratios, the BB sliver of the corporate bond
universe. And also our dividend products stand out as having tremendous
investment properties in these tumultuous times.
S&P 500 companies paid out over $50 billion in dividends in Q2, up 2.3%
sequentially and 5.9% above year-ago levels (meanwhile, M&A is actually down
10% YoY!). We recall when tech stocks refused to pay out dividends but lo’ and
behold, cash-generating machines like Intel provides a 3% yield, GE is also 3%,
and even Microsoft and IBM spin off 2% dividend yields too (you have to go
beyond the 5-year part of the Treasury curve to achieve that). Utility yields are
closer to 4% and REIT funds over 3%. And guess what? One of the most
attractive markets right now relative to bonds may well be Japan where the 2.2%
dividend yield on the TOPIX is slightly ahead of the S&P 500 and is now double
what you can garner in the 10-year JGB!"

Dr. Doom on the Stress Tests

Article about Nouriel Roubini's response to the stress test results:

European stress tests assumed a rise of 6 percent in unemployment, economic contraction of 3 percent on average and a 6 percent hike in market interest rates. Many analysts said the conditions were harsher than what they had anticipated.

"The assumptions made about economic growth, about sovereign risk are not realistic enough," said Roubini.

Other notable remarks:

"It's been like a beauty contest where the issue is not who's the prettiest, but who's the least ugly," he said about the oscillations in the euro's exchange rate against the dollar.

"I think the surprises are going to be on the negative side (in the US)," Roubini said. 

Stickiness

I recently read Made to Stick by Chip Heath and Dan Heath.  The book identifies the six elements that make an idea more likely to "stick."

1. Simplicity - The idea should be simple, yet profound.  Think proverbs.
2. Unexpectedness - The idea might violate people's expectations in order to generate interest and curiosity.
3. Concreteness - Our brains are wired to remember concrete data.
4. Credibility - You need ways to help people test ideas for themselves.
5. Emotions - People will care about our ideas if we make them feel something.
6. Stories - Hearing stories allows us to form a more complete mental catalog of critical situations that we might find ourselves in.

Yes, that acronym spells SUCCES!  This made me think about examples of stickiness in the "real world."

An example of unexpected stickiness is the fairly recent phenomenon of “icing” which was made popular on certain college campuses but has made its way across the country and even onto Wall Street.  Icing is a drinking game whereby an individual is forced to drink a bottle of Smirnoff Ice while on one knee, sometimes in a humiliating fashion.  The game was even featured on CNN Money/Fortune.
While icing has certainly gone viral in the short-run, it remains to be seen if this phenomenon will be sticky in the long-run.  It does contain some of the necessary principles of sticky ideas:  

Simplicity:  It doesn’t get much simpler than drinking a beverage.  

Unexpectedness:  This idea was truly out of left field.  Who would expect a beverage that is typically thought to be consumed by females to be the focus of a drinking game that is played primarily by males?  

Emotions:  Icing does promote specific emotions like fear (about getting iced) and happiness (remembering fondly how you pulled off a prank on a friend).  

Stories:  The viral nature of icing was accelerated by the now-defunct website because the website allowed users to post pictures/videos about their icing experiences and share stories.  The website was recently removed by Smirnoff.

Another Option for Strongish Balance Sheets

The latest earnings season has been generally strong for US stocks.  More than 83% of companies in the S&P 500 have exceeded the average analyst profit estimate for this quarter.  In light of this decreased probability of default, high yield bonds have performed well.  Another option for income in this environment is the high yield space.  My favorite junk bond ETF is SPDR Barclays High Yield (JNK).  The yield is currently over 12% and the expense ratio is 0.40%.  Costs don't get much lower in the high yield space.  Keep in mind that these bonds are called junk for a reason.  Average credit quality is B and average duration is currently 4.7 so if the Fed starts raising rates sooner than anticipated, this fund will be adversely impacted.

How To Play Strong Balance Sheets

Even during tough economic times, profits of US companies are rising.  However, the benefits are not flowing through to the labor market (see previous post) or the broader economy.  These profits are increasing mainly due to cost cutting, and firms are paying out higher dividends to shareholders or increasing the amount of cash held on the balance sheet as opposed to investing the excess funds.  

This New York Times article goes into greater detail regarding the profit situation for US firms.  There are numerous options for investing with an attempt to take advantage of this environment.  Here are a few:

1. M&A:  One may expect M&A activity to pick up at a time like this, but deal flow has not increased to the extent you might expect.  
2. Pick high dividend stocks
3. Dividend ETFs:  A safer play than trying to pick individual stocks and be exposed to idiosyncratic risk is to hold an entire index of dividend-paying stocks.  I personally like Vanguard High Dividend Yield (VYM) for this purpose.  The fund holds large cap U.S. stocks and charges a low expense ratio of 0.20%.  The current yield is 3.17% which might increase if companies continue to pay out higher dividends.  Another dividend play is the iShares DJ Select Dividend (DVY).  The main difference between VYM and DVY is that DVY holds smaller firms and pays out a slightly higher dividend.  The current yield is 3.94%.  However, while still affordable, DVY's expense ratio is 0.40%.      

Extension of Unemployment Benefits

I recently read this article from the Economist that debates the recent congressional decision to extend unemployment benefits.  This decision comes down to weighing two factors:  

1. protecting at least part of the earnings of workers who were laid off due to no fault of their own 
2. ensuring that unemployment is not comfortable enough to encourage workers to intentionally get laid off or not attempt to find work when unemployed

I side with Professor Gary Becker who writes:

During bad times, 6 months of unemployment compensation may not be long enough, but the 2 years in the new law is too long.  About 9 months of unemployment compensation would be the right length. Anyone unemployed longer than that would lose these benefits. If they want to work they should be forced to adjust, at least temporarily, to the bad economic environment, and accept jobs that they would turn down during good economic times.

Girls = Evil?

Theory of the Business

I recently read an old article by Peter Drucker titled "The Theory of the Business."  Even though it was written in 1994, the major concepts are still very valid.  I thought it was interesting so I will share some of the main ideas:

A company's "theory of the business" is essentially the assumptions about what the company gets paid for.  These assumptions change over time to the extent that the realities that each organization actually faces change quite dramatically from those that company assumes it lives with.

A theory of business has three parts:

1. Assumptions about the environment of the organization:  society/structure, market, customer, and technology (these define what an organization is paid for).
2. Assumptions about the specific mission of the organization (these define what an organization considers to be meaningful results).
3. Assumptions about the core competencies need to accomplish the organization's mission (these define where an organization must excel in order to maintain leadership).

In order to be a valid theory, these specifications must meet certain criteria:

1. Assumptions about environment, mission, and core competencies must fit reality.
2. Assumptions in all three areas have to fit one another.
3. Theory of the business must be known and understood throughout the organization.
4. Theory of the business has to be tested constantly.  

Eventually, every theory of the business becomes obsolete and then invalid.  It is important to recognize this.  When a theory starts showing the first signs of becoming obsolete, it is time to start thinking again about which assumptions are no longer valid.  It is also important to build systematic monitoring into the organization, in order to test the theory.

As an investor, I would like to see the businesses I'm investing in or thinking about investing in use a framework that includes some or all of these ideas.

Bill Miller interview

As someone very interested in behavioral finance and the psychology behind investing, I find that this interview with Bill Miller raises some great points about how to take advantage of behavioral flaws in the market.

Satellite images of oil spill