Financial Sarcasm Roundup for 02/12/16

I had a busy day today. Important things demanded my attention. I read a whole bunch of very interesting material. I barely have time for sarcasm right now, but I make time.

The Federal Reserve's chair does not wish to be blamed for stock market turmoil. What a bunch of hooey. The Fed's ZIRP has done more to misprice securities valuation than anything else it has done in its history. Normalizing rates sooner would have depressurized the stock market without all of this pain from unsustainable gains. Other central banks took off with variations of the Fed's approach and now we see China's collapse hurting other markets. Way to go, banker gnomes.

Europe's sovereign debt market is seriously stressed. I wouldn't be surprised if some random announcement from one of the PIIGS' finance ministers makes the whole tamale implode. Suckers bought European government bonds and will soon eat their losses. The ECB's dollar swap line agreements with the Federal Reserve were an open secret among Transatlantic bankers in the last crisis. The rest of us won't find out for years just how much credit the Fed has given the ECB to support its bond purchases now.

I just did a Google search of "leveraged ETF" to see that these stupid products are more popular than ever. Investors chasing these things and advisers pushing them obviously can't do the math on daily leverage calculations. The best hope for sanity is a market crash that wipes out the 2x-3x bullish ETFs combined with a credit crisis that destroys the liquidity of bearish ETF sponsors. Brokerages programming their robo-advisers use passive ETFs without leverage for darn good reasons.

I should be busy tomorrow. I continue to ignore losers who demand my attention because I only have room on my calendar for winners.

Small Business Indicators For Microcap Sector Choices

Microcap stocks are notoriously hard nuts to crack. They are the part of the capitalization-weighted investment universe that is typically less liquid, transparent, and profitable than large-cap choices. Investors do have some indicators they can use to estimate turning points in the microcap sector's aggregate health. A small number of microcap ETFs help diversify away company-specific risk.

The NFIB's Small Business Economic Trends (SBET) is one possible proxy for the sentiment of small business owner-investors. It combines data on both future plans and current results. The December 2015 report puts the Index of Small Business Optimism at 95.2, below the long-term average of 98. The small sample size and seasonal adjustments limit the index's usefulness. The SBET also does not disclose the average revenue, net income, or asset quality of its sampled businesses, so investors cannot presume any strong equivalency with microcap stocks.

The Wells Fargo / Gallup Small Business Index is probably a more robust indicator than the NFIB SBET. Gallup's index methodology also relies upon a small sample size but discloses a revenue range that could easily include the lower bound of the microcap sector's revenues. The index is one more addition to an investor's toolkit. BTW, this index also registered a decline in optimism in late 2015.

The Paychex IHS Small Business Jobs Index covers a vast sample size, so data quality here is less of a concern than with the previous two indexes. Measuring job growth helps investors determine whether small companies can afford to expand and handle higher sales volumes. Job gains at the end of 2015 were on a slight downward trend since early 2014, punctuated by some up months.

Dun and Bradstreet’s U.S. Economic Health Tracker covers a Small Business Health Index for payments and credit, with a large data set. The Tracker shows small business performance worsening so far this year, with weak payment performance. That makes two weak optimism indexes, a declining jobs index, and a weak payment/credit health index so far to start 2016.

Our macroeconomic data indicators for small businesses are not the only ways to understand microcaps. Investors need to know how different index providers assemble the microcap universe, because this ultimately determines ETF composition. The Boglehead wiki on US micro cap index returns compares several microcap indexes. The Wilshire index has the longest history, so performance data for products based on that index would be the most reliable.

Only a small number of ETFs cover the microcap sector. PowerShares Zacks Micro Cap ETF (ticker PZI, expense ratio 0.70%) and First Trust Dow Jones Select MicroCap ETF (ticker FDM, expense ratio 0.60%) are very thinly traded. Investors will face more difficulty with trade execution in thinly-traded securities. The Zacks product follows a proprietary index and the First Trust product follows a select index, so their returns are not directly comparable to those of ETFs that follow wider indexes.

The iShares Micro-Cap ETF (ticker IWC, expense ratio 0.60%) is more actively traded and has a larger market capitalization than PZI or FDM, and its construction from the Russell Microcap Index makes its methodology more reliable. Other details are less encouraging. It is currently heavily weighted toward the finance, health care, and information technology sectors. Those areas are all very much in bubble territory thanks to the Federal Reserve's easy credit (finance), unsustainable Medicare payouts (health care), and VC-funded startup unicorns gorging on cloud services (IT). Consider also how the R-squared result for IWC (at its Yahoo Finance risk data) declined from 77.77 at the 10-year mark to 47.66 in the most recent three-year period. The more recent period's performance thus has progressively less to do with the underlying index. That is a worrisome sign for an ETF that is supposed to stay very close to an index's results.

Investors are welcome to track the above four macro indicators and relate them to the microcap sector's leading products. Weakening indicators imply tougher times for small businesses. Leading index products that are increasingly divergent from their benchmarks (and more expensive than large-cap ETFs) are causes for concern.

The sad tales of microcap stock promotions gone wrong are always with us. The bad old days of investor relations conferences and seminars have given way to spam email stock scam promotions. Microcaps are easy prey for all manner of bad actors. The most broadly diversified instruments will at least give investors exposure to larger trends that can lift young, high-risk public companies to larger capitalizations.

Full disclosure: No positions in any securities mentioned.

Timber REIT Performance and Valuation Comparison

My search for hard asset hedges against hyperinflation continues apace.  I've already checked out self-storage REITs.  Now it's time to check out timber REITs and their related ETFs.  The leading candidates are below.  My sources are the same as before:  Yahoo for P/E and margin, Reuters for EPS and ROE growth.

Rayonier (RYN)
P/E:  18.69
Profit margin:  23.15%
EPS 5yr growth:  8.11%
ROE 5yr growth:  21.01%

Plum Creek Timber (PCL)
P/E:  30.71
Profit margin:  17.77%
EPS 5yr growth:  -4.76%
ROE 5yr growth:  14.74%

Potlatch Corp. (PCH)
P/E:  24.59
Profit margin:  11.83%
EPS 5yr growth:  -11.09%
ROE 5yr growth:  24.49%

Comparing RYN to its two competitors gives me one interesting implication.  The other two have increased their annualized ROE while their EPS have declined.  I don't get that at all.  The inverse of such a relationship  (EPS up, ROE down) holds if a company changes to a more conservative capital structure with less debt.  The long-term debt holdings of those PCL and PCH appear to be constant, so they don't seem to be levering up just to increase ROE.  I wonder whether they've increased their shares outstanding in recent years, as that would account for a larger denominator in the EPS calculation.

A further inspection at the balance sheets of PCL and PCH show increasingly negative retained earnings for several years.  RYN's balance sheet shows retained earnings to be large, positive, and increasing annually.  That result, along with the positive EPS growth for RYN and negative EPS growth for the others, give me enough reason to favor RYN over its two competitors.

Rayonier has a couple of other things going for itself.  Its free cash flow has been positive for three years.  Its long term debt is far above the 2X net income I usually prefer in operating companies, but I'm bending that rule for two reasons.  One, this is a REIT, where high debt is common.  Two, I need a hyperinflation hedge, and hyperinflation reduces debt mountains to molehills.  Oh yeah, one more thing.  Rayonier's P/E ratio is a lot more fairly priced relative to the S&P 500's historic average of 14, so it's somewhat affordable.

Let's find out just how affordable Rayonier should be for me to buy it.  I plugged its dividends into my Alfidi Capital REIT ETF valuation template, using the same assumptions I made for the self-storage REIT.  I get an intrinsic valuation of $17.16/share, so applying a 10% discount means I won't pay a penny more than $15.44/share for RYN.  It hasn't been that cheap since mid-2009 and it currently trades at $56.29.  I'll wait for the market crash first.

I'll also mention timber REIT ETFs, specifically Guggenheim Timber (CUT) and iShares S&P Global Timber & Forestry ETF (WOOD).  My objection to these ETFs is that their holdings are much broader than just timber harvesters.  These ETFs hold operating companies that are in some ways only marginal users of timber products.  Their expense ratios are also extremely high.  That's why I'm ruling them out as candidates for my hard asset strategy.

I've found my pure play timber REIT candidate.  I will wait to buy into Rayonier when the price is right.

Full disclosure:  No position in any of the securities mentioned above at this time. 

More Currency ETFs Coming Down The Pike From iShares

Oh great, just what we all need.  Here come more ETFs based on currency ideas.  The iShares family is filing to launch actively managed currency ETFs.  I can tell just by looking at the filing paperwork that there's no way I'd be interested in these instruments.

The language of the iShares templated prospectus puts me off.  "Financial exposure substantially similar to a purchase" of currency is not necessarily the same thing as the currency itself.  I am disappointed that these funds allow for the purchase of short-term debt denominated in US dollars.  The whole point of holding currencies not correlated with the US dollar is to reduce exposure to an inflationary calamity that would destroy the dollar's purchasing power.  Hiding US sovereign debt inside a currency ETF magnifies US dollar exposure rather than hedging it.

I already have long holdings in Australian, Canadian, and Swiss currency thanks to ETFs with a bearish bet against the euro.  The Guggenheim CurrencyShares are plain vanilla holdings of currency and nothing more.  Currency doesn't need to be actively gamed to be a viable hedge against home country inflation.

Full disclosure:  Long FXA, FXC, FXF; long put position against FXE.

The Haiku of Finance for 10/02/12

Vanguard index switch
Lower license cost makes sense
Pass the savings on

The Haiku of Finance for 08/18/12

Inverse ETF
I just don't see the appeal
Opaque and risky

Direxion Learned Nothing From ETF Closures

Direxion is one of those mutual fund companies that just doesn't know when to quit.  It's been playing around with leveraged and inverse ETFs for a while.  Such a bizarre interpretation of a passively managed, low-cost approach to investing was bound to blow up sooner or later.  Direxion learned the hard way and is now closing nine of its 3X ETFs.  But what exactly did they learn?  They still sponsor a large number of leveraged ETFs and have filed registration for six new ones.

These ETFs will of course appeal to investors who don't understand that the daily leverage calculation of these ETFs is a far greater drag on the funds' returns than an expense ratio of "only" 0.75%.  A plain vanilla ETF is far cheaper, and risk management with simple options is far more transparent.  Firms like Direxion count on investors having a nonexistent learning curve.

Full disclosure:  No position in any Direxion products.  

The Haiku of Finance for 04/27/12

Inverse ETF
Uses hidden leverage
Big tracking error

Hedge Fund ETFs Coming For Stupid People

Non-accredited investors will son be able to throw money away in the same manner as high net worth investors.  Hedge fund ETFs that mimic some value and activist strategies will soon be here.  I shouldn't have to say that this is beyond stupid but I enjoy hearing myself think out loud.  This blog is all about public service.

The incompatibility of hedge fund strategies and ETF strategies is plain.  Classic ETFs mimic broad indexes as closely as possible, with a lot of constancy in their holdings and little turnover.  Hedge funds can mimic any strategy in the blink of an eye, where holdings turnover rapidly and incur unpredictable tax events.  ETFs are cheap because they seldom change their makeup.  Hedge funds are expensive because they change what they hold a million times a day.  Changes in ETF holdings lag changes in their representative indexes by no more than a day or two.  Changes in hedge fund ETFs, according to the filing documents themselves, can lag the representative hedge strategy's 13F filing by as much as 45 days.  That giant lag alone makes a copycat strategy meaningless.

Investors who think that buying a hedge fund will give them outsize returns need to subtract the two-and-twenty premium to calculate the impossibly large long-term alpha the fund will have to generate just to beat the tiny long-term beta of an ETF.  Investors who buy a hedge fund ETF will get the worst of all possible worlds.

Nota bene:  I don't buy hedge funds or ETFs based on hedge funds.  

Thoughts On Master Limited Partnership ETFs

The prospect of hyperinflation demands due consideration of hard asset alternatives in a portfolio.  I've been exploring master limited partnerships (MLPs) to see if they fit my investing style.

I spend my daylight hours hearing roadshow pitches from oil and gas prospectors who explore producing wells one property at a time.  These wells are difficult enough for a small company with limited finances.  Pooling single wells into MLPs aggregates their production and enables partners to allocate capital where it can add the most to production.  Pipeline MLPs are intriguing for a related reason.  Their cash flow is the result of amalgamated production in large regions, regardless of how poorly a single well may be performing at any time.

Applying some Boglehead theory to MLPs leads to the conclusion that MLPs arbitrage away risks specific to single wells and pipelines.  It follows that an ETF of MLPs would arbitrage away risks of local geography and single MLP structures, leaving an investor with broad exposure to a flow of hard assets.

I will posit that the cash flow generated by an MLP ETF is a rough substitute for the cash flow generated by fixed income investments.  One crucial difference can make all the difference in a hyperinflationary environment.  Inflation gradually destroys the principal value of a fixed income security and reduces the real value of its coupon payments.  Even TIPS may not be immune to this destruction if their principal resets are not frequent enough to keep pace with inflation, or if the resets are based on artificially suppressed CPI calculations.  A hard asset ETF such as an MLP ETF may not suffer such a deficiency.  Its cash flows are derived from the nominal value of payments made for resource flows, so its value should theoretically hold during hyperinflation if it is rapidly marked to market.

The only MLP ETF I am currently considering for this role in my portfolio is the Alerian MLP ETF (AMLP).  I have not purchased it yet for several reasons.  First, it trades at a multiple of 22 times earnings, pretty pricey given the economy's long term average P/E of 14.  Second, its expense ratio is frighteningly high at 0.85%.  Finally, it has only been around for two years, and has not paid enough coupons for me to find its value using something like my REIT ETF valuation methodology.  I believe that methodology is applicable to an MLP ETF because REITs must pass through their cash flows as dividends to shareholders, just like MLPs.

I like that AMLP is optionable, so that if I did own it I could write short puts under it while inflation drives it up.  Other MLP substitutes like ETNs don't have that flexibility.  Come to think of it, I may decide to buy into it despite my reservations above if inflation really does get going.  Bargain or not, hard assets that generate cash flows bring the best of many worlds when hyperinflation starts destroying the value of everything else.

Full disclosure:  No position in AMLP at this time; this disposition could change with the onset of high inflation in the U.S.

Alpha-D Updates for 03/19/12

Hey folks, here comes my portfolio update following an options expiration weekend.  My covered calls all expired unexercised, so I renewed the call positions I typically have over GDX and FXI.  The value of GDX has fallen so far from its high that I'm willing to risk adding a little more involuntarily, so I wrote some puts under GDX with an expiration date next month.  I have the cash to buy shares if the strike price is triggered.  Picking up a little extra gold in the ground may prove useful as the U.S. edges closer to a hyperinflationary environment.

Speaking of hyperinflation, I remain on the lookout for equity positions in hard assets or sectors that serve hard asset production and distribution.  This can cover a broad gamut of things including energy production, energy distribution, railroads, pipeline operators, oil and gas MLPs, mining, and certain types of real estate.  This approach only seems broad when you consider that it excludes wide swaths of the larger economy that will probably not perform as well during hyperinflation.  I plan to stay as far away from consumer retailers, residential real estate, and consumer technology as I can for the next few years.

I still have my small holdings of California municipal bonds and I count off the days until they mature.  The return of my principal will give me the opportunity to see if an allocation to the TIP ETF will maintain a fixed income position that can adjust to hyperinflation.

The rest of my liquid portfolio is in cash.  I await the European trigger for a broad market correction.  I do not believe I am waiting in vain.

Full disclosure: All positions are noted.  

Does John Bogle Like Anything?

John Bogle is the originator of index investing.  Scanning recent headlines leaves the casual reader with the impression that he's a crusty old dude who can't stand modern life.  He dislikes the current federal tax scheme that gives big breaks to private equity firms.  I totally agree with him on that one.  He doesn't like ETFs because they tempt investors to actively trade something that should be a passive allocation to an asset class.  I see his point but I disagree; ETFs are useful for an index-based strategy that seeks to enhance yield over the short term using options.  He doesn't even like the financial system as a whole for its weak governance.  I do agree and I would come down even harder on proprietary trading than the Volcker Rule.

I've read enough of Mr. Bogle's writing to figure out what he really does like.  He's fond of low-cost, passive indexed, long-term approaches to investing.  Nothing else matters much for the average investor.  The unique thing about him is that he recognizes the existence of outliers like Warren Buffett who somehow outperform average investors and market indexes.  I believe Mr. Buffett's success comes from taking passive investing to an extreme, with a disciplined focus on minimizing risk and cost.  That is deep value investing in a nutshell, and when combined with some simple insights into market anomalies (like merger arbitrage, monopolistic pricing power, and very limited use of options) it makes for an awesome approach to building wealth.

Long live John Bogle, Paul Volcker, and Warren Buffett.  They are in the twilight of life and there are very few investment professionals who can step up to replace them.  Except me, of course.  I've been ready for a while.  

Alpha-D Updates for Feb. 2012

I made no real changes to my Alpha-D Strategy this month.  My covered calls on FXI and GDX expired unexercised so I renewed them for another month.  I made no changes to the small amount of California state municipal bonds I hold and I am waiting for them to mature in a few months.  For the record, I'm still thinking about buying some TIPS but only if I can conclude that a TIPS ETF will reprice quickly enough to hold its NAV near fair value regardless of the face values of its constituent bonds.  This is a theory worthy of a severe real-world test.

I'm sitting on cash, just waiting for this Greek default action to really get going.  Nothing has been resolved by this week's deal in Brussels.  Too many Greeks on the street will refuse to accept austerity measures.  Pressure from below will probably obliterate the deal and remove Greece from the euro.  I expect other bankrupt nations in the PIIGS to line up for bailouts that will prove just as impossible to execute, and then their exits will follow.

Any future eurozone bank destruction will be felt on American shores.  It is a matter of time but the timing is unknowable. That is why the personal capital I've committed to equities is at the lowest percentage of my net worth since August 2007.  That was the last time the markets had some kind of high point, and they are reaching similar highs now.  I'd rather wait for new lows.  

Gold Shares Don't Always Respond To Gold Prices

Gold mining shares don't always track movements in gold prices.  Longtime market observers know there's not a perfect correlation and recent trading makes this abundantly clear.  Gold miners are often leveraged whereas pure bullion doesn't come with any debt attached.  Bullion's lack of such encumbrance has made it more desirable to investors as they pour money into bullion ETFs.  Check out how the values of bullion ETFs have been bid up past the price of bullion itself, while the value of the top thirteen gold producers has lagged gold's market price. 

Some hedge fund is probably working on a way to arbitrage this action, but a saner way ahead for the typical gold investor is to divide gold holdings between mining stocks and bullion.  One very important caveat is the specious nature of gold bullion ETFs' accounting.  Even bullion held privately (under your bed, in your closet, or some Swiss bank's vault) is of little use if it can't be divided into lots small enough to buy things. 

Full disclosure:  Long GDX with covered calls. 

Find The Wisdom At Wisdom Tree

The financial services sector needs innovation as much as any other part of the economy.  That's the only way to achieve growth and deliver value over the long-term.  The bad news about innovations is that many of them don't work out as intended. 

Wisdom Tree rolled out ETFs based on value-adjusted weights rather than market cap weights.  A fine idea, until the underlying fundamentals of the ETFs' constituents demand broader portfolios.  The firm recently announced major changes to the composition of several of its ETFs.  The problem with value weights is that changing economic conditions will demand more rapid changes in portfolio composition as the ETFs' holdings become even broader.  This will raise transaction costs and make these ETFs less competitive than index-based products from Vanguard, BlackRock, and other players who compete primarily on cost. 

Wisdom Tree's experiment in ETF construction is necessary.  It will run its course.

Full disclosure:  No position in any Wisdom Tree products. 

Malkiel Likes To Random Walk With ETFs

Burton Malkiel, legendary investment theorist and author of "A Random Walk Down Wall Street," likes what ETFs do for the retail investor.  He has long endorsed the use of low-cost index investing so it's good to see him climb on the ETF bandwagon.  It would be great if he could mention their value in a covered call writing strategy.  Malkiel's further endorsement of high-frequency trading makes less sense.  It doesn't take a million trades per nanosecond to arbitrage an ETF's value into line with its holdings. 

He's not the only voice in finance pushing for more attention to ETFs.  Charles Schwab's study noting the favor independent advisors show towards ETFs is only slightly disingenuous.  Schwab is one of the most popular platforms for independent RIAs, so throwing them a bone is good marketing.  It also helps that this release is timed with the rollout of Schwab's ETF-selection tool.  Gotta hand it to Uncle Charlie. 

Full disclosure:  No position in SCHW at this time. 

Walk Like An Egyptian ETF - With Caution

The world's eyes were until recently glued to Greece, the cradle of civilization.  Now they're mesmerized by that other font of ancient mystery, Egypt.  U.S. retail investors have little access to the Egyptian stock market except through thinly traded instruments like the Market Vectors Egypt Index ETF (EGPT).  This ETF isn't as liquid as others because many of its underlying equities are illiquid, requiring new shares to be handled via in-kind creations.  Van Eck has suspended those creations now that Egypt's turmoil has closed its equity market.  Investor cash intended for EGPT can't be put to work in the fund, so the Egyptian market remains largely inaccessible to new investors despite increased investor attention.  Even ETF experts are unable to estimate a fair value for EGPT thanks to the implied tracking error of all that sidelined cash. 

Daily trading volume in EGPT has exploded in the past two weeks.  Long investors might be betting that the crisis will soon be resolved and stability will return.  Short investors can bet on further chaos.  Value investors need to consider the long-run implications of Egypt's problems.  Credit default swaps on its debt are extremely high, with yields rising due to uncertain bond market interest in new issues.  There is some risk that Egypt's logistics infrastructure can be compromised by political violence.  The Suez Canal seems safe for now but an explosion has taken a very important natural gas pipeline offline.  It is too early to tell whether that explosion was due to sabotage, but any any infrastructure vulnerability puts additional pressure on the military to implement backup measures. 

The risks of investing in emerging markets are obvious.  Egypt is a boiling cauldron right now, and investors can easily get burned. 

Full disclosure:  No position in EGPT. 

Updating The Alpha-D Portfolio For Nov. 2010

Here's what I didn't change this month.  I maintain my long puts against LMT (hedging the defense bubble) and IYR (hedging the housing sector). 

I also maintain my long holdings of GDX (gold sector bull), FXI (China bull), TDW (energy services bull and compelling fundamental value).  My covered calls on each expired unexercised and I refreshed them.  I also sold short puts under those three securities.  If they remain range-bound, I keep the cash.  If they drop in a flash crash, I pick up more of what I like at a discount. 

Here's one significant change. For the first time in over two years, I wrote a small number of short puts under EFA.  I do not have a long position yet in EFA but I'm willing to risk acquiring some.  I don't mind a Euro currency crisis or Asian capital controls as the trigger.  I consider EFA to be a way to own non-U.S. markets I can't track myself.  I'm not quite ready to take the same approach with SPY because I'm waiting to see whether a bond market dislocation puts the S&P 500 on sale. 

I didn't add much to my fixed income holdings other than buy a one-month Treasury with my cash proceeds from selling options.  The sickeningly low yields on Treasuries reduce the effectiveness of this yield-enhancement approach.  I just need to stay in the habit of rolling cash into F.I.  It will pay off when interest rates rise after the U.S. is forced to live within its means. 

Refreshing The Alpha-D For Sep.-Oct. '09

I'm not doing uncovered shorts anymore. That was too risky as my short calls on some widely traded ETFs went against me in a big way this month. Furthermore, the risk of not being able to access my account in a timely manner to cover those shorts is a real risk management threat that I realize I must now mitigate. I would like to take positions in the major indexes at some point, which is why I've written a couple of OTM puts (covered by cash) on SPY that expire before the end of the year. The worst that could happen is that I'll have to go long a small amount of SPY at a discount of more than 20% from last Friday's closing price. I am still quite bearish on the major indexes, but I am willing to risk owning a little SPY for many years as long as I get it at a big haircut.

I have renewed my covered calls on all of my holdings of IAU and FXI. I also sold a few calls on GDX because I am willing to risk some but not all of those holdings getting called away. If there is one gold security I wish to retain through this long economic crisis, it the one that represents established gold miners (GDX) rather than gold contracts (IAU) which may turn out to be merely paper.

I am not selling any puts under VWO, EFA, or IWM. I'll be patient and wait for large declines in each of those.

Refreshing The Alpha-D Portfolio for July '09

Here are the updates I've made to my asset allocation this month:

Equities: Bought more GDX.

Put options (covered): Sold on FXI, IAU, GDX.

Call options (covered): Sold on FXI and GDX.

Call options (uncovered): Sold on SPY, EFA, FXI, and GDX.

I added to my GDX pile for my usual reason: I believe gold will do well when serious inflation arrives.

Nothing else has changed.