Don’t Forget to Read Prem Watsa’s Shareholder Letter, Too

Like many other experienced investors, I appreciate the value of a high-quality insurance operation. Berkshire Hathaway is the gold standard in this industry from an investment standpoint and the recent 50th anniversary shareholder letter was widely commented on throughout the financial realm. It’s not as if the Berkshire family of insurers are the absolute greatest underwriters in the world. They simply have such grand size and scale in combination with enough discipline to continually underwrite at a profit which continues to provide Warren and Charlie with a ridiculous level of float to continue their intergalactic wheeling and dealing. Yeah, I said intergalactic, as in, Berkshire’s about to close a deal for part ownership of Ganymede, Jupiter’s largest moon. Rumors are swirling that Lemann and the boys at 3G will front most of the capital while Warren obtains the preferreds on the newly discovered salt-water bodies.

Much ballyhoo is paid to Buffett and deservedly so, however, Prem Watsa who is his much smaller counterpart up in Canada also provides a must-read annual shareholder letter. Watsa runs Fairfax Financial which has long been considered a “Baby-Berk” and you can scour the web to find countless articles on them. I’m not writing today to conduct a deep-dive on Fairfax. Feel free to dig into their old letters and annual reports for that. I just wanted to share a little content from Watsa’s most recent shareholder letter in light of all the press that W.B. and C.M. received for Berkshire’s. Watsa is a well-respected value investor who is often criticized for his asset allocations but he almost always has the last laugh.

Watsa’s letters are filled with quality analysis on current economic and market goings-on. Does he explain his whole playbook? Of course not, but he shares enough to make you consider your own stance and allocations. Many consider Watsa’s skills to be right up there with any asset manager alive. I thought I’d share what are a few important notions from his most recent letter, which was released at the beginning of March. Full disclosure, I’m a long-time and current shareholder in Fairfax Financial.

First, I’d like to display the Fairfax CAGR in Book Value as well as Share Price:


Holding a stock that had a 20% CAGR in the share price over the last twenty-nine years was an easy way to become wealthy for anybody who happened to have been smart enough to have purchased shares and held them. I, unfortunately, am not one of those smart persons. Aside from all the usual valuation metrics and models for the seasoned investors to analyze, at $545/share(USD) the investing novice can pick up some shares and let Prem work his magic for hopefully another 15 to 20 years. Watsa turns 65 at the end of the summer and he’s long said he does not want to work into his 80’s, but obviously we’ll have to wait to see what the future holds. It’s very difficult for a successful business person to just hand over the reins of their babies which they’ve built from nothing. I don’t see Watsa casually walking away from Fairfax just because of age. As long as his mental faculties allow him, I see him running Fairfax.

Watsa has done a brilliant job acquiring add-on insurance and reinsurance operations around the world to expand Fairfax’s international footprint. Additionally, he’s shuffled and empowered managers to tighten up underwriting standards across all lines. The result has been a significant increase in operating profits.


You can see that just a few years ago, Fairfax was underwriting coverage at a loss across multiple subsidiaries. Only the discipline at their largest revenues source, OdysseyRe, allowed them to maintain a combined ratio under 100% in 2012. For any readers who are not fully aware of how profit reporting works with insurance companies, if an insurer or reinsurer has a combined ratio of 100% or higher, then the company is underwriting policies at zero profit or a loss. It’s what’s called a lack of discipline and even if the CIO has tremendous investment results, consistent underwriting at a combined ratio over 100% is a sure-fire way to insolvency.

This trend in the combined ratio is a very positive development and I look forward to a consistent number in the low 90s or even 80s.

Arguably, the most important component of an insurance business to analyze is the float. Watsa has been very forthcoming about Fairfax’s float levels and how the float has positively affected the company’s “cost of capital” to invest. Disciplined underwriting allows Fairfax to essentially be paid to let one of the greatest investors in North America to invest it’s capital. Observe the following chart depicting some of Fairfax’s long-term float performance.


In Prem’s own words, “Our long term goal is to increase the float at no cost, by achieving combined ratios consistently at or below 100%. This, combined with our ability to invest the float well, is why we feel we can achieve our long term objective of compounding book value per share by 15% per annum. In the last ten years, our float cost us 0.3% per year – significantly less than the 3.6% that it cost the Government of Canada to borrow for ten years.” A negative number under “Cost (benefit) of float” means that Fairfax was paid to invest. That number is a return on float investment, which over the last 10 years, takes the average cost of investment capital to damn near zero.

For a deeper dive on the importance of the positive carry on float, have a read of Berkshire’s most recent shareholder letter if you haven’t already. Additionally, Porter Stansberry has produced a multitude of fine analyses on the value of quality P&Cs effectively managing float.

Like Berkshire Hathaway and even Markel, Fairfax has a bevy of non-insurance related public and private equity investments with the most well-known being Blackberry. You can read the entire letter or the annual report for the details on those businesses. The last part of the shareholder letter that I wanted to touch on is the equity hedges and Fairfax’s derivative book.


On the surface, it would appear as if Prem’s portfolio hedging decisions have been less than successful. These are mostly non-cash losses though as a majority of these are simple write-downs and not actually realized losses, but the cumulative impairments since 2010 are substantial. However, we saw the same thing leading up to 2007 – 2008. During 2003 – 2006 while credit was flowing out of every orifice on the earth’s surface, Fairfax suffered significant unrealized losses on their hedging program. Then 2007 and 2008 came along to make Prem look like a genius.


Look at those outsized gains. Watsa’s multibillion dollar winning bets paid off huge during a time when even the smartest investment players on the planet were sitting around slackjawed questioning the great existential philosophy of what it means to be an asset manager.

Although the losses are primarily unrealized, it also means that Watsa may have positioned too largely and too early. Not only does the hedging program require mark-to-market revaluation but there is also the cash outlay for the payments of premiums. It is clear Watsa feels he has been exercising prudence here despite possibly underestimating the impact of central banking on the investment world. I won’t begrudge him though, because what is more important, is that Fairfax is seeing a shift in the value of their hedging program. The trend is already beginning to move upward.


Notice how there was a slight improvement in 2013 and a doubling in value in 2014. This may be a precursor to broader market conditions as we saw the same thing leading up to the Great Recession. First, the valuation of the hedging program starts shifting positive and then the early bets pay off in spectacular fashion. It’s definitely something to keep in mind as you continue to invest in today’s markets. I would not discount the fact that Fairfax’s hedge book is beginning to increase in value.

Prem Watsa has earned the respect of everybody in the world of investing. He stomped out short-selling hedge funds via the legal system back in the 00’s. He’s grown Fairfax from virtually nothing into a highly successful international insurance conglomerate. His investment results, although admittedly choppy by Watsa, are legendary due to the big scores. Have a read of the recent 20 page shareholder letter. It’s fairly easy to digest and you get a very honest assessment of Prem’s current view on the investing climate. As Munger would indirectly say; read, read, and read some more.

Economic Distortions

Here at, I mention Jeremy Grantham and his firm GMO quite a bit. That is for two very big reasons. Number 1, he and his firm manage in excess of $100 billion for the biggest institutional investors across the land. And number 2, he’s publicly nailed multiple bubble calls. Does he nail them to the day? Well no, but he’s been close enough and has effectively ensured his clients were positioned accordingly to mitigate the damage of the last two major stock market bubbles.

GMO came out with its most recent 7-year forecast for various asset classes and equities. It ain’t a pretty picture. These guys have consistently nailed their forecasts, especially for equities. They’re predicting negative returns essentially across the board of various sectors with pockets of relative strength in Int’l value, US high quality, and emerging markets. Observe the drilldown:


Why do you think this forecast is so negative? It may be valuations, but I think it’s because they see a major dislocation occurring within the next 7 years. This dislocation will cause most sectors to lose money over the specified time period. And of course depending how one is positioned, losses can and will be a lot worse than what is depicted in the chart. GMO will never reveal the secret sauce, so to speak, behind their methodology in determining their 7-year forecast. It’s probably safe to assume they use an amalgamation of various data inputs involving valuation, macroeconomic outlooks, interest rates, monetary trends, geopolitical trends, and so forth.

You don’t need to be able to reproduce the forecast in order to trust it. Knowing that this is how GMO perceives equity market returns going forward, one really needs to be conscious with their long-money portfolios. This is a message I have been consistently sharing over the past few articles, so let’s visit a few severe distortions that may have a major effect on equity markets within the next 7 years.

The first distortion is excess reserves maintained at the Federal Reserve. This first chart is to show how ridiculously large this number has grown to, which is now in excess of $2.4 trillion. That’s the cumulative and collected excess reserves of the banks who collude conduct business with the Federal Reserve.


Notice how before 2007, the amount was virtually zero. I realize this chart only goes back to the early 1980’s, so here’s a “Discontinued Series” chart that the Fed previously utilized to report the excess reserves. It goes back to the 1950’s and shows the same virtual zero in excess reserves as the normal course of business. That’s right, up until the Great Recession the amount of excess reserves held at the Fed was in the single digit billions. That’s basically zero. Since 2007, it has been a different story entirely.


For the uninitiated regarding excess reserves, I want to provide a relatively brief explanation. For the reader with an already good grasp, I apologize for any redundancy. The excess reserves were at virtually zero for all those decades because the Fed never paid any interest on them. Then in response to the entire financial world sitting on the precipice of obliteration, a multi-part plan was instituted in order to maintain the status quo and keep the entire system intact. The federal funds rate was dropped to zero where it has stayed, interest began to be paid by the Fed on excess reserves, and the process of quantitative easing(“QE”) was illustriously birthed.

The federal funds rate was dropped to zero so as to stimulate the economy in the face of certain deflationary doom. The book is still out on whether the US has seen true economic improvement due to ZIRP. What we do know is that savers are being heavily penalized by this policy and investors of all ilk are being forced up the risk ladder in increasingly desperate attempts for yield. The paying of interest by the Fed for excess reserves is one of the Fed’s tools for maintaining interest rates where they want them. It also just so happens to be able to provide a colossal liquidity buffer for the so called balance sheets of the participating banks i.e. Wall St.

Between the erroneously valued derivative books across the entire industry and jumbled collateral chains, the participating banks and the Fed think they’ve built an adequate buffer to potentially withstand additional impairment to balance sheets. And why shouldn’t they? They’ve got everything under control because now they can taper QE. Quantitative Easing was established to fight both fronts of the policy as a tool to reduce long-term interest rates while also stimulating the economy. Do you feel like the economy is stimulated? I know one thing for sure that has been stimulated and that’s asset prices. Take a moment to yourself and remember how this story has played out for the Weimar republic of Germany, recently in Zimbabwe, and even more recently in Venezuela.

Wondering why it matters so much that the banks keep their excess reserves at the Fed instead of productively using them within the economy? It’s because the money is essentially free. When the Fed monetizes its debt and buys assets such as MBS, it creates an asset on its own balance sheet and a corresponding liability. That liability is the excess reserves that belong to the TBTF banks who are the Fed’s main partners in facilitating QE. The banks keep those excess reserves with the Fed because why would you give away your gravy train and expose it to more unnecessary risk? The Fed pays 0.25% on excess reserves. May not seem like much, but 0.25% on $2.4 trillion equals $6 billion for the biggest banks to collect risk free in interest income.

If you were a bank CEO and knew you had derivative exposure that could single-handedly dismantle the system, would you kill the golden goose provided by the Fed? The proof is already in the pudding as the velocity of money is cratering but has had no material effect on our economy thus far. There’s no velocity of the money supply because banks aren’t lending out to businesses and households. Sure large corporations have been able to finance buy-backs and special dividends but capital expenditures have yet to reach a point of acceleration where we know some good economic tidings are bound to follow.

In the chart below, I’ve overlaid the rise of the excess reserves vs. the velocity of the M2 money supply.


If that’s not a chart yelling out for some mean-reversion, then I don’t know what is. So what are some triggers to increase velocity and why does it matter? An increase in velocity matters because that price inflation that everyone was so scared of during the beginning phases of TARP and QE, could finally begin to materialize. And this could hamstring any efforts to get the economy breathing on its own without the use of a respirator. As far as a trigger to generate velocity, it would take the Fed no longer paying interest(like they’ve almost always done) or even charging to hold excess reserves. The participating banks would immediately withdraw that $2.4 trillion in cash and put it to work. Where? Businesses and households. If those dollars hit the economy in a flood over the course of a year or two, we could see some scary jumps in asset prices that matter and not just fine art and collectible cars. Not to mention, there’s still all that cash that the mega-corporations keep parked internationally. If the US were to shift tax policy for this money and it were to be repatriated and spread around the economy, we could be talking about a doubly increase in money velocity.

The Fed knows this and you would think they wouldn’t be dumb enough to cut off their nose to spite their face but the Fed is backed into a corner. Additionally, the Fed has to answer to its political masters all while managing the world’s perception of America’s currency and economy. This is a dangerous game being played right now, as after 2008, Fed policy entered the realm of pure experimentation.

Would the Fed have maintained these policies this long, which are causing massive economic distortions, if the economy had really reached escape velocity or at least was well on its way? Let’s revisit interest rates, the second massive distortion. Gary Tanashian, with his Notes From the Rabbit Hole newsletter, provided an elegantly simple chart putting on full display the lack of efficacy of the Fed’s ZIRP policy to have any material effect on the economy. Below you’ll see the 3-month T-bill yield($IRX) overlaid against the S&P 500 index($SPX). You can see in the past 20 years that as the economy and markets picked up, the Fed would subsequently raise interest rates. That is completely normal policy and has been consistently used for decades.


But as you can see in the chart, where’s the rise in rates? The correlation of the two are generally fairly strong. Oh, so our economy is not genuinely approaching a growth level that warrants a raise in interest rates? These are the results of the great financial experiment, of which we are all a part of the double-blinded no placebo study that’s about to have a phase 3 letdown in the next year or two.

The Fed has been able to subvert a normal business cycle by reflating on demand through interest rate policy and monetary policy. That last doozie back in 2008 should have seen the destruction of several industry giants and the Fed wasn’t ready to allow that to happen in America. I get it. The pain and suffering would probably have been unspeakable and potentially worse than the Great Depression. When you combine the fact that the developed countries are so interconnected, the US didn’t want to single-handedly bring down the entire world’s economies. All that being said, the tricks to perpetrate the subversion of normal business cycle forces have been used up. You can’t drive interest rates any lower. You can’t print even more dollars and expect sufficient potency. Hence, the notion that the Fed is backed into a corner.

As far as impact to the market, I read a simple statement over at, that sums up the good fortune the Fed has had in driving up market prices in an attempt to drive the wealth effect while building animal spirits. stated, “Within the last fourteen years, there have been two major market corrections, both of which saw drops of 55% from their highs. That, or more, is the potential for what lies ahead…but next time the government is unlikely to be able to re-inflate the stock market bubble. To put into perspective how lucky (investors have been), it took 25 years for the Dow Jones to recover to its pre-crash highs after the Great Depression. Likewise, the Dow hit an intraday high of 1,000 in 1962 but never closed above 1,000 until about twenty years later.”

These distortions are what the doomsday types, Austrian economics practitioners, goldbugs, and similar minded types have been seeing and simply can’t seem to shake off. The team at GMO has never been labeled as any of those types; only true professionals’ professionals in the game of capital allocation. Below is the other chart in their 7-year forecast and it covers multiple asset classes as opposed to just equities.


The granddaddy winner for the next 7 years is timber, according to them. So forget about investing. Go cut some trees down. Chop’em up and store them in your house. Over the next 7 years that wood will have outperformed your 401k. Lame jokes aside, there are a few ways to easily make a play on timber. There are of course the biggest North American players such as Plum Creek (PCL), Weyerhaeuser (WY), Rayonier (RYN), and Potlatch (PCH). If you prefer ETF’s, there is iShares Global Timber & Forestry (WOOD) which focuses on North America and thus has significant positions in the largest players here. For more of an international flare to your timber exposure, Guggenheim offers its own Timber ETF (CUT). A cursory glance of CUT’s holdings will show that it focuses its holdings around the planet as opposed to N. America.

Since the average joe can’t simply invest in huge plots of timber like a hedge fund, endowment, or pension fund, then these are decent options to play the sector. PCL is the biggest of the N. American group and thus has a well established reputation on the street. However, friends and old colleagues will already be familiar with what is probably my favorite way to garner some timber exposure, and that is through Brookfield Asset Management. BAM! Remember though, at the end of the day these are still equities and have the potential to be pulled down with every other sector in the event of a sell-off or major dislocation.

Comparing Plum Creek to Brookfield Asset Management is not exactly an apples to apples comparison, as Brookfield is a massive asset manager focusing on real or hard assets with a portfolio approaching $200 billion. Plum Creek possesses the largest portfolio of timber acreage in N. America, so their market capitalization is justified. PCL carries a timber portfolio worth approximately $5 billion. Brookfield’s portfolio of timber acreage is significant in real terms but small compared to their entire portfolio. BAM carries approximately $4 billion worth of timber assets, and that is after selling approximately $2.5 billion worth of timber assets last year to Weyerhaeuser. BAM will monetize assets when appropriate. They don’t hold just to hold, however they’re considered some of the finest value investors in the world when it comes to real assets.

Let’s take a side by side look at long-term performance of each company since 1990. We’re using 1990 as PCL was founded in 1989, so I wanted to give it a year of operations under its belt for comparison purposes. The following chart compares the split adjusted values of each stock starting with an initial $5,000 and includes dividends but excludes the two spin-offs(BIP & BPY) from BAM.

clip_image014*Dividend data garnered from

You can see that BAM’s long-term performance speaks for itself. If you account for BIP & BPY, then to me it appears to be a no-brainer between the two for long-term exposure to timber. PCL’s dividend is vastly bigger, so if an investor needed that higher yield for whatever reason then it would make the decision of choosing between the two a little tougher. Overall though, if you want some timber exposure in combination with other world-class real assets then BAM is a heckuva way to play it.

Valuations matter. Momentum can be ridden, but in the end a stock’s price will revert to an appropriate valuation after momentum has made investors lose their collective minds. GMO’s forecast is not to be taken lightly. It’s just another recent indicator that should really make investors pause and think before allocating capital. I tend to concur with old Uncle Warren in that it’s not usually a safe bet to bet against America, so I promise that I’m not a total gloom & doomer here at These economic distortions, just a few of so many, are communicating a signal that America and really the world’s developed markets could find themselves in some pretty rough seas in the not too distant future. Invest accordingly.

Cycles, cycles everywhere…

Sadly, I don’t have any original content with which to dazzle your investment senses with for this post. I just want to share some noteworthy work on cycles.

I was reviewing a couple of interesting charts this weekend, posted by Greg Schnell – The Canadian Technician. The two charts depict some consistent highs and lows across multi-week cycles. Chart number 1 breaks down the last 15 years of the S&P 500 within 66 week increments.


Here’s Mr. Schnell’s comments regarding the chart:

What has made the recent market cycles (last 15 years) so interesting, has been the difference in time spans. From the 2000 high to the 2002 low was a period of two 66 week time spans. From the 2007 top to the 2009 lows was 1 time span of roughly 66 weeks. Why 66 weeks? Well, it is only through the manipulation and experimentation of the cycle tool in Stockcharts that I was able to find a time span that worked for all the market turns. While multiples of 66 weeks like 132,198 and 264 work well, they all missed one of the turns. It was only the lowest common denominator that worked. This is trial and error, best fitting with the historical models.

You can see it worked pretty well on most cycle lines. It missed in 2001 at the blue arrow. What is most important, is the right edge of the chart. It is telling us that we are near one of those potential reversal points that George Lindsay talked about. Only the history books will tell us how it works out, but it is worth noting in a timely manner.

Upon publishing that chart, Schnell received a chart from a reader of his blog. This chart goes back even farther and utilizes a 346 week cycle, as denoted by the orange lines. Chart number 2 was sent into The Canadian Technician by Richard Rhodes of Rhodes Capital Management. The chart is equally compelling due to the uncanny ability to mark major highs.


Keep in mind, as Schnell admitted, these charts are “best-fitted” so to speak. So like every other chart you may look at to gauge potential direction, you have to take the information with a large grain of salt.

Can’t post on cycles without touching on The Election Cycle. Chris Puplava, at FinancialSense, shared a couple of interesting charts. The first one he posted, courtesy of Ned Davis Research, is based on the geometric mean from 1929 through 2009. We’re roughly at the blue arrow in the mid-term year.


If the Election Cycle holds to pattern then we could potentially top out in the early spring, bottom out in the late summer, and begin the vaunted run-up of the pre-election year in the Election Cycle. That potential run is demarcated by the black box. Puplava put together a chart over the last 5 mid-term election years that correlates nicely with the previous chart, stating that, “The chart below is an average of the last 5 mid-term election years, excluding 2002 (I’m not anticipating a bear market this year), overlaid by the S&P 500 so far this year. The pattern suggests a rally of 6.5% into an April peak before giving back all of its gains, followed by a bottom in late August, to finish up with a strong year-end rally.”


Why would I share two charts that seem to conflict with each other? Because I want to continue to communicate that one must be very careful how they interpret the squiggles. It’s doubtful we’re at a major top, but those first two charts make you stop and think for just a moment. On the other hand, the Election Cycle is real, well known, and has been expounded on by countless hordes of technicians. If a gun were put to my head to decide how to invest going forward just based on these sets of charts, I would definitely follow the Election Cycle.

The ongoing point across a great deal of my posts is that these are not normal times to be speculating. Thus, an extra measure of care has to be taken before running off and allocating capital based off of some macro-themed charts. For readers who don’t think that these are unique times to be an investor, then have a read of some excerpts from Seth Klarman’s latest letter to Baupost Group investors. It comes courtesy of ZeroHedge, and in it, Klarman shares his own thoughts that probably mirror many of your own regarding this Twilight Zone environment.

I’ve shared Seth’s credentials a million times already but if this is your first time here and you are unfamiliar with Mr. Klarman, then he’s the founder of the Baupost Group hedge fund. He manages approximately $22 billion. He’s a notorious value investor whose skills are in a class with the best. Last year alone, he returned $4 billion to investors because he didn’t find enough compelling investment opportunities and the fund’s size may have been getting a touch unwieldy. He’s a legend, so the commentary shared in his letters is worth heeding.

The volatility that has returned to the markets this year has been a thing of beauty. I know the traders of the world have enjoyed it. Well keep calm and carry on the fight to enhance your own personal wealth effect.

A Few Sample ETF Portfolios to Watch

Well 2014 has arrived with a tepid start and already the correction bells are ringing around the financial web. I’m as guilty as the next blogger of trying to front-run corrective moves in the greater markets, but in my experience, it’s rare to see a pack of pundits predicting market direction with collective accuracy. Sure, equities look a touch expensive here depending on which valuation-gauges you’re utilizing, but financial writers around the web(myself included) have been calling for corrections since the last one of note in June. Additionally, I’ve read plenty of analysts who state there’s still value at these stock prices.

Let’s consult the tea leaves and see what they communicate:


As the squiggle shows, if this weak start to the year is the genuine beginning to a sizeable(but perfectly healthy) correction of at least 8%, then there will be plenty of time to get properly positioned to take advantage going in and coming out. Notice at the blue circles above, how long the market takes to actually set-up the real dip that shakes things up.

Last year was the Year of the Passive ETF. The year 2013 caught the hedge fund industry with its pants down and the rich, whose funds were locked into 2&20, drastically under-performed the plain old, vanilla ETF of SPY. The S&P 500 tracker returned 29% last year, beating it’s very long term CAGR by a very healthy premium. In a mad trading world of short-term thinking and instant gratification, the long-term view of the Bogleheads destroyed churning traders on an absolute basis. Will 2014 be more of the same? I wouldn’t bet on it, but the consensus view out there seems to be that 2014 will be another good year…just not as good as 2013. Some more consensus thinking has been, “We’ll probably finish the year with the stock markets up about 14% to 16% compared to the prior year’s 30%’s for some indices.”

So in the spirit of following what worked last year while trying to include a touch of the contrarian and a dash of new trends, I’ve put together an ETF portfolio that I’d like to track in 2014. Because chasing always works! As always, this is not an investment recommendation. Since buy & hold was an elite strategy for 2013, and really since 2009 apparently, let’s see if 2014 continues to favor buy & hold with good fortune.

We’ll title the portfolio, Look Back and Ahead. Here’s a snapshot of its construction using


Let it be acknowledged that this portfolio is only partially constructed using a rear-view mirror, and that investing with one’s view on the rear-view mirror is generally not going to lead to short-term success. The Look Back & Ahead (“LB&A”) portfolio was constructed for short-term results in 2014 only and is looking to utilize prevailing trends and combine them with some of the strategies that had a rough 2013. Eight of the chosen ETF’s follow trends established in 2013. These are Japan(DXJ), Junk Bonds(HYG), Biotech(IBB), Russell 2000(IWM), Tech(QQQ), Share buy-backs and dividends in earnings growth(SYLD), Consumer Discretionary(VCR), and Health Care(VHT).

The remaining 4 ETF’s of LB&A are the contrarian plays that could bounce back in 2014. Some of the possible reasons behind any potential bounce-backs are: extended negative sentiment ready for a turn, value at these prices, or hot money moves in together creating a new trend. The 4 trends waiting for a potential 2014 rally off some lows are: Emerging Markets(DEM), Europe(FEZ), Gold(GLD), and Muni-bonds(TFI).

You might be thinking muni’s and saying to yourself, “Really?” They’ve had a tough year for sure. Certainly one of the worst performing years in the sector over the last 20. Barclays produced a chart of performance for the past couple of decades. It shows that after a down year, the sector tends to rally quite nicely. Will this time be different?


Since the S&P 500 index performed so well, we’ll track LB&A against the SPY for the year. But wait, there’s more. If I think that LB&A may be able to outperform the market by riding some established sector trends and a handful of potential counter trends, then why not leverage up. Well I have a portfolio for that too, that allows for a 2 or 3 times leveraged move in each of the sectors of LB&A without taking on margin risk into your investment account. Observe:


Unfortunately, ETFreplay subscriptions do not provide access to the entire universe of ETF’s. As they state on their website, “As of 2010, less than 500 ETFs have provided >98% of the trading ETF/ETN volume in the U.S. market.” Which means that due to a lack of liquidity and volume, six of the levered plays are not in the ETFreplay database. As such, I am unable to easily save and track the portfolio with their site’s tools. I’ll just save it on another site’s portfolio tools and drum up some charts in Excel for performance tracking purposes. And in the continued spirit of simple benchmarking against the S&P 500, we’ll use SSO(2x levered S&P ETF) as our comparison benchmark.

Just for ha-ha’s, we’ll track another portfolio in 2014 of purely contrarian plays. Construction of this portfolio should be obvious to most, but have a look at its make-up. It’s titled Contrarian New Year.


Obviously, the BRI of BRIC had a tough year so we’re allocating there for total country exposure. I also included Singapore but left out Turkey. With the ongoing corruption scandal in Erdogan’s government, there’s obviously a whole lot more than sentiment going on there. We’ll just see how that situation plays out and how it affects investor sentiment towards the Turkey ETF later in the year. Commodities were utterly atrocious, so I included DBC and GUNR but also wanted to concentrate performance for some mean reversion specifically in coffee, corn, aluminum, coal, and silver. Gold miners were…well you know the story by now. Utilities was one of the worst performing sectors in the US along with TIPS, as nobody expects inflation and everybody wants to buy growth. We’ll see if inflation starts to tick upward and relative value attracts some players back into the utility space in 2014.

Just like muni bonds up above, you may be thinking that the gold miners prove I’m a glutton for punishment. That may very well be, but risk can always be managed, and if the underlying product has a bounce-back year then the producers may see a little pop in performance. Especially if the metal can catch a bid sufficiently past most of the producers’ all-in-sustaining costs. Observe the following chart of the XAU’s performance over the last 30 years, courtesy of US Global investors via Bloomberg. It says to me that miners have a potential low risk/high reward set-up. Believe me, any time the word gold comes out of my mouth, I want to shoot myself in the face.


Remember, that these sample ETF portfolios are not investment recommendations and I reserve the right to allocate my own funds as I see fit into or out of any of the fore mentioned investment products. If you’re interested in some of the more professional portfolio metrics and want backtest results, Sharpe ratios, alpha and beta, correlations, etc., then too bad. Go look it up yourself. The name of the game in 2013 was absolute performance and so that is what we are measuring in 2014 with these ETF experiments.

And that ladies and gentlemen, is about all there is to basic asset management. Here’s the basic formula: Follow some prevailing trends to cover career risk + buy some contrarian plays based on quantitative models to cover career risk = hopefully benchmark beating results…and winning the grand prize of more AUM, which inevitably leads to diminishing performance. Obviously, I’m highly generalizing here. Asset management in any shape or form is usually performed by very well educated individuals or groups utilizing highly sophisticated quantitative or fundamental models drawn from a wealth of experience and knowledge. I don’t mean to belittle that nor do I begrudge anybody able to obtain a position managing assets. At the higher levels it is a very, very lucrative career that can build high-quality, long-lasting relationships.

For now, I’ll continue to trade my accounts, spend time with my family, post to my blog, and pursue interests. Am I going to be nominated for fund manager of the year for my efforts? Certainly not; but I just may have a shot at Dad’o the Year.

Now this wouldn’t be a real article, if I didn’t over-chart the reader. So with that, I’ll bid you adieu with a few charts to provide entertainment and food for thought. Charts are courtesy of some of the financial blogosphere’s most respected, TRB, Jesse, and Kimble.

The January Effect:clip_image010

The Recovery:clip_image012

Is the financial system stressed?:clip_image014

Below is the final “Portfolio Update” posted on 1/4/2015:

Here’s where I’ll maintain the updates to the ETF portfolios that I outlined in the January 2014 post titled, A Few Sample ETF Portfolios to Watch. If you haven’t read it and are curious as to the rhyme and reason behind these experimental portfolios, then please read the post for a full explanation. The portfolios all started with a “play-money” value of $100K. We’ll see how “buy & hold” closes out 2014. CLICK ON EACH TO ENLARGE.

Update 1/4/2015:  Say goodbye to 2014, the year of nothing specifically working except holding everything. Obviously, the adroit speculator was able to generate income in various and specific asset classes. However, the casual investor trying to pick stocks or even the majority of hedge fund managers were both trounced again by a levered ETF of the S&P 500. So much for trying to follow the trend while also also trying to be contrarian. That little thought experiment crashed and burned. I have a strong suspicion that indexing ain’t gonna be as easy as it’s been the last 2 years but who knows. I’ll leave these results up for the rest of the month and then bid adieu to this specific page regarding the 2014 experimental portfolios. Maybe I’ll come up with something else to add to the site, but at the rate I’ve been posting, don’t get your hopes up. Good luck in 2015, muppets!

1. Look Back & Ahead as of 12/31/2014:Look Back & Ahead (2014 Year End)

2. S&P 500 as of 11/18/2014:
S&P 500 (2014 Year End)

3. Levered Look Back & Ahead as of 12/31/2014:Levered Look Back & Ahead (2014 Year End)

4. S&P 500 2x Levered as of 12/31/2014:Ultra S&P 500 (2014 Year End)

5. Contrarian New Year as of 12/31/2014:

Contrarian New Year (2014 Year End)

Perception Management

The number one skillset to possess, in a world where true merit, diligence, ethics (work and moral), and pure results are forgotten notions, is the ability to influence how others perceive you. I dare you to dispute it. Perception management also goes by:


“Brown nosing”

“Boot shining”

The list goes on, but in your own endeavors, I would venture to say that you can instantly recall a specific hack(s) you used to work with or for. How did they obtain their position? Why do they keep advancing without truly accomplishing anything? How come they haven’t been demoted or fired? It can be quite maddening for the honest, ambitious employee who truly believes in a meritorious work environment. It’s not a concept that is exactly taught in business schools. No, schools teach about theory and principle; “And with a little hard work and diligent application of the theories and principles you have learned, you too will be successful.” Ha! Tell that to today’s early-career Millennials at the bottom rungs or the kids just exiting college and don’t see the most exciting prospects.

The name of the game is “you gotta get along to get along.” And that doesn’t just apply to the world of politics. It applies to any and all hierarchies. If you want to successfully rise within a hierarchy then you better master the concept of perception management. Or you can keep wondering why Johnny-Windbag keeps moving up the ranks even after sleeping with the wife of one of his subordinates and telling his vegan boss that he too is a vegan, when Johnny really spends his weekends clubbing baby rabbits and cooking them.

Universities don’t teach you how to treat your boss to drinks and weasel into their inner circle. Nor do they teach you how to effectively play all sides of superiors, subordinates, and colleagues without any conscious or semblance of empathy. In a business environment that appears to be filling with more and more successful psychopaths, sociopaths, and narcissists; maybe perception management should be added to the curriculums of business schools. Imagine?

You finally are accepted to Wharton and you are required to write a thesis on how to take credit for the specific work of a colleague while discrediting your boss to her boss so that she may be transferred departments. If it worked for Johnny-Windbag, who only has a lowly state degree, then why not get that B-school Master’s in Perception Management? Because eventually, if you don’t learn the game, you will plateau.

I really started to explore the notions of sociopathy, psychopathy, and narcissism in the work place only after experiencing it around every corner in one of my previous careers. One of the books I recommend, Snakes in Suits by Babiak and Hare, takes the reader through the mindset of a typical business sociopath and the opposing honest, ambitious hard worker. Back in 2011, Jesse from the Café Americain blog, wrote some great pieces touching on the mental sickness. You can read a sort of compendium of Jesse’s pieces on the subject matter here. I then started to evaluate, unprofessionally of course, former colleagues and superiors from my first career. The narcissism and psychopathy ran rampant in that culture and continues to this day.

Most psychopaths or sociopaths are not cold blooded killers or hard core criminals. In the workplace they’re just people inordinately motivated by a reward system and will generally execute any strategy they see fit to obtain rewards, despite any negative impact to fellow human beings. These people exist in your life right now…professionally and personally. They can sometimes be difficult to sniff out because the business-minded ones tend to be somewhat gregarious and skilled conversationalists. They can be genuine nice guys/gals to most people’s face and then stab them in the back for personal benefit at the opportune moment. The ability to dazzle you with their poppycock and malarkey allows them to sink their claws into you before deciding how best to proceed in the relationship. Always be on the lookout for these snakes.

To be fair, managing perceptions is a standard skillset that all persons operating within a corporation, partnership, or any hierarchy should possess. Wanting to put your best foot forward by having others perceive you well is a perfectly normal behavior. Obviously, I’m not referring to that normal sort of behavior in this discourse. And if you’re reading this and have worked anywhere where you desired a promotion, then you know exactly what kind of perception management this post is referring to.

It can be mentally and emotionally taxing working in an environment up against those psychological archetypes. I learned valuable lessons, though. I learned to appreciate and hold more dearly that which is truly important. I learned that the pursuit of your passions in lieu of a little salary in the short term, is decidedly more rewarding in all aspects in the long term.

Cue the un-smooth segue — in the markets, one can observe a prime-time game of perception management occurring in the hedge fund space with the “hedge fund hotels.” As it is, the thousands of excess, non-alpha adding hedge funds around the world get to charge 2 and 20 to under-perform the indices. Is that the new normal? It will be for the foreseeable future as central bank liquidity drives all risk assets up for the next couple of years, and knuckleheads of the 2 and 20 set try to outsmart a simple rising tide. Observe the following chart courtesy of HSBC’s Q3 hedge fund performance report via ZeroHedge:


Have a look at some of those names north of the S&P’s performance mark of 23.16% return through October. There are several OG’s. Caxton and Tudor. Additional giants include Pershing Square, Maverick, RenTec, Fortress, Brevan Howard, and the massive Millennium. These aren’t exactly the knuckleheads managing $40M. No disrespect to said knuckleheads for siphoning your $800K in fees and the cut for their skills. The list above represents gross fund assets in the hundreds of billions.

Where the career risk comes into play for fund managers is with the “hotel” stocks via the broker network, various grapevines, and 13F’s. Have to be in what Tepper says. Wait, what’s Einhorn buying? Get our damn trader on the line and tell him to average into whatever Dalio’s biggest holding is currently. Icahn bought $2.5B of what?! Now those are gross exaggerations for sure but have a look at this chart of the 50 stocks with the largest number of hedge fund investors through Q2, courtesy of Goldman Sachs Research via ZeroHedge. It shows just how much copycatting truly occurs in the industry and maybe provides just a portion of the explanation as to why so many funds continue to consistently under-perform.


Piggybacking may be one way to consistently generate alpha, but that justifies 2% of assets or even more in some cases? Please. Anyone with the guts and smarts to just hold through this liquidity fiesta could have easily outperformed virtually every hedge fund on the planet year to date. Take a gander at the following snapshot of 2013 YTD returns in some of the popular 3X levered ETF’s, courtesy of


It should go without saying but hindsight is 20/20, as I don’t think the world of speculators saw 117% absolute return just buying and holding a 3X levered RUT product. And I will readily admit that despite how easily money could have been made in 2013 by simply holding a handful of indices, I’ve whipsawed myself in and out of profit this year with various option strategies.

As for the “hedge fund hotels,” well we all saw what happened to Apple. Its parabolic spike came right back down into value territory, which is why it continues to be so widely held. Reasonable multiples to free cash flow in the biggest cash generator in the market will spark the interest of any value investor. Google may also see some downside action in the near future, but I’m not willing to currently bet against a behemoth that pumps out behemoth proportions of innovation and free cash flow. Betting against AIG is like directly betting against the government’s own equity speculation. Like Google, it could potentially work but I don’t want to currently go there either.

Beware of investing on the behalf of how others will perceive you. It could be hazardous to your financial self. As for career benefits, well by all means, manage perceptions till you’re blue in the face. How else are you going to get that edge over Johnny-Windbag to increase your discretionary income and improve your lot in life? Through merit? If you genuinely believe that, then you may want to scroll back to the top and have another read.