Monday, August 10, 2009

Seeking Breakeven Inflation

Seeking Breakeven Inflation

If you are in the camp that thinks that all this government spending and a resurgent global growth (after this recession is over) will cause an above average inflation scenario, and want an investment strategy that could help in such a scenario, then read on.

There are several ways one can hedge against inflation. One can invest in commodities, gold, oil, and the more traditional US TIPS. However, each comes with its own flavor of risk and a variety of factors that can cause the returns of the strategy to differ from just “Breakeven” inflation (terms are used interchangeably with inflation expectations).

What is breakeven inflation (BEI)? The difference between the nominal yield of say a 10 year Treasury, and that of a 10 year inflation indexed bond is a measure of expected inflation. Technically speaking, BEI is the rate which will equate the return on the indexed bond to the nominal bond. The current 10 year BEI is about 2%, which is close to the long term average.

So how does one invest in a BEI strategy using equity ETFs? Simply buying a TIPS ETF, though good for hedging inflation in general, may not track BEI well because TIPS (bonds) are affected by, among others, interest rates, which can rise once the economy gets back on its feet. For example, investing in the TIP ETF around Feb of this year ($99), through July end would have given a return of slightly under 2% ($100.4). The BEI in the same period went from 1% to 2% (100% change). The ETF strategy outlined below would have returned 100% ($1 to $2). All numbers rounded for simplicity.

What is the trade (do not skip the associated risks part of this article)? One way to implement it is to long (buy) TIP and short (sell short) IEF. Your net investment is about 1$. The way to make money on it is to lever it up. Leverage is, ironically, a 2X levered four letter word now. But you cant blame the knife for the crime. The leverage depends on your risk appetite and capital. The performance of this trade vs the 10-year BEI is shown below. The second chart shows the daily change in the BEI and the trade. As you can see, it has tracked the BEI trend reasonably well this year, with a daily percentage change that is similar too (with some exceptions when BEI is near zero).

Other ways to implement it would be to long IPE or WIP (World inflation), and short the various long-Treasury ETFs such as SHV, IEI, TLH, SHY, TLO with IPE, or BWZ, BWX with WIP.
You could get more sophisticated by duration matching the 2 sides of the trade, but given the variability in tracking using ETFs anyways, that may be overkill.

Note, if you can't short the ETFs, you could go long the short-Treasury ETFs such as TBT or PST. But then your ROI is dramatically reduced (less than 1% in the above example) to the point of being an exercise in futility, unless you trade on margin (I wouldn't recommend leverage + margin, that is a recipe for bankruptcy).

Also, if you have a deflation view, simply reverse the above trade.

What are the risks? We may not have high inflation, or worse, have deflation. In that case you lose on both sides of this trade (magnified by leverage). Bad scenario. Or, the trade may not track BEI in terms of direction and/or magnitude of return (as was the case late last year). Note: past tracking is no guarantee of future tracking. When the BEI is near zero, the daily change doesn’t track it even remotely. As with other leveraged ETFs, this is not a buy and hold strategy, but better suited to short term bets on BEI, which in itself is a risky bet given the uncertain state of the markets. Short term technical factors in the interest rates space can make this trade very volatile. This trade is not suitable for every investor.

Sunday, December 2, 2007

Dow 1 Million Before My Kid Retires - Seeking Alpha

Link to this article on Seeking Alpha
Dow 1 Million Before My Kid Retires - Seeking Alpha

Dow 1 Million, before my son retires

Before you dismiss that as an absurd, attention grabbing headline (it is), allow me to present a few facts and assumptions, and the objective of this story. I assure you that by the end of it, you will agree with me, statistically speaking.

First, the objective of this exercise: to focus you to think long term and realize the power of compounding. Nothing new here, but when you do a few extrapolations, the numbers may amaze your perspective.

Second, the facts: the Dow has returned about 8% historically since 1928.
I crunched DJIA data from 1928 through 2007 during which it has gone from 300 to 14,000 (chart 1).

The annualized rate of return has varied based on the time span you use, as you can see in the chart below, but it is about 8% for the 80 year period. And that’s conservative. The annual returns for the post-war period are more like 12%.

The S&P has also returned an annualized 8% for the past 57 years, and a little over 5% (annualized) for the past 100.

Third, the assumptions: this is where it gets tricky. Agreed that past performance is no guarantee of future results, but the idea of taking large spans of time for the returns above was to smoothen out short term volatilities, depressions, recessions, irrational exuberances, boom and busts etc. You get the idea. Also (being the optimist that I am), I have assumed that we – as in mankind – don’t nuclear-wipe ourselves out or choke the planet. And if we hit the Singularity in 2050, then all bets are off.

So I am going to assume that the market will return a conservative 8% over the next couple of decades. Put another way, it means that the Dow will double every 9 years. Ah ha! With me so far?

The rest is merely extrapolation. Starting with a 14000 Dow in 2008, you can see below that the Dow will hit a million by 2064 (at the risk of dating my son, he will retire in 2070)! But wait, go out a bit more and you have a 10 million Dow by 2094. (chart below)

Do you think this curve is irrationally steep? I thought so too. So I put the past and future 80 year periods on the same chart with a log scale. Now do the next 80 years look like the past (chart below)?

So what do I recommend? Invest periodically with a discipline (don’t try to time the market), and be in there for the long term (as far as you can afford to). Even if you are a passive investor in a Dow or S&P ETF, you will do fine in the long run. And, if I am not wrong, stocks have historically returned more than real estate. Now you may sleep better too.

Disclaimer: the author is “long” the market

Thursday, May 31, 2007

Emerging Market ETFs: A Look Under the Hood - Seeking Alpha

Emerging Market ETFs: A Look Under the Hood - Seeking Alpha
When you are holding a mix of funds, it is very important to know what your net exposures are to specific countries, sectors, asset classes etc. Else, you could be overweight in some areas while thinking that you are well diversified.
This is look-under-the-hood analysis is similar what does.

China Bubble Mania -

China Bubble Mania -

Thursday, May 24, 2007

Hunt on for new investment play as BRICs crack |

ANALYSIS - Hunt on for new investment play as BRICs crack
With investor risk appetite showing few signs of waning and many emerging markets promising sustainable economic strength, the hunt is on for other combinations of countries to tap into.
... Goldman has gone as far as identifying what it calls the Next 11 or N-11. It comprises Bangladesh, Egypt, Indonesia, Iran, Korea, Mexico, Nigeria, Pakistan, Philippines, Turkey, Vietnam.
... VISTA - Vietnam, Indonesia, South Africa, Turkey and Argentina