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Diversity/Non-Correlation/Profit

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May 31, 2011 – Comments (0)

Board: Macro Economics

Author: washcomp

I am going to address this from the perspective of the US dollar as a native currency, but I suppose the same would be true of other currencies (by changing the names of the guilty parties):


In the event of a massive meltdown (like we had in late 2008), there is a perception that correlations went to 1 and everything went down (didn't matter if it was stocks, bonds, gold, foreign currencies - or whatever). That's not "quite" true - in fact, the value of the US dollar soared.

(Ignoring the effects of taxations), We increase the value of our asset holdings in two respects - the return on investments (through interest, dividends, rent etc.), and the increase in the value of our holdings (in the context of them going up in "number of dollars" on an absolute basis.

Here's where I will begin to diverge a bit from what is commonly accepted. I've gone over my methodology, in the past, of establishing asset valuation by means of "weighting" them against the US dollar index. The reason for the importance of this filter is to determine the true affects of changes in macroeconomic conditions on your wealth.

Bringing this back to earth, there is a parallel set of (simplified) definitions that a strengthening dollar is showing deflationary tendencies and a weakening dollar the reverse. In a world of deflation, those who hold dollars are in a position to purchase other assets at extreme discounts (as demonstrated in late 2008-early 2009).

I won't belabor the above, but would point out that, as the dollar started dropping, most other assets (equities, bonds, precious metals, foreign currencies, food commodities, etc.) have appreciated at various rates to the detriment of the US dollar.

We are aware, due to the Fed's actions, that cash (and associated bonds) don't offer significant return. We are also aware, based on the above, that as long as the US dollar continues to drop, most alternatives will continue to rise. Some will rise more than others, but the trend will be the same. It is also obviously true that the reverse will take place as well.

OK, we have a nearly direct "see-saw" correlation - but we are looking not only for a hedge, but for categories that don't directly follow the path of the others.

Some examples would be currencies which are tied to events far enough outside the direct "gravitational attraction" of the US dollar to survive the blow better than other asset types. For a variety of reasons (which I've gone over before) the Australian dollar, the Swiss franc, the Norwegian kroner and a handful of other currencies tend to carve their own paths and can provide a measure of protection (though will still get hit). Beyond that, about the only safe thing I can think of holding while the dollar rises is - well - the US dollar itself (or bonds of short enough duration that rising rates would not hit their value much).

I am not predicting a reversal of the drop in the US dollar. I will, however point out that the Japanese economy is currently on life support. The Euro Zone has economic problems which may spin out of control on any number of trajectories over the near to medium future. China seems stable, but "stuff" happens and they are turning the knobs on their economic stereo in ways that may produce unexpected results as they try to supplant the US as the world's leading economy. India and Pakistan could fall out of love with each other or Israel could decide that Iran is too close to developing the ability to reach them with a nuclear warhead (and the Saudis are not calling in the US) and take matters into their own hands. Russian troops could roll into Ukraine. Or some other event - it doesn't matter what, just that it scares the bejesus out of everyone and they pour money into the US dollar.

At that point of time, it is important to understand both the effects of the beating you are likely taking in many of your asset groups and the sudden increase in the value (net worth) of your cash holdings. It is that cash which will allow you to acquire low priced bargains (again supporting the theory that that cash has actually appreciated in value - despite its paltry rate of return). If interest rates were to rise (and yes – this scenario would require someone battling with the Fed and dealing some significant body blows), the dollar will eventually respond heading much higher. This will be a dance we have seen before involving inflation expectations vs. long term interest return rewards. At the peak will be a time to buy bonds, but climbing to the peak will not be pleasant for bond holders.

I again point out that holding cash (and considering that holding a valid asset class) is not complete lunacy. While that portion of your assets may be losing value right now (as other asset classes gain), it is the asset most likely to appreciate in value (though not in terms of absolute US dollars - and why my recommendation to use the US dollar index, or similar other index if you prefer, as a means of re-valuing cash holdings).

In the scope of non-correlating diversity, don't forget to make sure you are balanced in your approach. Never get either so frightened or overenthusiastic enough to put yourself in a position that a sudden shift in any market (or group of markets) can deal a financial knockout blow.

I am curious whether others can explain how their particular asset allocation mixtures would withstand various classes of economic events. If a liquidity crisis hit, what would be the effects on your holdings? If the dollar rose by 10% (or 30%), how would your holdings fare? How do you rebalance? Do you market time or do allocation shifts (and why)?

We've had three years of unique laboratory learning experience (actually far longer for some of us). What have we learned? How have we changed our financial balance and posture to decrease the pain and increase the likelihood that we will benefit from the next meltdown?

(Just remember - what I've outlined above is generally the "anti-gold" scenario :-)

Jeff

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