Risk Reduction Using Arbitrage

The first question we often hear when talking about arbitrage is, "What is that?"

Simply put, arbitrage is when an investor finds the same asset for sale for different prices. To make money on this, the investor buys the asset at the lower price and simultaneously sells it at the higher price.

When speaking with a client, I often use the following analogy. Imagine that your local Wal-Mart is selling single eggs for 10 cents each. Later, you find out that the local Baker is buying the exact same brand of eggs for $2 per dozen. Someone who wants to make money on this situation could buy the eggs for $1.20 and then sell them to the Baker for a profit of 80 cents ($2 - 1.20=$0.80). It is also possible to do such a trade in the opposite direction if cartons are cheaper than buying the eggs one by one. Simply buy the carton, break it up and sell the eggs one at a time

Pure arbitrage is a risk-free strategy. This might happen if a stock sells on two different exchanges and one of them has a lag. Unfortunately for the typical investor, the Wall Street trading firms already have computer programs in place that snap these opportunities up within milliseconds of them developing. The good news is that other opportunites for arbitrage do still exist.

One of them involves the ETF markets. ETFs are Exchange Traded Funds. They are like a hybrid of a stock and an index fund. Like an index fund, they invest in a fixed basket of investments. The contents of this "basket" are available for any potential investor to examine. Like a stock, they trade on the open market instead of being issued and redeemed by the fund manager like mutual funds are.

When the price of the ETF is different from the actual value of the investments it owns, our investors can make a profit. This is like our example of buying eggs one-by-one and selling them by the dozen to bag a riskless profit.
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The discussion in this post is intentionally general in nature. The above strategy might introduce small to moderate levels of liquidity risk. For information regarding arbitrage opportunities in the current market, email us here.

Inflation - winning strategies

Today, lets look into how we can position our money to protect against, or even win in, an inflationary environment. To help us do that, let's take a look at who wins and who loses when inflation hits.

Losers

1)Savers When individual dollars lose their value, the most obvious losers are savers. It really doesn't matter if its cash in the bank or under the mattress, savers lose. Their dollars are no longer even worth the effort they put into earning them in the first place.
Avoid: Checking accounts, savings accounts, cash.

2) Lenders You might be thinking this doesn't apply to you. WRONG! If you bought a CD from a bank, you are a lender. Same goes if you bought a bond or a bond mutual fund. Once inflation begins to become an issue, the first thing the Federal Reserve thinks about is how to slow down the inflation rate. The method the Fed uses to slow inflation is to raise interest rates. Suppose you bought a 5-year CD that pays 6% per year and the Fed raised rates so that current CDs pay 9%. The bad news is that you are stuck with a cruddy return. The worse news is that inflation could easily be higher than the 6%. Bottom line is that you are actually losing money and you cannot get out without losing even more. Talk about a double-whammy!
Avoid: CDs, Bonds, Munis.

Winners

1) Stocks If inflation is a general increase in prices, then it makes sense that anyone able to sell things at the new, higher prices has some protection against inflation. But be careful because this isn't a sure thing for every stock. Inflation is generally painful for consumers. This means that most people will not be able to buy or spend as much as they could during the good times. The companies that will do best are the ones that sell goods and services that people must have. Companies selling large, expensive items that people don't have to buy will usually underperform.

2) Commodities If you pay attention to the financial news, you are already familiar with this one. The gold sellers are busy defining gold as "real money" while the oil and gas partnerships are busy hitting the phones dialing disaffected stock market investors. Commodities do have a good chance of performing well in an inflationary environment but it doesn't always happen the way one might think.

2a) Fuels For instance, Oil and other fuels can be a decent hedge against inflation if production and demand remain constant. If demand falls because of economic slowdowns, then the price of oil will fall too. Another worry is if producers guess wrong about the economy and produce too much, they could flood the market and drive prices down.

2b) Metals Gold and metals are another option. Industrial metals derive their demand from manufacturing and they are vulnerable to the same issues brought mentioned for fuels above. Gold, on the other hand is often labelled as a great inflation hedge. Dollar down, gold up, right? Wrong. truth is, there is very little correlation between the two. More details here: http://globaleconomicanalysis.blogspot.com/2007/02/is-gold-inflation-hedge.html
Now let's be fair. Even though the correlation is minimal, it is negative. That means that it can be a hedge against inflation, but you should only expect it work about 1 time out of 3. Its also important to remember that Gold is used in a decent number of manufacturing processes, especially in the computer industry. As the computer industry grows, gold will become more of an industrial metal.

Conclusion

What makes inflation tricky is that the losers are easy to pick and the winners are little more difficult. We believe that the smartest way to handle inflation is to pick a variety of potential winners and invest in the top 6 to 12 ideas. Our concentrated approach gives our investors a good opportunity to profit from inflation's winners without trying to bet the farm on one single idea.

Log in tomorrow to learn how we keep downside risk down even in nasty markets

Inflation vs Hyperinflation

So what are we looking at, here?

This chart shows that we have increased the money supply by over 10x in just one year. For those who may not remember, the money supply is the amount of dollars that are in the economy. In our current system, each dollar is only worth what the open market is willing to pay for it. There are two reasons why people and businesses would want to own dollars.

First, people use dollars for commerce. That is the easiest part of demand to understand. What to buy something in the USA? You'll need dollars. Want to buy something from an exporter based in the USA? You'll need dollars.

The second part of dollar demand is called "interest rate parity." This concept is simply common sense. Imagine that you, my reader, are a business executive in Europe and you need to find a safe place to invest some of your currency. Suppose that your home country offers an interest rate of 4% on its government bonds. Now imagine that US Treasury bonds offer an interest rate of 6%. Would you prefer the US bonds? Of course you would. So you would trade your Euros for dollars so that you could buy US bonds. This increase in demand for dollars would cause the value of the dollar to rise. Conversely, if US rates are lower than they are in other countries, then people would prefer to trade dollars out for Euros (or whatever currency applies), which would cause the value of the dollar to fall. That's how interest rates affect the dollar's value.

There is one more piece of the puzzle we need to understand before we can make sense of the the chart above. Both of the above concepts are simple to understand if the number of dollars available remains steady. This was one of the lessons economists thought we had learned from the Great Depression. Instability in the money supply makes it extremely difficult to accurately price goods, services and investments.

Here's why: imagine that our entire economy was comprised of 100 apples and we had 100 dollars to use for trading them. Each apple would be worth $1. Next, imagine that we decided to print 100 more dollars. Now, we have 200 dollars to account for 100 apples. How much is each apple worth, now? The answer is $2, of course. The orchard owner just grew his little economy from a $100 to a $200 one. But he didn't do a thing to actually increase production. He still only has 100 apples. All he did was create inflation.

You may by thinking this is a pretty foolish thing to do. I agree. It would be even more foolish if our apple farmer increased his dollars from 100 to 1000? You would need $10 just to buy an apple. Anyone who kept their money in a savings account or under the pillow would become destitute. But those people who bought apples would come out winners. And those people who invested in apple trees would become tremendously wealthy.

Take another look at our chart. Our government has increased the money supply at the same rate as our farmer. If interest rates remain constant, we are looking down the barrel hyperinflation (rates above 100% per year). To control this, the Fed is going to need to raise interest rates dramatically. Even with this band-aid, we might avoid hyperinflation but chances are very good that investors will still need to find ways to combat historically high inflation rates.

Log in tomorrow for our discussion on what type of investments we are using to turn the tables on inflation and make this a profit opportunity for our clients.

Deflation - Do you need to worry?

Welcome back.

Yesterday, we discussed inflation and how it can affect your financial well-being. At the end of yesterday's article, I noted that inflation occurred in each an every one of the last 50 years in the United States. That's half the story.

Here's the other half. Let's spread our net a little wider and see what the historical chances of inflation are since, say 1914. Uh-oh. Now the story changes a little bit. Instead of looking at a 100% certainty that we lose value to inflation, we find an 11.4% chance that cash money sitting under the mattress will actually increase in value while it sits there doing nothing.

Deflation was strongest in the period of 1927 - 1933. In 1932, deflation rose above 10%, the worst deflationary year in our country's history. As any student of the Great Depression knows, 1932 was one of the most painful years of the period. Jobs were lost, companies went out of business and it seemed like no one was hiring or buying anything but the bare necessities. Why not? Because it made more sense not to. If you had a pile of cash and you knew that it would be worth more if you simply sat on it, why would you risk it on a business venture? And what business can afford to pay $1 for something that will only be worth $0.90 by the time they can sell it? If you owned that business, you would need to sell your goods extra-super-fast or else just shut the doors. And when all your customers are losing their jobs, too, chances are you'll choose to shut down and save your cash.

Fast forward to today

With all the economic uncertainty we face right now, there are many who argue that we run the risk of hitting another deflationary cycle. If they are correct, deflation could wreak havoc on our economy and virtually shut down commerce in this country. Their reasoning in rooted in the fact that many of the current political policies from the White House mirror those of Franklin Delano Roosevelt, who was President during the Great Depression. In short, these experts believe that similar policies will create the same results. But there is one very big difference.

At the start of the Great Depression, the United States currency was on the Gold Standard. That means that every dollar was worth a certain amount of gold. When the economy began to contract, people decided they would rather own the the gold instead. The effect of trading in paper money for gold was to make paper money more scarce. The supply of paper money fell at an even faster rate than the general economy. With less dollars chasing more goods, the value of the paper money increased. Thus, we had deflation.

My point to investors is that the money supply today is actually growing, not shrinking like it did at the start of the Great Depression. But our economy is shrinking. This means more dollars will be chasing fewer and fewer goods. And that, my friends, is the dictionary definition of inflation.

A detailed analysis of deflation can be found here and here.

Inflation and TVM. What do they mean to you?

TVM means "Time Value of Money."

The simplest way to explain it is to say that $1 is worth more today than it will be tomorrow. It also explains why things keep getting more expensive, since $1 yesterday is worth more than $1 today. When the cash money you have loses its value over time, economists call that, "inflation." Like a balloon, the cost of everything 'inflates' and gets bigger over time.

Here's what this means to you: Every dollar you have is a leaking bucket. Just imagine the value dripping out drop by drop. Depending on the time period you want to focus on, inflation has typically been between 3% and 4% in the United States. So how much do you have in savings or checking accounts? Its nice and safe there, all nestled in with its FDIC coverage. But you know where this is going.

Let's say you start with $1,000. To see what it will be worth next year, multiply by 0.96.
In our example, your money is now worth $1,000 x -.96 = $960 even though your bank statement still says $1000. You lost $40 worth of value.
To see what happens after one more year, multiply your new number $960 by 0.96. $960 x 0.96 = $921.60. And you lost another $38.
What do you think you have left in 10 years? The answer is $664.83. You lost $335.17. And here I thought the stock market was risky!

Fact is, cash money is dead money and it is almost guaranteed to lose value. In the past 50 years, there was not a single year that cash money did not lose value. In the economic world, that's about as close as you can get to a sure thing. Or is it?

Log in tomorrow for our discussion on Deflation.

Check our data: www.inflationdata.com is a good source for historical inflation numbers.

"In your best interest" - a dirty little secret

Consumers of financial advice have long faced the question, "How do I decide who to trust?" This has always been a tough question. Recently, it has become even tougher. As if tax laws, inflation and business risk weren't enough, today's investment advisor has to be proficient in deciphering the effect of economic bailouts, political uncertainty and an exceptionally volitile stock market.

Today, I'm going to talk about what industry insiders call "designations." Designations are the alphabet soup that many advisors place after their names. The general belief is that the more letters the salesperson can insert after their name, the more credible they become in the eyes of the potential client. This "more is better" approach can be summed up thusly: "Missy Doe, CFP, MBA, ChFC" must be more educated and more ethical than "Jane Doe." Even though it might be true in some cases, educated investors know these extras are often nothing more than peacocking and puffery.

One of the most popular designations is the CFP or Certified Financial Planner. In my opinion, there is an awful lot of misinformation about what this really means. A CFP is a generalist. A study conducted by the University of Arkansas points out how little this actually means to the investing public. This study asked current Financial Advisors who earned the CFP how well it prepared them to provide investment advice and services. The responses are shocking: the average answer was only "somewhat." Compare that to the 75% of respondents who said they earned the CFP to "Establish their professional credibility." Read the study here.

Another portion of the study worth noting has to do with the concept of fiduciary duty. A fiduciary is someone who is legally required to place the client's best interests ahead of their own. Obviously, this is a far cry from the self-serving sales pitches one might expect from a stockbroker. I have read many articles telling investors to choose a CFP because they are required to place your interests ahead of their own. This simply isn't true. According the University's study, fiduciary duties are not covered in the CFP curriculum. The fact that CFPs are not actually required to act as fiduciaries is also clearly stated by the CFP Board of Standards itself. According to the Board, the CFP code of ethics relies on voluntary compliance from its members. Frankly, that shouldn't be very comforting.

Is there anywhere an investor can go to ensure that he or she finds an advisor who is actually legally obligated to put the client's needs ahead of their own? The answer is a resounding, "Yes." But you are going to have to dig a little deeper than just reading their business card. The Investment Advisors Act of 1940 is the law that governs Registered Investment Advisors. These firms are required by Federal law to act as fiduciaries for their clients.

To search the Federal database of Registered Investment Advisors, click here.

To search for complaints or disciplinary action against a broker or advisor, click here.