Saying it’s better to buy when securities are going up than when they are going down is easy.  Actually determining what is up and what is down is not quite as easy.

We have said and wish to reiterate that you should buy makes good sense to own for fundamental reasons when it is going up and not when its goes down.

We think computers with their cold objectivity can help draw the line between up and down or flat.  As humans, we may tweak our own criteria to make sure that the securities we like are interpreted as we wish them to be, more than as they are in marginal situations.

What makes logical sense to us is to define your criteria of up and down, and then hand-off the task of deciding what is up and down to a machine that has no emotional attachment to the determinations.

Time frame is the biggest issue (1 year, 1 month, 1 week, 1 day, 1 minute, or 1 tick).  The indicator is the next issue (eyeball inspection, moving averages, moving average cross-overs, linear regression, or something else).

Here is a set of examples based on weeks and months, avoiding eyeballs, and using both moving averages and linear regression slopes (price only, not total return — dividends excluded).  It’s not meant to be definitive, just indicative of a computer-based approach you might consider for yourself.  All determinations were done by formula in the MetaStock software tool.  We made up the rules and MetaStock did the work.

We performed the test on 27 categories of assets that represent most of those found in individual investment portfolios.  Not all categories are in all portfolios, but the bulk of portfolios can be described by securities of the general type in this list.

click images to enlarge

In this exercise, we measured the direction (up or down) of the 200-day simple moving average and the 100-day moving average over the past 4 weeks and 2 weeks, and also the linear regression best fit trend line slope over the last 200 days and the last 100 days.

The data which is color coded as green for up, pink for down and yellow for flat, still begs the question as to up or down, but narrows the scope of the information that must be considered.

If this time frame and these measures make sense for your purposes, that’s all well and good — you can decide for yourself the net direction.  If not, it may point the way to an approach for your time frame and indicator choices using a rules-based and computer generated analysis.

Here are the charts for several of the securities studied so show how the indicators reduce the nearly infinitely varied price patterns into some semblance of order for interpretation — and we hope also showing how a machine and indicators can overcome the data overload and excessive subjectivity that the eyeball approach entails.

The gold line is the 200-day average.  The green line is the 100-day average.  The red line is the 200-day linear regression slope.  The blue line is the 100-day linear regression slope.

BND

TLT

TIP

BWX

GLD

UUP

VTI

VWO

FXI

Securities identified in this article: BND, MUB, IEF, TLT, LQD, VWEHX, BWX, EMB, VCVSX,PFF, VTI, VEA, VWO, VGK, EPP, EWL, FXI, IFN, EWZ, TIP, VNQ, DBC, GLD, USO, DBV, UUP.

Disclosure: we own most of these securities from time-to-time in managed accounts.

Richard Shaw
QVM Group LLC

June 25 (Bloomberg) – “Barack Obama may be the worst thing that ever happened to tax-exempt bonds …. “

We certainly agree and see more trouble for tax-exemption down the road.

Obama Chief of Staff, Emanuel said, “A crisis is a terrible thing to waste.”, and the administration is taking that advice by sponsoring and subsidizing the issuance of fully taxable municipal bonds — “Build America Bonds” (the camel’s nose under the tent).

Presidents since Franklin D. Roosevelt have tried to tax the interest payments from municipal bonds without success, but the debt crisis has provided Obama with a way.

Build America Bonds (we prefer “Obama Bonds”) pay 35% of the interest cost for fully taxable muni bonds.

Presumably the subsidy also improves the credit quality of the bonds by having a portion of the interest come from the US Treasury.

Example Bonds YTM Rate Comparison:

We based our credit quality argument on logic suggesting the federal payment stream to more secure than the state portion; and upon an unscientific study of two issues (a CA tax-exempt ‘34 GO yielding roughly 6%, and a CA taxable Build America ‘34 yielding roughly 7.5%).

Since the after-tax return on the Build America bond is lower than the after-tax return on the traditional tax-exempt bond, and the maturity dates are the same and both are state GO’s, we presume investors perceive lower credit risk on the Build America Bond (although the posted credit rating is the same for both at A2/A).

On the other hand, the lawyers for CA weren’t totally sanguine about the risks, because the terms of the bonds provide the state the right to call the bonds (presumably to replace with traditional bonds) if the federal funding is not provided in full.

Control Hook:

Because this government program is “temporary” (yeah right, a temporary government program that raises taxes), and because the current funding is limited, the government must selectively subsidize.

If the program is extended (read that made permanent), then rationing of a small program will grow into mandated use of a large program, with the federal government effectively deciding which state and local projects get funded at all.  It will go from selecting which projects to subsidize, to mandating federal funding and selecting which projects to permit to be bonded.

If you don’t believe that, then name a major federal funding program that doesn’t come with mandates.  Name a major federal funding program which doesn’t trap or addict states.

Tax Hook:

Bloomberg pointed out,

“Interest on state and local government bonds sold for public purposes has been exempt from federal levies since the Constitution was ratified and remained so after the 16th Amendment was approved in 1913 creating the federal income tax.  Presidents and lawmakers have tried to roll back the exemption for decades. Since the 1960s, Congress has passed legislation prohibiting use of public debt for racetracks, massage parlors, golf courses and other private purposes. The House Ways and Means Committee initially proposed subsidizing taxable municipal bonds in 1969. President Jimmy Carter and Bill Clinton also embraced the idea. … There were no hearings on Build America bonds before they debuted, so there was no opportunity to mount opposition…”

We suppose the lack of hearing on Build American Bonds is part of the transparency Obama promised and continues to promise.

Given the search for tax revenues, and the “share the pain” and tax the rich orientation of the current US legislative and executive branches, it has surely not gone unnoticed that 44% of the $72 billion of tax-exempt income in 2006 was claimed by households earning over $500,000 (the people in the general tax increase cross-hairs).

Eliminating the tax-exemption for those high income taxpayers would generate $30 billion of revenue.  That $30 billion would effectively have to be recycled as subsidy of taxable municipal bond issuance, but it would further governmental control of state and local governments, and further the redistribution of wealth.

There are opponents in Congress.  One notable voice is Barney Frank, chairman of the House Financial Services Committee.  He says there’s “zero chance” Congress would permit the municipal bond tax exemption to be eliminated.   Bloomberg noted that Barney has his most of his life savings in Massachusetts tax-exempt bonds.  We’d call that enlightened self-interest, as opposed to what Larry Summers called “unenlightened capitalists” when the first lien bond holders of Chrysler wanted their liquidation priority honored. We supposed Barney didn’t own any Chrysler bonds.

Adverse Investor Scenarios:

Here are some conceivable investor perspective scenarios adverse to municipal bond investment programs (not conceivable pre-AIG, pre-Chrysler, pre-GM, but conceivable now):

• Mandated Use of Taxable Munis: Federal government mandates state use of taxable municipals, resulting in lower supply of new tax-exempts to replace maturing tax-exempts, thereby phasing out tax-exempt investment opportunities (perhaps increasing the value of issued tax-exempts).

• AMT on Traditional Munis: The Alternate Minimum Tax is modified to phase out exemption for upper income tax payers.

• Prohibition of Bailout Money Use for Traditional Munis: As in the case of Chrysler and General Motors bailouts, where bondholders were royally shafted, muni bondholders may receive similar treatment in a California or other state bailout.  We can imagine the strings attached to a state budget bailout requiring 100% funding of any and all state obligations (and perhaps wish list projects) other than muni bond interest (or even principal) before any payments on tax-exempt muni bonds are made.

• Universal Muni-Tarp Jam-Down: To avoid adverse effects on states taking subsidy (let’s call it “muni-TARP”), as with the banks, there may be a jam-down so that states that don’t need the money have to take it any way.

The first action would limit reinvestment opportunities and probably generate a premium on issued bonds.

The second action would eliminate the scarcity premium on issued bonds.

The third action would  generate a discount on issued bonds, damage (perhaps collapse) the secondary market for traditional issues from states with “muni-TARP” funding, while putting a premium on issues from states that are not receiving “exceptional assistance” (as the term is used with bank TARP).

The fourth action would eliminate the premium for self-sufficient states, generated by the third action.

We own muni bonds for about ½ of our overall bond allocation, but are anxiously watching developments.  As Bill Gross, co-CEO of PIMCO, said in his recent missive, don’t turn your back on the government when it comes to your investments.

There’s not just future inflation to worry about with municipal bonds, but also possible vanishing tax-exempt reinvestment opportunity, and possible mandated contract rights violation.

Time Frame:

A year ago, we would not have considered these adverse scenarios to be a realistic risk, or have had the audacity to talk about them.  Now we do.  A few months ago, we would have said we do not believe any such changes, if ever, could be made in months.  Now we do.

Event Risk Fat Tail:

This nightmare story may never come true, but it might, and in terms of event risk, this would be a big fat tail for muni bonds — not a Black Swan, because it is on the radar screen — but off the charts in terms of historical events for municipal bonds.

Be Watchful!

Richard Shaw
QVM Group LLC

IRS Website Reference:

R-2009-33, April 3, 2009

“The American Recovery and Reinvestment Act of 2009 creates the new Build America Bond program, which authorizes state and local governments to issue Build America Bonds as taxable bonds in 2009 and 2010 to finance any capital expenditures for which they otherwise could issue tax-exempt governmental bonds. State and local governments receive a direct federal subsidy payment for a portion of their borrowing costs on Build America Bonds equal to 35 percent of the total coupon interest paid to investors.

This new program is intended to assist state and local governments in financing capital projects at lower borrowing costs and to stimulate the economy and create jobs. … Build America Bonds can be issued in 2009 and 2010. There is no volume limitation on the amount of eligible Build America Bonds that can be issued during this period”

IRS Notice 2009-26 “… provides guidance on Build America Bonds to enable state and local governments to begin using this program. This notice includes guidance on eligible types of projects and financings, initial implementation of the direct federal subsidy payment procedures, elections to use this program, and information reporting for this program.“

Goldman Sachs coined “BRIC” for Brazil, Russia, India and China.  Some commentators have recently suggested that Russia’s stocks are too volatile, economy too fragile and politics too hostile to capital, and that maybe “BIC” is more attractive.  Based on the recently released forecast for GDP growth by the World Bank and the OECD, maybe “BICI” will become popular (Brazil, India, China and Indonesia) someday.

Actually, we don’t expect that to happen as a product phenomenon (although it may become a theme), but we do take note of the GDP growth ranking of Indonesia higher than Brazil and just behind China and India.  Indonesia is a very small market and its country funds have quite limited trading liquidity.  They have a long way to go to be in the same class as the BRICs for “investability”.

Country GDP Growth Outlooks:

The following table presents historical, estimated and forecasted GDP growth rates for selected countries reported by the World Bank and by the OECD in their June outlook reports.

click image to enlarge

Note that the developed economies are shrinking and not projected to approximate 2007 levels of growth until 2011.

The combined developing economies, excluding China and India, are shrinking and not expected to achieve 2007 levels of growth by 2011.

Among the BRICs, China and India are still growing, although at half the rate of 2007, and not expected to achieve 2007 GDP growth rates by 2011. Yet at half speed they will be growing more than 3 times as fast as the US in 2011.

Russia is shrinking more than Japan, the second worst in the batch reported by the World Bank in its “Global Development Finance” report in June 2009.  Growing its GDP at -7.5% now and expected only to achieve 3.0% growth by 2011, it is pulling up the rear — not much better than the developed economies in 2011.  Oil prices are a wild-card there, we would think.

The OECD in its June “OECD Economic Outlook” report has a less optimistic view of the 2010 US, European, Japanese and Indian economies, and a more optimistic view of GDP growth for China, Brazil, Turkey, Mexico and Russia.

Some relevant country and region funds are: SPY, VTI, IWV, BIK, EEM, VWO, IEV, VGK, EWJ, FXI, IFN, IF, EWZ, EZA, THD, TUR, EWW, RSX.

Richard Shaw
QVM Group LLC

[post-script: just noticed Trader Mark at Seeking Alpha reported last week that Morgan Stanley suggests adding Indonesia to BRIC to get BRICI.  Oh well, we tried to be original with our BICI comment, but are apparently late to the party]

Different strokes for different folks.  Some investors, prefer individual stocks and bonds.  Others prefer funds.  Some have a combination.  All too often, investors have an eclectic collection of stocks, bonds, funds and  annuities that they have accumulated over a lifetime with no clear rationale or plan.

Greater simplicity is most often the obvious need.  At the extreme of simplicity is the use of a handful of broad, passive index funds.

We frankly prefer an intermediate portfolio composition — less than complex, but more than simple — let’s call it “simplexity”.  However, for those seeking great simplicity in their portfolios, here are some very basic ideas.

A small group of funds could be used as a the core of a portfolio or as the entire portfolio (examples shown in the image above).

Once allocation weights are established for each broad asset category, if you have a large cash position,  you would step into the market for each category in stages based on the fundamental logic and/or market conditions applicable to each category.

To the extent that you wish now or later to have exposures that differ from the core funds, you could “tilt” the exposures by:

• Supplementation (such as by adding a China fund to increase that country’s overall weight in the emerging markets category, or by adding an investment grade corporate bond fund to increase the weight of that form of debt in the US taxable bonds category), or by

• Complementation (such as by adding an foreign currency denominated international Treasury fund to expand the fixed income exposure beyond US only bonds; or  by adding a commodity or real estate fund to expand into those categories).

There are all sorts of ways to supplement or complement core exposures with regional or country funds, sector or industry funds, market-cap and/or style funds, thematic funds, bond funds with different credit quality or duration, and other subclasses and categories; but selectivity is important to avoid recreating a complex mass of holdings, or inadvertently recreating a virtual broad index with many funds.

Tilting the few simple core positions remains an option when and if appropriate or desired to expose you to various risks/opportunities in a tactically targeted way.

Here are charts for seven of the funds identified in the image above as candidates for a simple portfolio:

Even if you don’t chose simplicity, or even “simplexity” for your portfolio, a simple portfolio concept may be useful as a benchmark against which to compare your actual results in yoru real portfolio.

Securities named or implied in this article: VT, ACWI, BND, AGG, VTI, IWV, VEU, MUB, VWITX, VEA, EFA, VWO, EEM, FXI, LQD, BWX, DBC, VNQ.

Richard Shaw
QVM Group LLC

The S&P 500 is moving down lately.  Let’s look at some chart perspectives to project possible near-term end points for the price movement.

Support, Resistance and Retracement:

The S&P 500 is approaching a potential support level at about 875 based on 20-day price channels.  If it pierces that level and stays there for a few days, a much larger downward move is probable.

click images to enlarge

An extended decline below 875 might likely go to the 805-810 area as a 1/2 retracement, or the 750-760 area as a 2/3 retracement, from the recent peak.

S&P 500 Internals:

Several internal dimensions of the S&P 500 also point downward at this time.

The percentage of the 500 constituent members with bullish Point & Figure charts has crossed the 75% level (at 59%) level in a downward move.  The ratio of new highs to new lows has crossed 25% (at 20%) in a downward move.  The percentage of constituents above their 50-day moving average crossed 50% (at 41%) in a downward move. The percentage of constituents above their 200-day average is approaching 50% (at 52%) in a downward move.

The trading volume in the index has declined ever since the price level exceeded about 800 in late March.

Primary Trend:

The 200-day simple moving average is still downward sloping.  The 200-day exponential moving average, while nearly flat, is still slightly downward sloping.

Linear Regression View:

Approaching the question of possible price ranges from a different perspective, linear regression best fit form various beginning points shows mostly possible price levels based on trend continuation.

The values for today that are implied by the linear regression best fit trend lines are:

• from Jan 1, 2008: 735
• from Sep 1, 2008: 787
• from Jan 1, 2009: 904
• from March 6, 2009: 960

Odds Cone Projection:

Taking a perhaps more balanced, not just downward view, a statistical probability approach based on prior volatility suggests theses price ranges to a 90% confidence level:

• 60 days forward based on 60 day history: 1020 to 784
• 60 days forward based on 40 day history: 1010 to 793
• 60 days forward based on 20 day history: 1003 to 700

Even though the odds approach is symmetrical up and down, we tend to put more faith in the lower ranges based on the the other decidedly negative factors discussed above.  If the market does go up, 1000 to 1020 may be the limit for the next 60 days.

We believe we are in a correction phase at this time.

Richard Shaw
QVM Group LLC