Archive for June, 2011

The Effect of Gold in a Diversified Portfolio – Part 2

Monday, June 27th, 2011

In Part 1 of this article (6/13/11) we looked at how including gold as a candidate asset class affected classic Modern Portfolio Theory (MPT) portfolios. We found that gold was only advantageous for the more conservative portfolios and even then only at modest percentage allocations. MPT is, of course, still very much relevant for those with defined financial objectives and long time horizons who wish to minimize the risks associated with achieving their financial goals. The concept of broad diversification among investment classes is a basic and universally accepted precept of sound investment practice.

Nevertheless, MPT does have its critics. Its chief assumption is that the future will be like the average of the past, a point that has been the subject of debate. While in the long haul that is very likely to be true, there will be significant periods of time when that does not hold. Extended bear markets or short term crashes such as those experienced in the last decade can wreak havoc with even properly diversified portfolios that can take many years to repair.

The question now becomes: Is there a way to avoid the bulk of losses experienced during downturns while still benefiting from the periods of recovery? The answer to this is yes, and we’ll see how this can be accomplished.

The application of market timing to MPT-constructed portfolios
What we will be looking here is the application of a cautious market timing modification to MPT. In particular we will examine the effect of including gold as a candidate asset class in the same way as we did in the first part of this article.

Briefly, the approach is to apply a timing oscillator optimized specifically for each asset class. When the oscillator turns positive, a long position is entered into with the portfolio percentage determined by MPT. The position is held (with monthly allocation adjustments as determined by MPT) until the oscillator goes negative, in which case the asset class is liquidated and moved into cash (T-bills, insured money markets, etc.). Utilization of this monthly rebalancing strategy has historically shown to achieve the same financial objectives as classic MPT but at much lower risk. More detailed information on this approach is available here.

Risk comparison between non-gold portfolios with and without the benefit of market timing
Let’s look at some results. Table 3a below shows the current allocations (through April 2011) for market timing modified MPT portfolios without gold as a candidate. Note that the risk associated with each targeted portfolio return (given in column 1) is defined by the standard deviation shown in column 2.

Table 3a. Current Market-Timing Modified MPT allocations without gold

The portfolios in the above table compare to those in Table 1 in Part 1 of this article. The table is reproduced here for your convenience:

Table 3b. Current MPT allocations without gold (no market timing)

An important takeaway from this article is to note that the application of an optimized market timing system considerably reduces risk in an MPT constructed portfolio. At higher portfolio percentages (8% and above), the risk is reduced by 50% or more which is amazing! Additionally, the probability of experiencing a losing year drops as well. In a 10% target return portfolio, one can expect a losing year every six years instead of every three.

Another important point to note is that higher returns can be achieved by using the market timing approach. Compare the top returns in both models: a 12.2% return is the maximum achievable return (at this point in time) in MPT-constructed portfolios with no market timing versus 13.8% in models with it.

Risk comparison between portfolios containing gold with and without the benefit of market timing
Table 4a below shows the current allocations (again through April 2011) for market timing modified MPT portfolios with gold as a candidate. The striking difference from Table 2 in Part 1 of this article (reproduced in Table 4b below) is the prevalence of gold throughout the range of alternative portfolios.

This result tends to indicate that gold is a worthwhile investment component in your portfolio but only if you watch it closely and are nimble and reactive in getting in and out of your positions. However, comparing the standard deviations with those in comparable Tables 3a and 3b above for those portfolios of equal required return, the advantage of including gold as a risk reduction tool is actually quite minimal.

Table 4a. Current Market Timing Modified MPT allocations including gold

Table 4b. Current MPT allocations including gold (no market timing)

A historical perspective
The above tables reflect current allocations and risks associated with MPT generated portfolios. These numbers, however, are not indicative of long-term performance. For that, we need to start at the beginning of our data (January of 1928) and calculate how each portfolio would have done since then.

To that end, let’s return to the conservative 6% compounded annual return portfolios we looked at in Part 1. Figure A below compares the classic MPT approach to the market timing modified MPT approach without gold as a candidate asset class. The lines show the growth of a portfolio following each of these two strategies with monthly rebalancing according to each model’s recommendations. The magenta line is the classic MPT portfolio (repeated magenta line from the graph in part 1) while the green line represents the performance of the market timing approach.

As you can see, both approaches met the target return and in fact exceeded it (7.1% for classic MPT, “long” and 7.3% for marketing timing modified MPT, “comb”). But that is not the important result as both were only trying to achieve a return of 6%. The significant result is that the market timing modified strategy achieved the target with a substantially lower standard deviation than the classic MPT portfolio, 5.4% versus 6.8% (a 20% reduction in risk).

Figure A. Historical comparison of MPT derived portfolios (without gold) for a 6% required return with and without the benefit of market timing


You can see from the above table that over the past 83 years both approaches not only attained but exceeded the required 6% return. The difference is that the portfolio that included market timing did so at approximately a 20% lower level of risk.

Now let’s compare the same portfolios but with the addition of gold. Figure B below shows that again both portfolios met and actually exceeded the targeted return, and again the market timing strategy (green line) did so at an even lower risk (25% lower) than the classic MPT portfolios!

Figure B. Historical comparison of MPT derived portfolios (with gold) for a 6% required return with and without the benefit of market timing

Adding gold increases risk
Comparing the risks from both plots for comparable strategies we see that including gold as an asset class actually caused a 7% increase in risk in the classic MPT portfolios and a 2% increase in risk for the market-timed MPT portfolios, although that was mitigated by the slightly higher returns achieved. Again, the application of market timing decreases the risk in both models.

From our analysis, we can make the following conclusions:
1. The application of market timing to MPT significantly decreases portfolio risk.
2. The addition of gold increases risk in both models (market-timing vs classic MPT models) but much less so in the market timing model.
3. Higher levels of portfolio returns may be achieved with the market timing model.

The conclusion reached in this article reinforces the conclusion stated in Part 1: There is little to justify gold as an asset class for long-term objective based investments.

FYI: Visit our website for further information on how we apply market timing and how your portfolio can benefit from it, too.

Acknowledgement: Pat Glenn contributed research and analysis to this article.

The effect of gold in a diversified portfolio – Part I

Monday, June 13th, 2011

With the continued upswing in the price of gold many investors are once again either wondering if they should buy, sell, or hold the metal in their investment portfolios. This article will examine the contributions made by the gold asset class to a investment portfolio allocated according to Modern Portfolio Theory (MPT).

Used by many fund managers and investment professionals, MPT allocates asset classes according to a desired average rate of return while simultaneously minimizing portfolio risk. Risk can be looked at as fluctuations in portfolio returns; in MPT, risk is measured by a statistical term called the standard deviation.

Because of the broad scope, this discussion is broken up into two parts. In the first part, we’ll compare allocations, returns, and risk in portfolios where gold is included to those portfolios where it isn’t. This comparison will tell us to what extent gold is meaningful as an asset class in a diversified portfolio with a long investment horizon.

In part two, we’ll revisit an article written a couple of years ago to see what effect the recent rally in gold has had on long term returns. We’ll examine it using traditional MPT assumptions and compare the results to those obtained by adding the extra dimension of optimized market timing to see how we can actually decrease risk while increasing returns.

The politics of gold
Our MPT portfolio includes the nine traditional asset classes (see tables below). Monthly total return data from all of these asset classes were only readily available after 1928 which is when we’d like to begin our analysis. We could start later, but in statistics, the more data one has, the more reliable the results.

One problem with this approach is that the price of gold was politically controlled for much of the time between 1928 and the present. In 1933, Americans were prohibited from owning non-jewelry gold and in 1961 they were even barred from holding gold in foreign countries.

Further, the price of gold was fixed in 1934 at $35 per ounce. That changed in 1968 when a two-tiered pricing system separated official transactions at the fixed price while providing for a free market at fluctuating prices. In 1975, Americans were once again allowed to officially own gold as an investment class.

MPT analyses require that data from all asset classes be available for the entire time period with the earliest date being designated as the starting point. Some might argue that 1975 should be the start date since the price of gold was artificially fixed before that. On the other hand, the political nature of gold pricing is a significant reality that should be considered in any analysis. As mentioned above, the performance of the other asset classes is better evaluated using as much data as possible. So, starting the analysis in 1928 has the advantage of including a much larger database from which to predict the performance of asset classes going forward from the present time. [An analysis of portfolios with and without gold using 1975 as the starting date can be found in the July 7 and July 8 articles written in 2009.]

The rise of gold
The figure below shows that one dollar invested in gold in January of 1928 would be worth just over $74 today. [A note on pricing: Gold prices used here are the London Price Fix, the most commonly used benchmark since 1919.]

As you can see, much of the activity has occurred since 1968 when the two-tiered market came into being. The first significant runup in the price preceded the lifting of the legal ownership ban and the second spike accompanied a period of high inflation in the US. Recently, gold has seen a resurgence as confidence in other financial assets has waned.

Current portfolio returns with and without gold
What does this all mean for your portfolio? Should you own gold, and if so, how much? The answers to these questions depend on your risk/return objectives.

Table 1 below shows the current MPT risk/return allocations among the nine traditional asset classes (excluding gold). The average annual compounded rate of returns currently achievable by the MPT model are listed in the first column. The second column shows the risk (standard deviation) which naturally increases along with the required return. Subsequent columns show the probability of portfolio loss in any one year and the Sharpe Ratio which is a measure of return versus risk with higher numbers being more desirable. This table and the next one were derived from the SMC Analyzer portfolio optimization software.

[To use this table, decide which return in Column 1 is right for you, according to your own appetite for risk and your investment horizon. Then, form your portfolio according to the allocations shown in that row. Note that all of these asset classes having corresponding mutual funds and/or etfs that mimic the underlying asset class; for example, the SPY–the S&P 500 etf– could be used as a proxy for Large Company Stocks.]

Now let’s see what effect adding gold as an asset class does to the above allocations. The right-most column in Table 2 below shows the gold allocations as calculated by MPT.

As you can see, MPT allocates gold into only the most conservative portfolios, and then only at modest percentages. Furthermore, the addition of gold provides virtually no risk reduction in those portfolios. This somewhat counterintuitive result supports the conclusion of economist Thomas Sowell who in his book, Basic Economics: A Citizens Guide to the Economy, noted that over time stocks and bonds have produced greater returns than gold.

A comparison of historical returns
The above chart shows that a portfolio constructed for a 6% return has the largest allocation of gold. Using this return objective, let’s compare how a portfolio with gold would have compared with a comparable one without gold. Running the MPT analysis from 1928 to the present, we see from the figure below that while both portfolios actually exceeded their targeted return, the no gold portfolio did so with lower risk (6.8% vs 7.3%).

There is no doubt that over the past few years gold has indeed been a spectacular investment but the data show that growth is sporadic. MPT portfolios are not about producing extraordinary returns in the short term; rather, they are designed to achieve a defined objective return at minimum risk over the long haul.

If you’re a die-hard gold bug who believes that the yellow metal has more room to run, then by all means go out and get yourself some. The moral of the story: Just don’t overdo it.

In a follow up article we’ll look at the effects of gold on a portfolio that uses an optimized market timing approach to MPT to see if we can achieve greater returns at lower risk.

Note: Pat Glenn contributed research and analysis to this article.

Intraday market notes & observations – June 10

Friday, June 10th, 2011

3:00pm ET: Next support levels
Look to the March lows as the next support levels for the major averages:
SPX 1250
DTX 495
DJIA 11550
Nasdaq 2600
OEX 560

12:50pm ET: Intraday support/resistance:
SPX 1264.5/1288.5
DTX 505.5/513.5
DJIA 11925/12125
Nasdaq 2643/2677
OEX 564/574
VIX 17.9/19.1
Trin range: 1.1 – 1.7 (bearish)
Average VWAPs: 34/54 (mildly bearish)

Note: The VWAPs are constantly changing and the number given here is accurate at the time of writing. It is to be used as a gauge of current conditions. The indicator is best watched during the day to deduce trading trends.

Intraday market notes & commentary – June 9

Thursday, June 9th, 2011

12:55pm ET:  Intraday support/resistance:
SPX 1279.5/1297.5
DTX 509/518
DJIA 12050/12200
Nasdaq 2670/2700
OEX 570/579
VIX 17.1/18.3
Trin range: 0.6 – 1.0 (bullish)
Average VWAPs: +64/-28 (mildly bullish)

Intraday market notes & observations – June 8

Wednesday, June 8th, 2011

1:05pm ET:  Intraday support/resistance:
SPX 1280/1290
DTX 508.5/514.5
DJIA 12040/12120
Nasdaq 2683/2702
OEX 570/575
VIX 17.5/18.4
Trin range: 0.95 – 1.50 (bearish rising trend)
Average VWAPs: +48/-48 (bull/bear tug-o-war)

Intraday market notes & observations – June 7

Tuesday, June 7th, 2011

12:55pm ET: Intraday support/resistance:
SPX 1286/1299
DTX 515/519
DJIA 12090/12175
Nasdaq 2700/2720
OEX 572.5/576.5
VIX 17/18.5
Trin range: 0.85 – 1.30 (neutral)
Average VWAPs: +44/-47 (neutral)

Intraday market notes & observations – June 6

Monday, June 6th, 2011

2:50pm ET: Financials under pressure
Financial stocks are trading in the red today. Reflecting that action is the Ishares Financial ETF, IYG, which is breaking $54 support. Making an even stronger statement is the 3x inverse financial bear ETF, the FAZ. Its daily chart below is showing that it finally broke a 5 month resistance level at $45.50.

Update: It’s also worth checking out the 2x short financials, SKF, which is also breaking out.

1:20pm ET: Market Alert! Major averages breaking key support levels
Despite lackluster trading today, the major averages are trading below their 100 day moving averages and these key support levels:

Yet another bearish sign is the SPX breaking its lower channel bound:

1:05pm ET: Intraday support/resistance:
SPX 1290/1300
DTX 516/524
DJIA 12090/12170
Nasdaq 2718.5/2736.5
OEX 574.5/578.5
VIX 17.4/18.6
Trin range: 0.95 – 1.50 (rising Trin is bearish)
Average VWAPs: +28/-72 (mildly bearish)

Intraday market notes & observations – June 3

Friday, June 3rd, 2011

1:10pm ET: Intraday support/resistance: SPX 1298/1313
DTX 522/531
DJIA 12100/12250
Nasdaq 2740/2770
OEX 577/584
VIX 16.6/19.9
Trin range: 0.7 – 1.1
Average VWAPs; +80/-27 (moderately bullish)

Intraday market notes & observations – June 2

Thursday, June 2nd, 2011

3:00pm ET:  5/31 blog update: SPX hits lower channel bound
We noted on Tuesday that the SPX is caught in a tight downward trending channel. On that day, it bounced off its upper bound and today it appears to be bouncing off its lower bound. We’ll see if there’s follow-through to the upside tomorrow.

12:50pm ET: Intraday support/resistance:
SPX 1302/1318
DTX 527/535
DJIA 12180/12300
Nasdaq 2755/2785
OEX 578/586
VIX 17.5/19
Trin range: 0.6 – 1.35 (currently 1.0)
Average VWAPs: +31/-72 (slightly bearish)

Intraday market notes & observations – June 1

Wednesday, June 1st, 2011

1:15pm ET: When is FLAT not flat?
The answer is: When it’s trending. In case you don’t know FLAT is the symbol for the iPath US Treasury Flattener. Got that? I didn’t think so.

According to the fund, its goal is “to replicate, net of expenses, the inverse performance of the Barclays Capital US Treasury 2Y/10Y Yield Curve index. The index employs a strategy that seeks to capture returns that are potentially available from a “steepening” or “flattening”, as applicable, of the U.S. Treasury yield curve through a notional rolling investment in U.S. Treasury note futures contracts. The level of the index is designed to increase in response to a “steepening” of the yield curve and to decrease in response to a “flattening” of the yield curve.”

From the daily chart shown below, it’s clear that the yield curve is steepening and has been since April as FLAT has risen nearly 9% since then. Today, it jumped another 1.7% breaking near-term resistance. This is a signal that FLAT will continue to rise meaning that we can expect the yield curve to continue to steepen. This might explain why so many longer-term Treasury funds are breaking out of their bases today.

12:30pm ET: Intraday support/resistance:
SPX 1321/1345
DTX 534.5/547.5
DJIA 12330/12570
Nasdaq 2795/2835
OEX 586.75/597.25
VIX 15.95/17.25
Trin range: 1.30 – 2.20 (bearish, above 2.20 becoming contrarian bullish)
Average VWAPs: +26/-100 (bearish)