January 2009

This is a good article by John Hussman about portfolio rebalancing and matching your timeframe to your portfolio’s duration. If your primary tool for investment tweaking is asset allocation, it is very good to give you an extra dimension from what you probably already know well.

With the recent surge in Treasury bond prices, the effective duration of a 30-year Treasury bond has climbed from just over 16 years to nearly 20 years. Meanwhile, the plunge in the stock market has collapsed the duration of the S&P 500 from nearly 60 years to just about 30 today.

For investors who rebalance their portfolios annually, this is essential information. Given the probable long-term returns that stocks and Treasury bonds are priced to deliver, an investor seeking a 7% long-term total return would currently require an allocation of about 60% in stocks and 17% in bonds, for an overall portfolio duration of about 21 years ? only a third of the duration that an investor seeking that same long-term return would have had to accept just 15 months ago! Given the poor long-term returns that Treasury bonds are priced to deliver, an investor with any view at all about market direction would likely forego the 17% allocation to long-term bonds, opting for shorter-duration (and only slightly lower yielding) securities until the Treasury market normalizes.

The tired old measure of bull and bear markets are a 20% move in one direction… a purely arbitrary measure of bull/bearishness, but something that a lot of people tend to latch on to.

With that definition, we are currently in a bull market. Even before Friday’s surge, the S&P 500 has gone from a low of 741 at the end of November to a high of 918 around mid-December. That’s a 24% gain in a month, making it a bull market by the “20%” definition.

Does it feel like a bull market to you?

With everyone a-buzz over lower mortgage rates and the large number of people applying for refinancing their mortgages, it might be time to check in on the unintended consequences.

Mr. Mortgage has a good piece titled Low Mortgage Rates to Spur New Wave of Defaults. His argument is that many of those looking to refinance will be rejected, bringing the housing crisis to full front-row impact to all the prime borrowers out there. Here’s a quote:

[Today] the first thing done after the loan application is taken is to call the appraiser for a comparable sale check to see if the value at which the home owner states the house is worth is on target.

Therein lays the rub.

From early reports since rates fell sharply in early December, 80% of the loan applications are not getting out of the starting gate easily. Loan officers are all saying the same thing ? that appraisals are not coming at value due because ?all of the foreclosures and REO sales have taken the value down?. In the majority of these cases, this kills the loan.

The loan officer then notifies the borrower of the news and they are in disbelief. All home owners think that their home is worth the most on the block and I have been told that this is a tough pill to swallow. This brings the crisis home instantly.

Everyone trying to refinance into lower rates at once should hasten the national reality that the largest portion of the home owner?s net worth has evaporated in the past year. One loan officer I spoke with equated this call to a Doctor notifying a patient that they had a terminal illness.

The other three top reasons that loans are not making it out of the application phaseare because of credit scores coming in too low, interest rates not really being what the borrowers are hearing hyped and Jumbo money is near all-time highs.

It may or may not cause the defaults Mr. Mortgage predicts, but there are usually some unintended consequences that wreak more havoc than anticipated… and this would fit the bill for an unanticipated result of lower mortgage rates.

Paul Wilmott is a pretty big name amongst Quants, and it is amusing to read his blog. He recently wrote a little blurb on economic models, and the economists who should give back their Nobel Prizes… The problem is economists who trick themselves into the mistake of adding complexity to a model in the theory that it improves accuracy…

We don?t need more complex economics models. Nor do we need that fourteenth stochastic variable in finance. We need simplicity and robustness. We need to accept that the models of human behaviour will never be perfect. We need to accept all that, and then build in a nice safety margin in our forecasts, prices and measures of risk.


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