There was a time in the 1990s when the thought of investing in anything other than Cisco Systems (CSCO), Microsoft (MSFT) or the major U.S. markets would’ve seemed downright daffy. Foreign stocks? Commodities? Small caps? Who needed ‘em when Sun Microsystems (SUNW) and the S&P 500 went up a tidy 20% every couple of months.

But in the markets, change is the only constant. And while American shares have long been the locomotive that pulled the world’s train along, lately they’ve been more like the caboose. Right now, the market seems to be showing a preference for most anything besides U.S. stocks. Because equity markets are the best gauge of economic growth that we’ve got, this underperformance bodes ill for both America and its currency.

The biggest fear most people have when putting money into a market is a dramatic, 1987-style crash. It’s a largely irrational fear: The Nasdaq didn’t go from 5000 to 1130 overnight, nor did Nikkei. It took roughly 14 years for the Japanese market to drop from 39000 to 7600, while the rest of the world, especially the U.S., steadily passed it by. U.S. markets aren’t plummeting, it’s true, but the truth is that it’s the slow, trendless markets that are usually even more dangerous than the massive one-day drops.

And while American shares have been largely stagnant this year, world-wide shares are leading the charge higher. The Dow, Nasdaq and S&P 500 are anywhere from 10% to 58% off their record peaks. Meanwhile, stocks all over the world — in New Zealand, Australia, South Africa, Vietnam, Saudi Arabia, Brazil, South Korea and India — are at or near their all-time highs. You can’t just write off stocks as a weak asset class nowadays. The fact is that equities in general do have a bid. The only problem is they don’t have bid here in America.

Stocks are hot, but so are hard assets, which doesn’t bode particularly well for the dollar, of which we’ve grown very accustomed to being a strong and secure store of value. Along with the widely reported record prices in oil and natural gas, various metals have also shot higher lately. Copper and platinum, for instance, aren’t far off from record highs and gold, bullishly profiled in this space last month, has now outpaced the Dow by a cool 11% year-to-date. Gold has usually been thought of as a novelty or diversification, but talk to someone who’s lived through currency devaluation, and they’ll swear by it as their core holding.

And what of U.S. stocks? While energy shares continue their bull run, many other widely owned domestic names appear downright sick. Fannie Mae (FNM) and Freddie Mac (FRE), along with every mortgage REIT under the sun, look like death — not a huge vote of confidence in the housing boom that’s helped propel the economy forward in recent years. Several Dow components like DuPont (DD), International Paper (IP) and Wal-Mart Stores (WMT), names you’d expect to prosper in the face of economic growth, are instead plumbing multiyear lows. It’s the same story for many bank stocks. Bank of America (BAC) and JP Morgan Chase (JPM), two widely owned benchmarks, have lost much of their oomph lately. The most successful domestic plays have come from betting on a few winning sectors like utilities and energy, or by using option-writing programs that benefit from flat or trendless markets. Considering how many other equity markets are sharply higher, that’s not exactly a major vote of confidence in the good ol’ US of A.

How to approach such an uncertain market? As I wrote last week, before taking new positions, the best course is to deal with the ones you already have. And when it comes to existing, winning positions, your instinct should always be to preserve gains rather than take them. Stocks discussed in this space that I hold at a gain, such as Warner Music Group (WMG) and MarketAxess (MKTX) will be kept. Same goes for my positions in several utilities, especially the international ones like Brazil’s CPFL Energia (CPL) and Chile’s Enersis (ENI).

In addition, I’ve added exposure to a few areas that, despite the last of a clear fundamental story, appear to be on the verge of showing new leadership. The metals boom has benefited gold and copper shares such as Glamis Gold (GLG), Goldcorp (GG) and Freeport McMoRan Copper & Gold (FCX), so I’m again dipping my toe back into the palladium market. Regular readers will recall that the white metal was a winning trade a couple of years back, and if current trends persist, palladium operators like Stillwater Mining (SWC) and North American Palladium (PAL) could end up big winners again. Of course, the usual bevy of risk factors, including lack of liquidity, should be considered before putting money to work.

I love this country dearly. But despite my devout patriotism, I’m objectively ready to accept the notion that, for whatever reason, the U.S. might not be the economic leader in the future that it has been in the past. Just as we couldn’t think of sending our money overseas in the 1990s, in this century, we might not imagine doing otherwise. If the commodities boom ends up a harbinger for a weak U.S. dollar, then holding metals plays like StreetTracks Gold Trust (GLD) or iShares Comex Gold (IAU) might become as common as Time Warner (TWX) or General Electric (GE).

The point is that everything is on the table. Successful traders should keep their eyes open, their heads down, and be ready to expect the unexpected.

– Originally on Oct 03, 2005 by Jonathan Hoenig

I’m always preaching the gospel of absolute return. The truth is, a quick pop isn’t the best way to achieve one.

It’s hard to convince most people that they don’t want a quick 10% jump in one of their holdings. But it’s true. The best trades — that is, the ones that tend to be the most profitable — don’t occur over a few days, but over months. They aren’t knee-jerk reactions to an earnings report or a TV tout. Steady, silent price action defines a trend at work.

My philosophy starts with the notion that the market isn’t chaotic. It moves in trends, most of which unfold over time and persist longer than most people think. Therefore, the smartest thing an investor can do is trade with the trend. This means following the market, not fighting it.

When I evaluate ideas for new money, I don’t look ahead to next week, but to the next few months at least. And the types of investments that interest me aren’t those poised for a 10% pop, but those that could rise by at least 50% or more. These big moves are where the real money is made — and big moves take time.

Trends require patience, the thing most people lack. For them, the payoff isn’t making money, but the excitement of bagging a winning trade. Their addiction is fed by a small cadre of snake-oil salesmen who prey on the public’s eternal quest for a quick, effortless buck. You’ve seen the ads: 10 trading ideas a week for just $39.95 a month. Visa and Mastercard accepted.

For me, trading ideas are a matter of quality, not quantity. As we’ve pointed out before, a trader needs only a few really good ideas a year to make money. The object isn’t simply to make trades, but to build strong positions in the market’s dominant trends.

So what do I think of today’s market? I must admit that despite the rally in domestic stocks, I’m not paying too much attention to the familiar names of the S&P 500. I am, however, captivated by — and maybe a little bit obsessed with — the continuing and persistent weakening of the U.S. dollar. As we wrote a few weeks back, this underreported phenomenon continues to be the biggest trend in the capital markets — hands down. And because trends tend to persist, I’m sticking with many of the assets we’ve profiled over the past few weeks that capitalize on this undeniable trend.

First, as regular readers know, we’ve been looking overseas for quite some time. And from esoteric Latin American countries to the more established European ones, I see non-U.S. stocks outperforming their U.S. counterparts by a mile. From Brazilian banks to Turkish telephone companies, I’m still most interested in the foreign stocks that haven’t yet been picked over by the herd, despite their strong trending performance.

Second, a weak dollar has also benefited commodity-related hard assets, continuing a bullish move that, as we pointed out this summer, started well before the California energy crisis or the Iraq war. From real estate to gold, palladium to potash, inflation-oriented names are among the only domestic issues where I’m finding significant value.

Finally, although interest rates haven’t yet risen substantially, bank loan funds, whose interest rates “float” above a benchmark such as Libor, have continued to perform well since we highlighted them in September.

Best of all, while all of the aforementioned assets are strong, I’ve yet to see serious evidence that the herd is galloping through any of them. The message boards are dormant, the volumes still comparatively weak. And because their price action has been the slow and steady type associated with long-term trends, I’m of the mind that these weak-dollar plays still have room to run.

– Originally on Dec 08, 2003 by Jonathan Hoenig

My strategy has always been to watch the markets and steer clear of the herd. While I’m certainly not profitable in all of my trades, the herd rarely gets it right. So when it comes to choosing investment strategies, my goal is to find out where the herd is, and go somewhere else.

Generally speaking, the biggest component of the herd is probably mutual-fund investors. While there are plenty of razor sharp individuals out there using mutual funds, as a group they tend to have less-than-perfect timing. For example, as we’ve pointed out before, the biggest net inflow into equity mutual funds came in the first quarter of 2000, just around the time the Nasdaq began its historic decline.

As regular readers know, in addition to hard-asset and inflation-oriented investments, I’m also looking abroad right now. My thesis is that as the U.S. dollar weakens, so will the attractiveness of U.S. assets relative to those in other countries.

Thus far, the theory seems to be working. As I highlighted in last week’s column, many foreign stocks, from emerging and industrialized economies alike, have recently outperformed U.S. markets. Yet it’s downright impossible to make the argument that the herd, as evidenced by the behavior of most mutual-fund investors, is running wild in foreign names.

Consider some of the statistics complied by the Investment Company Institute, and you’ll likely agree. Since 1990, inflows into foreign funds have never come close to those into domestic funds. And of the $2.6 trillion of U.S. assets held in equity funds, only about 15% is pegged to overseas assets.

Of course, mutual funds are no longer confined to the traditional open-end variety familiar to most investors. Exchange-traded funds, which trade like stocks and are priced throughout the day, have taken off in recent years. Products like Spiders (SPY), which track the S&P 500, and Cubes (QQQ), which follow the Nasdaq 100, are among the most actively traded investments on earth.

Although there are ETFs based on a number of foreign markets, the volume is dwarfed by that of the big domestic funds, even as many international markets outpace those in the U.S.

For example, consider iShares Austria (EWO), which we last mentioned more than a year ago. The fund is up almost 35% this year, handily beating the Dow Jones Industrial Average and the S&P 500. Yet the average daily volume is still a meager 14,000 shares, worth about $160,000. Compare that with Spiders, which routinely trade 38 million shares a day, worth nearly $4 billion.

Similarly, iShares Germany (EWG), which has gained over 40% this year, trades only 100,000 shares a day, worth about $1.4 million. Compare that with the Cubes, which have also gained more than 40% yet trade 80 million shares a day worth a cool $2.8 billion. The herd might be out there, but it’s certainly not in foreign ETFs.

As we like to point out, the only thing that consistently works over time is discipline. Yet because the herd exists — and sports such a historically lousy track record — it’s worth following its tracks. Although there’s no sure thing, when a particular trading thesis is working and the herd is nowhere to be found, I know I’m on the right path.

When volume explodes in foreign ETFs and the mutual-fund industry can’t roll out new products fast enough, when Business Week does a cover story about how the U.S. market is dead and the smart money is all overseas, and when barbers and cabdrivers begin opining on the economies of Latin America and Eastern Europe — perhaps then I’ll believe that the herd is rushing into foreign stocks. But we’re not there yet. We’re not even close.

– Originally on Nov 03, 2003 by Jonathan Hoenig

Our mantra here at Tradecraft: Technique is everything. That is, it’s not so much what you trade, but rather how you trade that ultimately makes a difference. And because the market will test your biases, it seems the best move is to not develop them in the first place. Without an open mind, even the best stock pickers won’t bend in the wind — they’ll break.

That’s why I think too much formal education in the markets is dangerous. As we wrote a few months back, the most educated traders tend not to think, but to assume. Yet the real challenge sometimes is to be able to forget history as easily as you remember it. In the market, anything can happen.

Internet stocks can go from boom to bust to boom again, all within a few years’ time. Energy prices can rise both before and after a war. And while we often chuckle that a stock can fall only to zero, sometime they actually do just that — even the seemingly “safe” names that at one time seemed like money in the bank.

So when you’re long XYZ at $50, and it falls to $40 and you’re smugly thinking “no problem I can stay with this thing forever,” — get ready, because all too often the market will hold you to your word. And when you shun a particular trade because you’ve never heard of the stock and, well, “the easy money has been made,” be forewarned — you just might end up with your foot in your mouth, buying it 20% higher. That’s the funny thing about money: It often makes you do things you say you’d never do.

The market will test your ability to withstand losses, and to the extent that you’re able to remain disciplined, setting limits on losses should by now be a routine affair. We’ve written extensively about the use and importance of stop-loss orders over the past few years, and most people now understand that every big loss started as a small one with a trader who just had to be right.

Even more fascinating, however, are limits on the upside. That is, how long will a particular trend have to persist before you actually get motivated enough to get on for the ride? Keep in mind that although the market rose in 1995, 1996, 1997 1998 and 1999, it wasn’t until early 2000 that many people actually bit the bullet and got in.

Perhaps we’re just plain lazy. Instead of taking the time to research a new market or group of securities, we too often get comfortable watching only the investments with which we’re familiar — whether or not they happen to be the best options at the time.

So what do I do? Simply put, to the best of my ability, I follow the market and avoid the herd. Because the herd always comes last to the party, I like to start where the herd is not. At least then I know I’m starting on the right track. When a market is moving, and the herd is strangely silent, that’s where I want to be sniffing for opportunity.

Right now that’s leading me into, or I should say out of, the U.S. dollar. Mention the falling dollar, and how technically weak it appears against most world currencies, and most investors’ eyes seem to glaze over. The herd doesn’t seem to “get it” — worse off, they don’t even seem to care.

But the market will test us. And although some people wait for the Business Week cover story to begin considering their options, I’m doing my best right now to understand and follow the action as it unfolds.

Shall I talk turkey? Domestically, I’m betting on REITs, hard assets, bank loan funds and other inflation-sensitive instruments. In terms of equities, it’s my continuing belief that foreign stocks, both from emerging and more developed markets, look ripe to outperform for some time to come.

As always, only the tape will tell.

– Originally on Oct 20, 2003 by Jonathan Hoenig

So at a time in which most people are just starting to think about diversification away from the big domestic stocks, my sights are focused on a few more exotic locales, since it’s quite likely that the next big bull market will occur somewhere outside the U.S.

I’m not the only one making the call. In recent days, both Credit Suisse First Boston and Merrill Lynch have upped their allocations of non-U.S. equities, and although the pundits have a habitual knack for inaccuracy, I do believe this is one of the few macro calls worth heeding. A few weeks back we discussed some general opportunities in foreign and emerging markets. This time around, we’ll focus primarily on fixed income.

Because they are backed by the “full faith and credit” of the U.S. government, U.S. bonds are considered the world standard. Because they’re the most liquid and actively traded bonds in the world, U.S. Treasurys are the most often quoted barometer of interest rates. When most people refer to the bond market, they’re referring to the U.S. 30-year bond and, more recently, the 10-year note.

But while U.S. stocks have rebounded from September levels, domestic bond investors, even those who hold mutual funds, have taken a beating. For example, the Vanguard Total Bond Market Index fund (VBMFX), which seeks to track the entire market for investment-grade domestic bonds, is down 2% since mid-September. The Long Term Treasury fund (VUSTX), which tracks the 30-year bond, is down over 4%.

Using some basic technical analysis, it’s pretty clear the picture for Treasurys isn’t a pretty one. The yields on both the 10- and 30-year bonds have now crossed above their respective 200-day moving averages. Chosen because there are about 200 trading days in the year, this indicator is a widely used measure of intermediate to longer term trends. And while no technique is foolproof, it’s a good bet that interest rates, at least as far as Treasurys are concerned, will be going up.

That isn’t good news for the many investors who are increasingly focused on protecting principle and reducing volatility. A great majority of them will turn to bonds, specifically the supposedly “safe” Treasurys we consider to be risk-free. While bonds deserve a place in every investor’s portfolio, that place shouldn’t necessarily go to those issued by the U.S. government.

For over a year now, we’ve been pointing out that there’s more to investing than the huge and familiar. Even as the broad market has remained soggy, many investors have profited from everything from gold to small caps. These days, a similar subtlety is occurring in bonds, where emerging-market and foreign bonds have been outperforming U.S. issues in a big way.

According to Morningstar, the average international bond fund is basically flat year-to-date. Not burning up the charts, but still outpacing Treasurys. The average emerging-market bond fund, however, is up over 6% in 2002, with some up over 10%, and the entire group continues to look strong.

I love this country, but I’m making most of my new buys — especially in fixed income — in nondollar instruments. We may be staying at home and “cocooning,” but that doesn’t mean our money has to as well. Owning a foreign bond fund is one way to give your cash some “flash.”

A few weeks back, we mentioned both Templeton Emerging Markets Income fund (TEI) and Morgan Stanley Global Opportunity Bond fund (MGB) as potentially attractive closed-end bond funds. There are a few open-ended funds you might want to consider as well. Scudder Emerging Markets Income (SCEMX) is a no-load fund with well-placed bets in Russia, Brazil and Peru. It’s up 8% year-to-date. T. Rowe Price Emerging Markets Bond fund (PREMX) owns bonds from many countries, from Poland to Panama. It’s also a no-load fund, with reasonable expenses; it’s up 6.4% this year. And Payden Emerging Markets Bond fund (PYEMX), a tiny fund with only $34 million in assets, is up 4.9% so far this year. It sports a low expense ratio of less than 1%.

As to why U.S. bonds have done so poorly, some suggest the market’s expectations for faster economic growth (which would lead to higher interest rates, and, in turn, lower bond prices). There’s Enronitis and Greenspan, two convenient whipping posts.

I’ve constructed my own “lean” of why U.S. bonds might be beginning a tidal shift toward subperformance. A lean is your worldview. It’s your hypothesis, your expectation and your reason for making the trade in the first place. Whether it’s a fundamental data point, an economic indicator or a technical trendline, we all need a lean. It’s the confidence behind any trade.

My lean against U.S. bonds is focused around recent action not on Wall Street, but in Washington. Although President Bush campaigned on a platform of free trade and lower taxes, recent legislation seems more tilted toward economic strangulation, not stimulus. The federalizing (read: monopolizing) of airline screening, the endless investigations of Enron (ENRNQ) and the levying of new tariffs on steel imports are all factors in my recent distaste for U.S. bonds. I’m leaning on the notion that these are harbingers of bigger government, more regulation and consequently, higher taxes.

And what do higher taxes have to do with the value of U.S. assets? Those in Washington would do well to note that long-term U.S. interest rates started dropping the week of Aug. 18, 1988, when George Bush Sr. flipped the now legendary verbal bird: “Read my lips, no new taxes.”

The greatest vote of confidence you can give a country isn’t to wave its flag, but to buy its bonds. And although Bush Sr. eventually had to renege on his promise, the very fact he made lowering taxes such a clear and present national priority made one bullish on the future prosperity of the American people. Until the current administration can deliver a similar pledge, our nation’s bonds just might not be worth owning.

– Originally on Mar 11, 2002 by Jonathan Hoenig

And while it took a 68% drop in the Nasdaq to finally sink in, most investors are now realizing that the most effective way of reducing risk in their portfolio is by diversifying among various types of assets. Diversification lowers a portfolio’s volatility and can even enhance returns. And while index funds that track the S&P 500 give the illusion of diversification, because they are weighted by market capitalization they are essentially focused on large-cap stocks. Owning Cisco Systems (CSCO), Intel (INTC), General Electric (GE) and an index fund exposes you to as much diversity as a potluck dinner at David Duke’s house.

Among financial planners and mutual-fund companies these days, diversification has become synonymous with buying small-cap and midcap stocks. And for most people’s portfolios, that’s a healthy start: Both small-caps and midcaps have outperformed as of late, and should be considered as part of a stock portfolio. But what most financial planners don’t realize is that investing in a range of market capitalizations doesn’t solve the real diversification dilemma. The problem is correlation.

Let’s define some terms: Correlation measures how closely two assets relate to one another. In this case, it refers to how closely two stocks tend to move in the same direction. For example, Cisco and the Nasdaq are very highly correlated. Cisco and the S&P 500 are less correlated, but still tend to move in similar fashion.

A perfect correlation would be expressed as 1.0, and would mean that changes in XYZ would result in identical changes in ABC. When XYZ zigs, so will ABC. A perfect negative correlation is expressed as -1.0, and indicates an identical inverse relationship. When XYZ zigs, ABC zags by exactly the same amount. A correlation of zero means there’s no relationship between the two securities. A movement in one has no bearing or predictive qualities on the other.

And while small-cap and midcap stocks don’t move in exactly the same direction to exactly the same degree as large-cap stocks, historically, they’re darn close. Using some of the low-cost index proxies available to the individual investor, I have created a correlation table to demonstrate just how tightly linked small-cap and midcap stocks are with their big-cap brethren. The Vanguard Small Cap Index fund (NAESX) (which mirrors the Russell 2000) is strongly correlated with both the Dow and S&P 500, and even more so with the Nasdaq. The S&P MidCap 400, represented here by the exchange-traded MidCap SPDR (MDY), is even more closely correlated with the major indexes. By adding smaller stocks, you will diversify your portfolio away from large caps, but not from the market itself. From a risk-management perspective, it’s like adding pepper to an already spicy bowl of chili.

When it comes to diversifying your portfolio, simply holding a broad array of stocks won’t reduce your overall risk profile. You’ve got to focus on holding noncorrelated assets — that is, something that will zig while the rest of your portfolio zags. Among market scholars, creating that perfect “mixture” of assets has become known as the “efficient frontier.” Not avoiding risk, but dealing with it. Elimination by mitigation.

Bonds are a perfect place to start. While they don’t boast the historical returns of stocks, bonds have outperformed the broad market for more than a year and are still sorely absent from many investor’s portfolios — especially those who are in it for “the long haul.” According to the Investment Company Institute, stock mutual funds still contain roughly four times as many assets as bond mutual funds. While the returns of individual bonds can be highly volatile, bond mutual funds, even those tracking corporate and junk issues, are statistically uncorrelated with the equity market.

But bonds are just the beginning. Commodities, currencies, precious metals, real estate and international securities are all generally uncorrelated with stocks. And thankfully, the ever-crafty mutual-fund industry has developed products to allow even the sophomore-sized Soros to take positions in each, spreading bets around among uncorrelated asset classes — just as hedge funds do.

The Oppenheimer Real Asset fund (QRAAX) invests in futures and fixed-income instruments that move in relation to commodity prices, and is highly uncorrelated with the stock market (0.01 for the S&P 500 and Dow, 0.04 for the Nasdaq). The fund is off about 8% year-to-date after gaining 36% in 1999 and 44% in 2000. From a macroeconomic perspective, it’s one way to benefit from rising fuel prices, since the fund’s underlying index (the Goldman Sachs Commodity Index) is highly sensitive to fuel prices.

The Franklin Templeton Global Currency fund (ICPGX) holds money-market instruments denominated in three or more of the world’s major currencies, and is one of the few ways most investors can quickly hedge themselves against fluctuations in the U.S. dollar. Even more important, it’s negatively correlated with the stock market, meaning that when the market falls, the fund should rise. Sadly, the fund has been recently closed to new investors, and will soon be merged into the company’s global bond fund, which has much less favorable correlation statistics, as high as 0.32 with the S&P 500.

An alternate option could be a precious-metal fund, as gold tends to be negatively correlated with both the dollar and the major equity markets. The Vanguard Gold & Precious Metals fund (VGPMX) is a cost-effective way to get exposure to precious metals. This has been a perennially poorly performing group — but its low correlation to stocks means that it has posted a slightly positive return so far this year.

Real estate investment trusts, or REITs, continue to boast solid returns and low levels of correlation with the equity market. The iShares Dow Jones Real Estate Index fund (IYR) can be traded like a stock and offers immediate, diversified exposure to REITs, albeit with an emphasis on the index’s two biggest names, Equity Office Properties (EOP) and Equity Residential Properties (EQR).

Finally, international investing is often suggested as a way to diversify a portfolio away from domestic stocks. But as markets have become more advanced, so have the correlations that link them. Most developed European and Asian stock markets tend to be positively correlated with those in the U.S. Among the notable exceptions is the iShares MSCI Austria fund (EWO), which boasts a low correlation with all major U.S. indexes and is up 10% year-to-date.

– Originally on Apr 26, 2001 by Jonathan Hoenig