Correlation between asset classes

We have recently taken a look at allocation of asset classes. As a Calgary based investor, I have always been concerned about how similar or dissimilar the appreciation has been for different asset classes. To do so, I have updated my spreadsheet that compares the Dow Jones with Calgary Real Estate (Single Family Dwelling). I have updated it for 2011 and… I have added a 3^rd asset class: Gold.

The results were striking. Between 1973 (the start of my data base) and today (year end of 2011), $1 invested in Calgary Real Estate has appreciated to $17.46 while the Dow Jones appreciated to $14.36 and Gold to $16.92. Isn’t that something all three classes show over time a very similar amount of appreciation (not counting net rental income and dividends). But the path that each class followed was quite distinct (see the graph below).

 Figure 1 - Appreciation of $1 invested in Gold, Dow Jones and Calgary Real Estate

A numerical expression of how distinct their paths were is called correlation. The poorer (lower) the correlation the better for diversification. Gold is poorly correlated to the Dow (0.50) and it is a lot better correlated , but far from perfect ,to Calgary real estate (0.84). The Dow and Calgary Real Estate are again a bit poorer correlated (0.82).  The graph shows that while the Dow was up big time in the 1990s, real estate was subdued; but from 2000 until 2007 the pattern reversed resulting in rapid appreciation. Gold was even more subdued in the 1990s when compared to the Dow and it performed also poorer than Calgary Real Estate. Yet since 2000, Gold has taken off like a rocket.

We have discussed risk before, but not in terms of standard deviation. Let’s see how the asset classes (Gold, Dow Jones, Calgary Single Family Dwelling) compared on that basis (table below).

Figure 2 Returns and Risk of Asset Classes

Not counting dividends and net rental income, there seems to be a relation between risk and reward. Since 1973, Gold has had the highest average annual return (10.2%) and Calgary Real Estate has had the lowest (8.5%). But real estate also experienced the lowest volatility (S.D. =9.7%) and Gold the highest (23.2%). During gold market downturns losses are typically as high as -36% (calculated based on average return and 2xS.D.). Yet, somewhat contradictory, the worst annual return experienced in the real world was a modest -25%, i.e. only slightly worse than Calgary Real Estate in 1984. The Dow Jones lost most between 1973 and 2011, 34% in 2008. On the positive side, both in real terms as well as when calculated for a typical bull market (Maximum Expected Return) Gold has the best upside. So, a bit of the standard ‘Risk and Reward’ equation is probably at play here.

In terms of appreciation, Gold has since 2001 appreciated much faster (17.1% annually) than its bench mark rate of return (10.2%). This begs the question how much longer? Calgary Real Estate experienced explosive value growth from 1996-2007 (12% annually) and in particular during 2006 and 2007 (39% and 27%); there after appreciation has flattened to around 1.3% per year and the asset class appears to revert back to its long term bench markrate. Still an average long term annual appreciation of 8.5% (which equals a compounding rate of 8%) is still astounding. However, after removing the effects of oil price shocks a more normal pace of appreciation maybe 3% as Calgary experienced between 1983 and 1993.

Finally, the stock market experienced appreciation above its 8.6% benchmark rate between 1994 and 1999 (25% per annum), followed by a volatile but modest actual appreciation from then onward (2.6%). Thus, it appears, that the stock market has now underperformed for the longest time, while Gold is an ‘accident waiting to happen’ and Calgary Real Estate in a ‘Steady Eddy’ mode.

When looking at these three asset classes combined, they appear to create excellent components for a diversified portfolio. We also have an idea, based on the principal of ‘reverting to the bench mark,’ as to which of the three classes appears most promising and which appears most risky. Another other asset class that we have not yet mentioned in this post,  but that also has overshot its long term benchmark by a wide margin are bonds, in particular North American government bonds. With inflation not far away, these bonds are also due for a period of significant negative adjustments.

Nobody can look into the future but maybe we can extrapolate some of the trends we see here to create a suitable asset mix for the foreseeable future while controlling our risks. Gold has always played a very subdued role in my portfolio and I am reluctant to add a lot to my portfolio at this stage of the market. Yet, once reverted to the benchmark or below, I will add it definitely to my portfolio mix.

Portfolio Allocation and Performance I

 Recently I have started to analyze my portfolio performance as far back as 2003 (that is how far my Quicken files go – older files got corrupted and the data was basically lost). What motivated me? Well, simply the current stock market and all the screaming media types we have been coming across during the current market hysteria. Also, my investment reading list has focussed a lot on long term performance and as regular readers of this blog may have noticed, Jeremy Siegel, Dreman, Ken Fisher and more recently James O’Shaughnessy are amongst my favorite authors. I have always been aware of the importance of asset allocation, it is kind of an intuitive truth to me, hence the title of this blog. However, I have not read a lot of books on asset allocation until recently.  I looked for one recommended by some sophisticated fellow investors and came across William Bernstein’s ‘The Intelligent Asset Allocator’. I am sure that resemblance with Benjamin Graham’s ‘The Intelligent Investor’ is purely coincidental (yeah right!).

It was definitely a book worthwhile reading and it seemed to draw on similar data sources as James O’Shaughnessy's work.  One of the main messages I took away from it was that diversification works and may even augment performance during rational times, but that during stock market panics there is little protection against a falling portfolio value. At best your paper value losses during such occasions are about 25% less than that of the overall market, but you’re still significantly down. I also realised that the 2008-2009 collapse was the most severe since the Great Depression with some markets losing over 55%. Contrast that to the heaviest losses reported by William Bernstein of 35% and more typically of 25%. Of course, over period that follows such a market collapse when you hold on rather than selling in a panic, you’ll do just fine. If you have the nerve to add cheap stocks at heavily discounted prices during those bear markets you do even better.

How was my own performance over the last 10 or so years? Although I am suspicious of bugs in Quicken’s software (things don’t always ad up correctly) it is the best personal finance software around that I know. One of its newer features I just love – it is a series of asset allocation and investment portfolio performance graphs. Pity it’s tracking of non-stock market investments such as real estate is not that good and it is not included in the above mentioned graphs. So, we’re just looking at the performance of my investment portfolio and try to break it down so we can see the effects of stock allocation on performance. I’ll show a fair bit of graphs, so we’ll spread this topic out of several posts.

Portfolio Allocation and Performance II

So here is my portfolio performance expressed as $10,000 invested in May 2003 which would be worth $45,000 today. So over the last 9 years it quadrupled or in other words it doubled every 4.5 years and some. Using the rule of 72, that suggests an annual rate compound rate of return of 72/4.5= 16%. Not bad for a stock market that many claims to have resulted in an annual return of 3-4% over the last decade. So does that mean that your blog writer is an investment genius? I wouldn’t count on that!  In fact, in the beginning of this decade I worked for one of Canada’s premier petroleum companies; in fact in my books it is ‘the best’.  I received options and participated in the company savings plan. You may recall my earlier postings that state that with normal savings and returns you will become well off, but that to become truly wealthy you need a break. Many people get breaks during their life and do not take advantage of it. I described a number of these breaks and how to use them to your benefit earlier; I certainly used mine. My break was my employment at this great company. But already in the 1990s did I overweight my investments in oil & gas – a sector I was quite familiar with.  Between 1998 and 2008 this sector exploded and I certainly profited.

The graph above shows how I fared without the oil and gas sector investments. Now, $10,000 invested went to $18,000 in 2012 – not quite a double. So, for convenience sake let’s assume I doubled, which results in an annual compounded return of 72/9 = 8%. Ok. Ok!! I still outperformed the stock market but by a lot less. Let’s dig in a bit deeper and see what is left of this investment genius after that!  Let’s look at what I did between May 2008 and today.

Oh, oh! The ‘genius’ underperformed!! How smart is he now? $10,000 went to …. $10,000. No losses no gains!  What happened?  Answer: those same oil and gas stocks underperformed and although I did cash in on the profits between 1998 and 2008. I was still on overweight in 2008 -2010  and Oil&Gas really underperformed starting in the summer of 2010. 

Next question is, then how did my non-oil&gas holdings perform between 2008 and today? Well look at the figure above. Now isn’t that interesting?  Those investments outperformed the market  until the Spring of 2011. In fact if you go back to the non-oil&gas portfolio graph of 2003-2012,you can see that another big change happened around September 2011. So lets discuss that in the next post.

Portfolio Allocation and Performance III

I thought to leave this graph for last. My performance for the last 12 months! We all freshly remember this summer’s tribulations focussing one day on U.S.  debt load and political paralysis, the next on Greece and the European debt crisis and before the day was over we fretted about a collapse in the growth of emerging markets, specifically a hard landing in China. While pundits announced sagely that the ‘end is near’ yet again, stock markets experienced a significant correction if not a mild bear market. In September, I decided that the risk of actually ending up in a severe bear market was too great and I removed the riskier assets, in particular oil & gas stocks from my portfolio. My cash level, already 15% jumped to 30%.

 I knew, there was a new risk. Not one of losing a fair bit of net worth (temporarily) in case of a market collapse but the opposite: losing in upside because nearly 30% of my portfolio would not take part in a possible market rally. Hence the portfolio’s under performance. As of today, I am still struggling with my real emotional motivation about this move. Was it, what behavioral finance experts call “recency”, i.e. the effect of a recent occurrence in the investment environment (the 2008-2009 crash) that influenced my thinking more than the long term investment history justifies or… was it a truly calculated move because of my changing investment requirements (I am getting older and maybe I should consider a lower risk profile).

So over the last decade or so, overall performance of my portfolio was tremendous. But there were some major asset allocation shifts and changes in specific market sector performance that affected this overall performance. Investment performance, as James O’Shaughnessy points out, is to be compared to benchmark performance. Both O’Shaughnessy and William Bernstein point out that performance of an investment class or type always reverts back to its long term median annual return (the benchmark). From 1998 until 2008, the oil & gas sector outperformed its benchmark by a large margin and after 2008  its performance has coincided with the overall market or as lately it has underperformed. The sector is in the process to revert to its benchmark. As far as I can see, with the economy placing a cap on oil prices and with gas prices near a 10 year bottom, this process is likely to continue for some time. But, I would not bet the barn on that.

The risk of a market crash and double dip recessions are on the decline and we seem to be in a grinding slow moving bull market that is climbing an enormous wall of worry. Overall, stock markets have underperformed their benchmark (7% plus inflation), and based on the principal of reverting to the benchmark, there is a good chance we’ll do better in the future. But with investor’s sentiment turning rapidly bullish (though not extremely so), the market could do the opposite.

The other principal we have learned is about defining risk. The main risk about investing in the stock market lies in its volatility and the time it takes to recover from any temporary decreases in portfolio value. This is often expressed in terms of the standard deviation of the investment type from its benchmark. I hope to discuss this topic in more detail in future posts but for now, one could describe it as follows. O’Shaughnessy calls its: ‘Minimum expected (annual) return’ and it basically describes the average fall (bear market) of an investment type based on historical performance data. In the following example, a portfolio of low P/E stocks has an average annual return of 18.23% and a standard deviation of 18.45%. Then the value decline in a typical bear market to expect equals the benchmark rate minus twice the standard deviation. In our example that would be 18.23 – 2x18.45 = -18.68%.  However, the worst historical performance measure between 1927 and 2011 in a single year could be as bad as 52.6% (call it a ‘black swan’). An example of such an event was 2008-2009 (not surprisingly). The best performance for this Low P/E category was + 81.42% for the 1927-2011 period.

The risk of losing 52.6% in one year is the motivator for a diversified portfolio. It is achieved by investing in different asset classes or investment types. Most of the research on this has been focussed on stocks and bonds. Very little is known about the risk profiles of real estate, but just looking South should remind you that risk is everywhere. 

An investor should aim to have a well-diversified investment portfolio and as shown earlier, shifts in the allocation of the various investment types (which should have widely different performance patterns – or have a ‘poor correlation‘) is key to surviving (but not necessarily avoiding) significant market down turns which are usually highly emotional and irrational events. After a time of above average investment type performance a reversion to the benchmark should be anticipated, i.e. a period of underperformance and the asset allocation should be based on that expectation. At the same time, dramatic asset allocation changes, such as going to high cash levels, may result in severe underperformance. This may be justifiable in a period after experiencing excessive profits, but overall it is best to stick to your long term allocation targets with minor adjustments.

The Pipeline Debacle

First Keystone now Gateway appears to be targeted by environmental interest groups – not only Canadian ones but also those funded by foreign so-called charitable organizations. It is not that oil companies are always innocent bystanders but I would surmise neither is any other industry group.

Yet, oil companies seem these days to carry the brunt of the activists. Especially Canadian ones, not because they are polluting more than others or because Canada is a fascist dictatorship, but rather the opposite. Canada's oil industry is paying more attention to environmental regulations and  Canada is a democracy contrary to many other oil producing nations, and thus  it is an easy target. If activists tried to pull off similar tricks in say Saudi Arabia or Venezuela, they likely would not experience the end of the day, so to speak.

Many of the activist groups seem to think that by focussing on the pipelines and other Canadian mega projects they can stop consumers from using fossil fuels and that those fossil fuels in their deluded dreams are the culprits causing that elusive and difficult to prove issue of global warming.

As pointed out by many geoscientists, climate has changed as long as the earth has been turning around. Whether CO2 or another greenhouse gas released by mankind is even influencing the climate remains to be seen. The evidence is basically inconclusive. Be that as may be, that doesn’t mean that we shouldn’t strive for a sustainable economy - that is being careful and wise in the use of our resources. Ironically, that would make economic sense!

The real problem with many of those activist groups is that they are ideologically driven and that many have been involved in those games since their socialist high school days. They are frustrated by their never ending fights and continuous losses. Now they are trying to stop the world from going around – in particular they dream of fossil fuel free energy sources. Problem is, there are no fossil fuel free energy sources that are large enough. Even the much lauded electric car, and the hydrogen fuelled car before it, needs in the end a true energy source to generate hydrogen or electricity.  Unfortunately the true (main) energy source for electricity and hydrogen are once again coal, gas and oil. 

Yes, we have wind energy and solar, but it is not so easy to energize the entire world with it. In fact it is not even enough to energize the existing demand for electricity generation let be that it also could fuel the entire transportation system.  Even if you would ad, heaven forbid, nuclear energy you would not get even close. And really, would you want a hundred tower windmill farm in your back yard, or many square miles of solar panel farms to look out over?  What about nuclear waste disposal adjacent to your summer cottage?

We love to hate banks and we love to hate the oil and gas industry, but really we’re all depending on them. Even the activists drive or fly to their conventions and demonstrations using fossil fuels. Man over time has become increasingly efficient in its energy use, but simultaneously our lifestyle needs everyday energy for yet another gadget. Add to this the emerging market population who also would like to enjoy a lifestyle such as ours; top it off with a still increasing world population and you see why energy and consumption are becoming such hot buttons in spite of our efforts.

 Most oil patch geologists and engineers that I know love the outdoors; individually they are all very responsible people – however, they do tend to get swept along with the drive to do things quickly and cheaply in order to enhance the so-called bottom line. But that is the capitalist way we’re living and operating in – it is not just the oil industry that is guilty here. We all are, including investors who want ever higher quarterly earnings and consumers who want vacations in Thailand and Hawaii.  You may want to blame the overpaid execs but really the buck often stops with you – consumer, investor, whatever.

Many of today’s anti-pipeline groups are funded by billionaires such as Intel’s Moore family. Guess what? Remember the high tech boom?  Dot.com companies?  Ring a bell?  Wasn’t that capitalism and greed and innovation? Not only that, but a lot of manufacturing and high-tech booms of the 1990s along with the China explosion and the low inflation era of said 1990s were dependent  on cheap energy prices.

The current low gas prices in North America are an aberration due to the landlocked gas reserves on this continent combined with the success of the multi-stage fracturing technology (invented by those same ‘evil’ oil and gas companies).  But worldwide, energy is getting ever more expensive.  According to several economists, including Jeff Rubin, the 1990s boom was based on low commodity prices, in particular oil and gas. But these cheap fossil fuels are now passé and only the deeper and lower quality; more expensive hydrocarbons are now brought to market.  Jeff Rubin went so far as to state that the high oil and gas prices of the 1970s and again in the early 2000s are the real culprit of economic malaise and that the chicanery of the banking industry during the financial crisis was just a sideshow.

You may not agree with this interpretation, but with North American activists trying to interrupt the supply of affordable energy by its manipulations in B.C. and Keystone and where-ever else they can cause significant havoc the outcome will be even less energy supply . To think that alternative energy can take the place is a pipe dream for at least another decade or two. Thus it will be just a matter of time that oil and gas prices will peak once again and the economy will tank again and again.  When that happens, don’t blame the big oil conspiracy; blame the Moore Foundation and similar institutions as well as their groupies.

This does not mean that Keystone or Gateway should go ahead without a critical review of its environmental and other impacts. To the contrary, but the current approval processes have nothing to do with technical and environmental issues rather it is an ideological circus that if not stopped will leave a very sour economic taste for years to come. As with the hysteria of climate change which took on near-religious proportions, the same self-righteous crowd now aims their negativity at the oil industry while forgetting that parable about a splinter in the neighbour’s eye and the beam in their own.

Big new hopes for U.S. housing

You may have read my earlier posts regarding the improving U.S. housing market and its potential impact on U.S. GDP. Here is an important tidbit from GlobeInvestor that supports this idea.

 By: DAVID BERMAN

12:28 EST Wednesday, Jan 11, 2012

Lennar Corp.’s fourth-quarter results are having a big impact on U.S. home building stocks: The S&P industry group rose 5.2 per cent on Wednesday amid the latest signs that the housing market is showing signs of life. In the case of Lennar, it reported that new orders rose 20 per cent in the fourth quarter from a year ago, suggesting that demand for new homes is on the upswing.

Of course, this isn’t the first rustling among home builders. The group has surged 80 per cent since the start of October, with big gains by PulteGroup Inc. and D.R. Horton Inc. contributing to the gains as well. Part of the earlier pickup was due to upbeat news on the U.S. housing sector – particularly the rise in housing starts in November and rising builder confidence.

Bloomberg News quoted Lennar’s chief executive as sounding upbeat as well: “As I look ahead to 2012, I’m cautiously optimistic that we’re seeing a real bottom form and we’re beginning to see a recovery. I feel that stabilization will emanate from the most desirable markets and spread slowly outward.”

Despite the strong gains by the S&P 500 homebuilder index, it is still 77 per cent below its high in 2005

Do not rush into REITs

There are numerous REITs (Real Estate Investment Trusts) listed on the TSX and knowing all their in and outs is too much unless you're specialized in it. To choose which one is better is even more difficult and these days I prefer investing into ETFs comprising REITs, in particular 'iShares S&P/TSX Capped REIT' symbol XRE. In general the largest REITs are usually of the best quality and many have their own area of specialty such as RioCan for shopping malls, BoardWalk for Western Canadian apartments, Canadian Real Estate Investment Trust (symbol REF.UN) for high quality retail, office, and commercial real estate, Calloway for senior housing, Brookfield Office Properties (well this is a corp not a REIT), etc. If you want to learn more about specific REITs check the internet or watch BNN Market Call that features sometimes money managers specializing in REITs and Real Estate investments. They discuss many of those REITs including the latest gossip about them. That is a great starting point for research.

The point I am trying to make though is that REITs are dependant on a healthy real estate market, some inflation and low interest rates. In the last year or so, many of those REITs have provided above average profits and now they are becoming a bit expensive. Yields are modest compared to the past and the payout ratios of several are streched. In other words, you may be buying high or near the top of the market and the risk of disappointment is high. REITs, utilities, pipeline and communication companies such as BCE are all priced at high PEs (prices that do not allow for any earnings disappointment). A trigger for a significant down fall may be increased interest rates and those, as discussed earlier, may not be that far off.

Finally, REITs such as Boardwalk and Main Street Capital are western based apartment operators. Oil prices may not have much upside in this economy and with new technologies North American markets may become oversupplied as happened with natural gas. Our markets are landlocked and with new pipelines to the West Coast and the Gulf of Mexico being the focus of much controversie, oil markets in North America may weaken significantly. This would undoubtedly also reflect in less Alberta jobs and rental demand, which in turn make investing in REITs such as Boardwalk riskier.

In my books, REITs, especially Western Canadian REITs, are a hold NOT A BUY.