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Last week marked the first anniversary of the Dodd-Frank financial regulation bill, and the news this week is full of perspectives on the debt ceiling "crisis." Common Cents Investing (CCI) tries to avoid political commentary, and this post is certainly not trying to be political. However, these events seemed like a good trigger to take a step back and take a broader perspective on the state of the overall global financial system. Specifically, here as few data points that describe today's markets:

  • Market Watch points out here that “The derivatives time bomb is bigger than ever — and ticking away. Just before Lehman collapsed, at what we now call the height of the last bubble, Wall Street firms were carrying risky financial derivatives on their books with a value of an astonishing $183 trillion. That was 13 times the size of the U.S. economy. If it sounds insane, it was. Since then we’ve had four years of panic, alleged reform and a return to financial sobriety. So what’s the figure now? Try $248 trillion. No kidding. Ah, good times.” It is worth noting that as the Greece situation unfolds there is more to the story than determining how much austerity the Greek people will feel vs. haircuts bond holders will take. There is also the concern over if the event will be considered a default. That determination plays into what would happen to the many credit defaults swaps written against these bonds. Would the writers of the swaps really be able to pay off or would the holders of the bonds find out that they don't really have the insurance against their positions that they think? This seems like deja vu all over again with the housing market.
  • My understanding is the U.S equity market is now comprised of about 15 equity and options exchanges, and more than 30 dark pools (private electronic trading networks). Information here indicates that over 50% of the trades in the market are done by high-frequency, algorithmic traders. Most of them are trying to profit from inefficiencies between these various aspects of the market. While this might increase market liquidity, it is hard to see how this activity adds economic value or stability to the market. This trend seems to have increased over the past few years.
  • Per Phillip Davis recently posted at Seeking Alpha “they trade 6 BILLION barrels of oil per month at the NYMEX and end up delivering 30M barrels to Cushing, OK - that's a 200 to 1 speculator to consumer ratio!” It makes sense that the potential users of the 30m barrels might want to have one or more hedges against price changes, but 200 to 1 ... common sense says something is not right with that picture.
  • Since the last crisis, the VIX seems to have gained popularity as measure of volatility/fear. There are now ETFs that make it easy to “invest” in the volatility index with the intent of it providing returns that are non-correlated with the stock market. Michael Santoli at Barrons described this as millions of dollars trading on a “ derivative of a derivative of a statistical byproduct of other derivatives' price.” No amount of common sense can even decipher that statement, yet it seems accurate.
  • I've read a few different articles that highlight the percentage of assets controlled by the largest banks. These articles seem to quote different percentages so it is unclear to me what is the right number, but they all seem to agree that the big banks have gotten bigger. Seems like “too big to fail” has become “much too big to fail.”

  • A SIFMA representative was on CNBC last week and indicated that leverage is down to 11:1 from 16:1. Hmm, is that level really a lot safer? Indeed, most banks do seem to have more capital on their balances sheets, which should make things safer. Of course, that might mean that much of the money recently printed by governments is sitting unproductively in the hands of the financial services firms that were at the core of the problem last time.
  • To keep CCI non-political, I will not comment on the current debate in Washington DC, or in many state capitals. However, it is hard to see how the situation is inspiring confidence that things will be under control soon. Then there is the rest of the world. The unique EU arrangement is having challenging times, Japan seems to continue to be on a treadmill to nowhere, China seems to be playing by its own rules, and it is hard to tell who exactly is running several Middle Eastern countries. It seems the risk of some sort of policy mistake or geo-political event somewhere in the world that could have very unusual impacts on markets is far from a black swan event.

The most common question seems to be “ Who is to blame for the situation?” Depending on your point of view, common answers to the question include: the financial services industry, Republicans, or Democrats. There is plenty of blame to go around, but I don't think trying to affix blame is the right question.

The right question is “What should people on Main Street and in the investor class do to prosper and protect themselves if the market continues to have characteristics like those shown above?" After all, it has now been one year since Dodd-Frank, and about three years since the "crisis" became obvious and it does not seem like too much has changed. In the best case, perhaps some of these things will change over the next year or two. However, that means it will have taken four or five years for the system to react to the last crisis. That does not seem like anywhere near a fast enough feedback mechanism in today's rapidly changing world.

Realistically, there is probably no simple, silver bullet for how investors should behave in today's world. However, common sense seems to dictate that the best performing approaches will not be based on the conventional wisdom of the past. Modern Portfolio Theory (circa 1952) is based on a set of assumptions about average returns, volatility, correlation, market participants, market speed, etc that no longer seem to exist. This has meant that the conventional wisdom from the financial community of selecting an asset allocation of something like 60/40 of stocks/bonds and periodically rebalancing has achieved underwhelming results over the past 10-12 years. With a continually challenged financial system it seems that an investor needs to think and act differently than conventional wisdom.

Possible ways the investor needs to act differently might include:

  • The often touted way to protect against financial system stress is to buy gold. It would seem that a few percent asset allocation to gold has almost become an accepted part of anyone's asset allocation. The only question is how to get some exposure to gold. Putting gold coins in your mattress is one approach. However, that seems more like buying an insurance policy against social unrest than an investment strategy. The easier, cheaper, more liquid approach to adding gold exposure is through the gold ETF such as GLD. Another alternative is to use options on the GLD ETF. Implied volatility for GLD does seem that high for an entity which conceptually seems like it could be very volatile. I've discussed one way to play the options market in GLD in this article at SeekingAlpha.
  • Increased exposure to commodities seems like another strategy to diversify a portfolio for today's world. It might be a challenge for many investors to directly trade commodities, but there are now many etfs that provide exposure to commodities such as USO and DBA. However, these types of ETFs generally use futures contracts to represent a position in the actual commodity. That means there can be a difference between the performance of the ETF and the actual commodity price, especially over the longer term. Another perhaps more straightforward alternative is to simply overweight the materials sector in a stock portfolio via sector ETFs such as XLB, IYM, MXI.
  • To the degree the concerns above are a U.S. phenomenon, another approach is to look to different markets for returns. Emerging market ETFs such as EEM and VWO are commonly used to provide this exposure and may indeed make sense for many investors. However, IMO, this approach might be yesterday's news, very dependent on China's economy to grow in a consistent and aggressive manner, and subject to even an additional set of systematic risks. I've described another approach to diversifying away from the U.S. economy and dollar while trying to reduce the systematic risks of emerging markets in an article here at SeekingAlpha. I've also described a more aggressive approach to getting exposure to the emerging market consumer in another SeekingAlpha article here.
  • Most individual investors seem to be only invested from a "long" perspective. They seem reluctant to have short or hedged positions. However, most institutional investors often have hedged positions. It seems like the individual investor needs to consider embracing some amount of hedging strategies in their portfolio to dampen volatility in today's new world. That includes such strategies as shorting stocks, usually as part of a pairs trade, using options, and even potentially dabbling in the double and triple short ETFs now available. I've started to document hedging strategies I've started to use in the "The Short Game" section of my CCI blog.
  • Last but not least, it seems an investor must be more educated, open to new ideas and willing to change strategies and holdings much more rapidly than in the past. Hopefully Seeking Alpha will continue to be one platform that helps investors in their efforts to do this.

In summary, the last several years have been a unique time in the world of investing. Many investors might be longing for the good old days to return. Unfortunately the global financial system seems to continue to exhibit a new set of characteristics, and it seems unlikely the investing world will ever be like it was before. Perhaps it is time for the individual investor to depend less on conventional wisdom and more actively manage their portfolio while embracing some new ideas.

Source: Questions to Ask on the One Year Anniversary of Dodd/Frank