Leap Years Are Not Lucky

As we all enjoy this fifth Friday in February, we can look back on all the other Leap Year trading days. Not a very good track record unfortunately:

Hat Tip: Bespoke

Pandora is Cool

I've recently become addicted to internet radio site Pandora. If you haven't already checked it out you should go there now. It's a great way to find new music. My only warning is that it is a bit addicting. As usual all things in moderation.

The End of the Yen Carry Trade?

Much has been made of the prevalent role of the Yen carry trade in today's market. So let's start with a little education. What exactly is the Yen carry trade? Here's the definition via the San Francisco Fed:

In the most common version of this strategy, an investor borrows a given amount in a low-interest rate currency (the “funding” currency), converts the funds into a high-interest-rate currency (the “target” currency) and lends the resulting amount in the target currency at the higher interest rate.

In today's market the "funding" currency is often the Yen which the BOJ has kept at or near 0% for over a decade as they attempt to jump start their economy. The target currency is often the USD, as hedge funds and insurance companies have crowded into the strategy to bump up their returns. So how does the carry trade effect the markets? (from Gillian Tett at FT.com):

Just how large the carry trade is, nobody really knows ... But whatever the precise number, what is clear is that carry trades have been fueling the dash into risky assets in the past couple of years.

After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5 per cent a year, apply a bit of leverage and – hey presto – produce returns of 20 per cent, or more. Conversely, if an investment bank wants to create a collateralised debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books – funded by ultra cheap yen. The yen has thus been tantamount to the ATM of the global credit world – spewing out (almost) free cash.

So when will the carry trade end? It certainly looks as if Japan's economy is finally growing. Though the weak first quarter numbers, 2.4% annualized, left a little to be desired the growth is solid and should be sustainable. While no rate hike is currently expected, if you read into Toshihiko Fukui's rhetoric he has left the door open to raise rates above 0.5% even if consumer prices continue to fall as long as growth continues. So don't be surprised if by the end of 2007 the Yen reverses trend in FX markets against the USD and wipes away the carry trade. Using the past as a guide, the last major period of Yen carry trade activity was from the summer of 1995 to October of 1998. In October of 1998 the Yen appreciated 18% in just three days, burning many in the process and contributing to the meltdown at Long Term Capital Management. Unfortunately exchange rate movements are notoriously difficult to predict. When the Yen does recover it is safe to say that the fluctuation could be dramatic and the unhedged will be hurt badly. For more on the Yen carry trade check out these links:

Mish's Global Economic Analysis
MarketThoughts.com
Federal Reserve Bank of San Francisco

Eugene Fama on the Keys of Investing

Eugene Fama, the ultimate random walker, has a video on the Dimensional Fund Advisors website in which he gives advice to investors. I encourage you to view the video in its entirety here. Here is a quote of the most important advice:

"The evidence is quite clear. If you do any systematic analysis of investment performance what you find is people basically get return for risk and then from that you subtract fees and expenses. It is the costs that basically determine deferentials in portfolio performance. Active managers charge more so they tend to do worse. But, that doesn't mean people will stop doing it. Especially MBA students, all the ones that want to be portfolio managers want to be active managers naturally since if they're lucky and they win they end up rich. And that is very, very attractive to them so lots of students in my class even end up being active portfolio managers. I don't know where they learn how to do it though. The evidence is also clear that what does matter in portfolio strategies is asset allocation. The choice of stocks versus bonds and within stocks a tilt toward value and a tilt towards small. Now those are basically the decisions you face, plus international diversification is another aspect of it."

I agree with Eugene in large part, though I'm sure most Hedge Fund managers would watch this video and laugh all the way to the bank. I was a little bit disturbed by the fact that international diversification seems like such an afterthought to Gene as I feel it is such a pivotal part of portfolio construction. I also personally feel that utilizing other asset classes -- such as REITS and commodities -- can be very valuable in portfolio construction particularly as a means to dampen volatility and drive returns during prolonged market downturns. It would be interesting to ask Gene his opinion on that question in person. It might be a while before I get that opportunity . . .

Commission Free Trading is Here

Back in 1970 if you decided to buy $2,000 worth of a stock through a broker the transaction may have cost you roughly $40. At first that may seem like no big deal, after all many people still pay roughly $40 to buy stocks through big wirehouse brokers. But $40 in 1970 is the equivalent of $215 today. Now, that's nothing to sneeze at.

For a long time brokerage firms depended on fixed trading costs as a consistent revenue stream. However in 1974 and 1975 Congress and the SEC took away the NYSE's ability to set the commission rates its member firms charged. Few large brokerage houses did anything at first, but eventually discount brokers like Charles Schwab emerged and offered lower commission trading for a fraction of the costs. These discount brokers pulled this off by not offering much in terms of research or guidance to its investors. That began the discount brokerage trading commission race to the bottom. Just a few years ago trading for $10 seemed like a great deal. Today, many investors are trading for absolutely free on sites like Zecco.com or through programs at large banks like Bank of America.

Many who follow the brokerage industry have long said that commission free trades are inevitable. But trading costs are not the only factor in where to hold your assets. The word on the street is that Zecco's interface has more ads than MySpace, still doesn't have a great trading platform and may be unreliable. Bank of America's free trading platform requires a $25,000 minimum investment. Unless you are a day trader the minimal costs savings probably don't outweigh the risks at this point. But, hopefully this move towards commission free trading will spread and discount brokers like Schwab and TD Ameritrade will follow. Until then, proceed with caution.