FXIS Market Insights

Exchange Traded Funds (ETFs) have been all the rave.  Ongoing investor interest has prompted an amazing growth of this type of investment vehicle. For most individual investors the traditional ETFs do provide an easy, certainly more cost effective way of diversification and therefore spreading risk among possibly several hundred companies. Many of these ETFs track the major stock market indices such as the SPDR S&P 500 (Ticker: SPY), SPDR Dow Jones Industrial Average (DIA) and Powershares NASDAQ 100 (QQQQ).

I have been repeatedly critical of some of the more complex ETFs in the past.  Leveraged ETFs (double and triple) as well as inverse ETFs should only be considered by more experienced investors as they generally incur much higher risks.  Worse yet, they tend to do a rather poor job at tracking the underlying index or basket of assets, often lagging far behind the expected performance.  We discussed this in detail in numerous articles, more recently in Naïve expectations versus actual performance.

By contrast, as long as one invests in the traditional ETFs tracking just the major market indices, one should take comfort from the fact that diversification through the many different companies provides some insurance against individual company risk.  Or does it?

Let’s look at an area of risk that’s not all that obvious on first glance: concentration risk.

Whenever I examine a new ETF or Mutual Fund, my first question is always:  What are they actually buying and what are their current holdings?

One should do the same before buying any index fund too.  Be aware of what the index is actually made of and what the fund allocations are.  For instance, looking at the top ten holdings of the Dow Jones ETF (DIA), it is clear that a significant portion of that index, about 10%, is allocated to one company – IBM.  Nothing against IBM, but just be aware that this is quite a large allocation in just one stock. 

DIA Top Ten Holdings	as of 2-25-11
Components	Weight
IBM	10.08%
Chevron	6.39%
Caterpillar Inc	6.30%
3M Co	5.64%
Exxon Mobil	5.39%
United Technologies	5.18%
Mcdonalds	4.71%
Boeing Co	4.43%
Coca Cola Co	4.00%
Procter & Gamble Co	3.95%

Granted that the Dow is only made up of 30 companies, that concentration risk is still relatively benign.  Much more of a concentration risk has been gathering steam in the NASDAQ 100.  The extremely successful company Apple now comprises more than one fifth of the Index, clearly a huge allocation in just one company.

QQQQ Top Ten Holdings	as of 2-25-11
Components	Weight
Apple Inc.	20.47%
QUALCOMM Inc.	5.29%
Google Inc.	4.24%
Microsoft Corp.	3.59%
Oracle Corp.	3.17%
Amazon.com Inc.	2.43%
Intel Corp.	1.96%
Cisco Systems Inc.	1.70%
Comcast Corp.	1.68%
Teva Pharmaceutical	1.68%

Apple has been a huge success no doubt and the NASDAQ 100 Index has also been profiting from Apple’s stellar performance in recent years.  Without going into detail as to how the component allocation of these indices are calculated, the average investor should at least be aware of the top 10 holdings of these ETFs as they provide some insight into how much or how little the index is actually diversified.  Given the larger allocation of Apple in this case has been a huge plus for holders of QQQQ.  But the same holders should appreciate that there is a significant concentration risk through this massive holding in just one company.   Don’t get me wrong, I love Apple and its products and I am not here to argue as to whether Apple’s astronomical market cap of $320 billion is justified.  But the fact that Apple is now more than 20% of the NASDAQ 100 leaves me a bit uncomfortable. 

You could consider buying Apple stock directly (if Apple were the “chosen one”) while achieving your desired level of diversification through a broader index like the S&P 500. In that index comprised of 500 companies, Apple is still the second largest component stock. However, with a weight of just 2.65% it looks more like diversification is actually happening.

SPY Top Ten Holdings	as of 2-25-11
Components	Weight
Exxon Mobil	3.65%
Apple Inc.	2.65%
General Electric Co	1.85%
Chevron Corp New	1.73%
Microsoft Corp	1.70%
IBM	1.68%
Jpmorgan Chase & Co	1.51%
Procter & Gamble Co	1.49%
Johnson & Johnson	1.39%
Wells Fargo & Co New	1.39%

Again, I’m not debating the commercial viability of Apple Inc. (although there are those who fear that the absence of Steve Jobs will eventually hurt the long-term prospects of the company). This is rather a heads up for those who might not realize how much of their money is invested in just one stock when they purchase shares in the ETF QQQQ.  Always good to know what’s inside the shopping bag…

Weekly Snapshot
• Saudi Arabia raises oil output as Libyan exports are disrupted (Reuters)
• Ireland's Ten Year bond near record high yield of 9.35% ahead of general elections (AP)
• U.S. consumer sentiment in February rose to its highest level in 3 years (Reuters)
• U.S. Real GDP grew at an annual rate of 2.8% in the fourth quarter of 2010 (ESA)
• The yield on Portugal's Ten Year bond reached a record high of 7.59% (Bloomberg)
• Crude Oil futures price in the U.S. topped $103 on Thursday (Reuters)
• New orders for manufactured durable goods in January 2011 increased 2.7%, to $200.5bn (ESA)
• U.S. new-home sales 12.6% below the revised December level, and 18.6% below Jan-2010 (ESA)
• Moody's downgraded Japan's sovereign rating outlook to Negative (Reuters)
• U.S. national home price index declined by 3.9% during the fourth quarter of 2010 (S&P)
• U.S. consumer confidence index rises to 70.4, the highest level since Feb-08 (Reuters)

Market Barometers

Chart Of The Week
Oil prices have been on a big move for the second week in a row.  Crude oil futures rose over 14% since last week.  There is this ongoing price difference between oil futures traded in London (Brent Crude) versus oil futures traded in the US (West Texas Light Sweet Crude Oil).  We have alluded to this price discrepancy in our market wrap of 11-Feb-2011.  The price spread in favor of Brent Crude has spiked above $15 in the past week. Historically, the two futures contracts have tracked each other extremely closely reaching a correlation of over 99% when comparing the weekly closing prices since 1986.   

In recent months however, the two oil price benchmarks started to drift apart.  Political tensions in the Middle East have been identified as a primary contributing factor.  However, there are additional factors that come into play as we shall discover below.

Recommended Read 
We have been wondering why these two oil futures prices have been diverging in recent months.  Political tensions in the Middle East and possible supply problems may have been the prima facie main factor causing European oil prices to rise much faster than the US counterparts.  There has also been some talk about over-supply of crude oil in the Midwest.  But there are other reasons why the prices have traded so far apart.  Please consider an in-depth write up and find a not so obvious explanation as to Why are WTI and Brent Prices so Different.

Recommended Video 
Back to our favorite subject: banks and interest rates.  Please enjoy this fun approach to lending and interest rates.

 

Good luck and good investing!

Disclaimer
Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance. Please note that there is no requirement and no commitment to make any payments to FX Investment Strategies LLC in order to access our published information be it via email or via website publication. All information is publicly available without any required monetary consideration.  Any payments or donations made by you are deemed to be voluntary and cannot be considered as payments for investment advice given to you.

Weekly Snapshot
• China raised its reserve requirements by 0.5% to 19.5%, the second hike this year (WSJ)
• China surpassed Japan to become the world’s second-biggest economy at $5.9 trillion (Economist)
• U.S. Consumer Price Index increased 0.5% in December, seasonally adjusted (BLS)
• U.S. Producer Price Index for finished goods rose 0.8% in January, seasonally adjusted (BLS)
• U.K. inflation rate increased in January, to 4% or double the Bank of England’s target (Economist)
• U.S. retail sales in January rose 0.3% from prior month and 7.8% from prior year (ESA)
• China's consumer price index rose 4.9% in January from a year ago, vs. a 4.6% gain in December (NY Times)
• Euro finance ministers agreed to double the Euro rescue fund €500 billion by 2013 (Spiegel)
• Euro area GDP up by 0.3% from previous quarter and +2.0% compared with Q4 of 2009 (Eurostat)
• President Obama’s budget plan foresees a record deficit of $1.65 trillion this year (ESA)
• Deutsche Boerse will take over NYSE Euronext to create the world's largest exchange operator (Reuters)
• Japan's GDP fell an annualized 1.1% in Q4, as exports slowed and government stimulus faded (Bloomberg)

Market Barometers

Chart Of The Week
The new U.S. budget proposal for fiscal 2012 is out.  You can download the entire budget here or skip right to the summary tables which is what I did.

Since the last budget and forecast, the state of fiscal affairs has not improved. It’s just more spending with no end in sight and not even an attempt to get anywhere close to a balanced budget - let alone a reduction of the overall U.S. Debt.  I have taken the liberty of displaying the proposed numbers in a graph and added a regression line to the deficit numbers. I realize this may oversimplify things mathematically (sorry Quants) but it illustrates the simple point that there is a trend when it comes to the U.S. budget.  The trend is clearly downward meaning the deficit is not improving. This makes it increasingly difficult to believe that the overall U.S. debt will ever decrease.  Consider that the cost of financing this unfathomable debt burden has been super low thus far.  Now consider what a 2-3% increase in the cost of capital might do.  In such a scenario, the chart below would be wishful thinking.  Japan, all over again…  

Putting some of these numbers into context, here’s a unique way of looking at these $ trillion amounts which seem to be thrown around so casually by officials these days.  Courtesy of Political Calculations comes a neat calculator that converts those billions and trillions into an equivalent quantity of Gold.  Take a look at the projected 2011 deficit of $1.645 trillion or consider the proposed $3.729 trillion in government spending for 2012.  The equivalent quantities in Gold are displayed below: 

2011 Projected Deficit		2012 Proposed Spending
Source: http://politicalcalculations.blogspot.com

Now for a real fun exercise, I would invite you to run the numbers for total public debt outstanding which is $14.1 trillion give or take a few billion.  As Political Calculations concluded:

“Paying off the entire U.S. national debt in gold would take nearly double the entire amount of gold ever found in the world.”

Recommended Read 
Just in case you’re still wondering why the price of gold is so high, consider this excellent white paper by Chris Goolgasian, courtesy of State Street Global Advisors:  In Gold We Trust

Recommended Video 
Speaking of Budgets, please consider this insightful master class for budgeting Aussie style. Enjoy!

 Good luck and good investing!

Disclaimer
Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance. Please note that there is no requirement and no commitment to make any payments to FX Investment Strategies LLC in order to access our published information be it via email or via website publication. All information is publicly available without any required monetary consideration.  Any payments or donations made by you are deemed to be voluntary and cannot be considered as payments for investment advice given to you.

Weekly Snapshot
• Egyptian president Hosni Mubarak steps down after 30 years in power (FT)
• The U.S. trade deficit increased 5.9%  in December 2010, to $40.6 billion (ESA)
• U.S. consumer sentiment rose to its highest level in 8 months in early February (Reuters)
• 27% of U.S. homeowners with a mortgage were underwater at the end of 2010 (Zillow)
• HK Shares End At 6-Week Low Due To China Tightening Concerns (WSJ)
• The IEA raised its 2011 forecast for global crude oil demand for a fifth month (AP)
• The Bank of England left its benchmark interest rate unchanged at 0.5% (Bloomberg)
• U.S. jobless claims dropped more than expected to touch their lowest point in 2-1/2 years (AP)
• U.S. home foreclosures rose 12% from last month but down 11% from a year ago (Reuters)
• Germany's Deutsche Boerse is in advanced talks to buy NYSE Euronext (Reuters)
• The London Stock Exchange is to buy the Toronto Stock Exchange operator TMX (Reuters)
• China's central bank raises interest rates to 6.06% in fight against inflation (AP)

Market Barometers

Chart Of The Week
Egypt cheered on Friday when Hosni Mubarak officially stepped down after 30 years of being the president of Egypt. While Western leaders are now assessing the impact of new political leadership in Egypt, equity and capital markets rallied on the news of Mubarak’s resignation. We noticed an interesting correlation of the events in Egypt with the price of oil.  Light Sweet Crude Oil futures peaked on January 31st just hours before Mubarak announced that he will not run for re-election. From that moment on, oil traders must have seen Mubarak’s resignation as an inevitable outcome as they continued to favor the shorts for the better part of the past two trading weeks. Mubarak’s official resignation on Friday put additional pressure on the price of oil. Much ado about nothing one would think as crude oil is back to square one.

Source: www.finviz.com

Having said that, the European equivalent of the West Texas Light Sweet Crude Oil futures contract, namely Brent Crude Oil, appears to have taken a slightly different assessment of political impacts from the turmoil in Egypt.  Granted, the two futures contracts are not identical and have historically seen price discrepancies before.  But on average, they tended to track each other’s price movements fairly closely.  However, since the beginning of this year, the two oil price benchmarks started to clearly diverge and Brent Crude is currently trading at a more than $15 premium to its US equivalent.

Brent Crude Oil		WTIC Light Sweet Crude Oil
Source: www.netdania.com

Granted that physical supplies of oil in the US are much higher than their European counterparts.  But it is hard to imagine that alone could make up the bulk of the $15 price difference. One could however argue, that European traders were perhaps less concerned about Egypt on its own.  Mubarak’s resignation in itself does not guarantee a calmer political climate. Further still, political movements in other Middle Eastern countries might now be encouraged by the events in Egypt.  The spread of political unrest throughout the region is now looked upon more likely than before. A prognosis of further political changes is outside of my realm of understanding.  However, taking a lead from the continued upward pressure on Brent Crude Oil, I reckon there are a few more surprises on the horizon.

Recommended Read 
It is always good when others remind you not to take yourself too seriously.  That said, among those who make a living predicting future events, economists tend to have a much longer shelf life than the average trader or analyst.  Why is it then that economists get it wrong so often and yet, everyone still listens when they speak?  Please consider Why do economists get it so wrong? by Tim Weber Business editor, BBC News. Why bother with economic forecasts?

"It's a starting point for analysis or discussion," says the chief executive of a large asset management firm, "but you don't have to believe it... economists are just one input among many."

So how often do the economists advising his firm get it right? He shrugs his shoulders: "Oh, about 3 or 4 times out of ten."

Recommended Video 
Judging from the speed and strength of the (stock market) recovery, the word double-dip recession is no longer in everyone’s vocabulary.  In case you still wondered what a double dip recession might look like, here’s a good explanation from Paddy Hirsch, senior editor of Marketplace.  Come the next dip, at least you’ll know how to spot one now. Enjoy!

Good luck and good investing!

Disclaimer
Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance. Please note that there is no requirement and no commitment to make any payments to FX Investment Strategies LLC in order to access our published information be it via email or via website publication. All information is publicly available without any required monetary consideration.  Any payments or donations made by you are deemed to be voluntary and cannot be considered as payments for investment advice given to you.

Weekly Snapshot
• The U.S.unemployment rate fell by 0.4 percentage points to 9.0% in January (BLS)
• Nonfarm payrolls increased by 36,000 short of analysts' estimate for a 140,000 gain (Bloomberg)
• The European Central Bank kept interest rates at a record low of 1% (Reuters)
• The industrial producer price index rose by 0.8% in the Euro area in December 2010 (Eurostat)
• Prices of agricultural commodities at new highs, sugar at 30-year high (FT)
• Euro area seasonally-adjusted unemployment rate unchanged at 10.0% in December 2010 (Eurostat)
• The U.S. Treasury has been urged to sell "ultra-long" bonds with maturities of up 100 years (FT)
• Copper continues its ascent, reaching a record high of $10,000 per metric ton (Bloomberg)
• The U.S. is on track to hit its $14.29 trillion debt ceiling by the end of May (Bloomberg)
• The Federal Reserve has surpassed China as the leading holder of US Treasury securities (FT)
• S&P cut Ireland's credit rating to A-/A-2 from A/A-1 and maintains a negative outlook (Reuters)
• Brent Crude oil surges above $100 for the first time in over two years (FT)

Market Barometers

Chart Of The Week
Friday’s employment report was another one of those head scratchers. Although the unemployment rate fell by 0.4% to 9%, companies didn’t exactly go on a hiring spree; they added only 36,000 new jobs to their payrolls.  Keeping in mind that the U.S. needs to create at least 100,000 jobs per month just to keep up with demographics, the employment situation is not at all rosy. In terms of creating and finding jobs, education still appears to be the one factor separating the wheat from the chaff. Case in point is this fascinating chart courtesy of Calculated Risk.

source: www.calculatedriskblog.com

Recommended Read 
Please consider “The Fed passes China in Treasury holdings.”  An interesting change in the terms of who owns U.S. Treasuries. 

Based on weekly data released on Thursday, the New York Fed’s holdings of Treasuries in its System Open Market Account, known as Soma, total $1,108bn, made up of bills, notes, bonds and Treasury Inflation Protected Securities, or Tips.

When the Fed buys U.S. Treasuries it’s akin to putting your money from your left pocket into your right pocket. Sadly, if an individual investor does that, it has no effect on his/her financial situation.  When the Fed does it, it’s called QE2 and it is supposed to fix the economy.  I will file this under: Things that me go hmmm…

Recommended Video 
The entertaining and über-passionate Howard Davidowitz is always fun to watch. You may or may not agree with some of his political comments but he does have a refreshing common sense approach to looking at the markets and the economy. Enjoy!

Good luck and good investing!

Disclaimer
Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance. Please note that there is no requirement and no commitment to make any payments to FX Investment Strategies LLC in order to access our published information be it via email or via website publication. All information is publicly available without any required monetary consideration.  Any payments or donations made by you are deemed to be voluntary and cannot be considered as payments for investment advice given to you.