Over the last few decades, we’ve become accustomed to a negative correlation between stocks and U.S. Treasury bonds. Bonds used to serve as a great diversifier against macroeconomic risk. Specifically, the last four downturns in 1991, 2001, 2007-2009, and 2020 were all so-called “demand-side” recessions where the drop in GDP went hand-in-hand with lower inflation because a drop in demand also lowered price pressures. The Federal Reserve then lowered interest rates, which lifted bonds. This helped tremendously with hedging against the sharp declines in your stock portfolio. And in the last two recessions, central banks even deployed asset purchase programs to further bolster the returns of long-duration nominal government bonds. Sweet!
Well, just when people start treating a statistical artifact as the next Law of Thermodynamics, the whole correlation collapses. Bonds got hammered in 2022, right around the time when stocks dropped! At one point, intermediate (10Y) Treasury bonds had a worse drawdown than even the S&P 500 index. So much for diversification!
So, is the worst over now for bonds? Maybe not. The future for nominal bonds looks uncertain. We are supposed to believe that with relatively modest rate hikes, to 3.4% by the end of this year and 3.8% by the end of 2023, as predicted by the median FOMC member at the June 14/15, 2022 meeting, inflation will miraculously come under control. As I wrote in my last post, that doesn’t quite pass the smell test because it violates the Taylor Principle. The Wall Street Journal quipped “The Cost of Wishful Thinking on Inflation Is Going Up Too“. I’m not saying that it’s impossible for inflation to easily subside, but at least we should be prepared for some significant upside risk on inflation and interest rates. Watch out for the July 13 CPI release, everybody!
So, trying to avoid nominal bonds, how do we accomplish derisking and diversification? Here are ten suggestions…
In this year’s April Fool’s post, I marketed a made-up crypto coin that would completely hedge against Sequence Risk, the dreaded destroyer of retirement dreams. Once and for all! Most readers would have figured out this was a hoax because that complete hedge against Sequence Risk is still elusive after so many posts in my series. Sure, there are a few minor adjustments we can make, like an equity glidepath, either directly, see Part 19 and Part 20, or disguised as a “bucket strategy” (Part 48). We could very cautiously(!) use leverage – see Part 49 (static version) and Part 52 (dynamic/timing leverage), and maybe find a few additional small dials here and there to take the edge off the scary Sequence Risk. But a complete hedge is not so easy.
Well, maybe there is an easy solution. It’s the one I vaguely hinted at when I first wrote about the ins and outs of Sequence Risk back in 2017. You see, there is one type of investor who’s insulated from Sequence Risk: a buy-and-hold investor. If you invest $1 today and make neither contributions nor withdrawal withdrawals, then the final net worth after, say, 30 years is entirely determined by the compounded average growth rate. Not the sequence, because when multiplying the (1+r1) through (1+r30), the order of multiplication is irrelevant. If a retiree could be matched with a saver who contributes the exact same amount as the retiree’s cash flow needs, then the two combined, as a team, are a buy and hold investor – shielded from Sequence Risk. It’s because savers and retirees will always be on “opposite sides” of sequence risk. For example, low returns early on and high returns later will hurt the retiree and benefit the saver. And vice versa. If a retiree and a retirement saver could team up and find a way to compensate each other for their potential good or bad luck we could eliminate Sequence Risk.
I will go through a few scenarios and simulations to showcase the power of this team effort. But there are also a few headaches arising when trying to implement such a scheme. Let’s take a closer look…
Well, it is a Bear Market as of this week! We dipped well below the -20% line on March 12 due to the awful 10% meltdown that day. But we also recovered very nicely on Friday the 13th, of all days!!! I’m putting together some notes about my thoughts. To be published on Wednesday, March 18. Stay tuned! Good luck everybody! Stay invested! 🙂
Original Post (3/4/2020)
Volatility is back! Did it feel a little bit like a bear market last week? Actually, that wasn’t even a bear market, only a correction so far. Hence the title picture with the Koala “Bear,” which is not a bear at all but a marsupial. But it still felt like a mini-bear-market, didn’t it?
So, I thought it’s a good time to write a response to some of the questions I’ve been getting over the last few days:
How bad is this event compared to other corrections? How long will this last?
Should I sell my stocks now?
Is this a good buying opportunity?
How did some of the “exotic” investment styles fare during this volatile time (Yield Shield, Merriman’s Small-Cap Value)?
What does this all mean for my retirement plans?
Did your leveraged option writing strategy blow up already?
My little blog here may be mostly known for the Safe Withdrawal Rate Series. But I’m surprised how many people share my other passion: options trading. Both here on the blog and at FinCon last weekend lots of fans of the blog asked me when I’m going to write something about derivatives again. Wait no more! I have been thinking about this one for a while; it’s another cautionary tale about markets going haywire and unsuspecting and unsophisticated investors are caught in between. And then they realize the “safe” and “conservative” strategy marketed by their financial adviser can blow up in their face!
The Wall Street Journal came out with a pretty detailed article (subscribers only) a few weeks ago, but the story has been around for a while. See, for example, on WealthManagement.com or SeekingAlpha.com. And this time it’s not some obscure small shop in Florida that got into trouble. No, it’s one of the big fish: UBS! Their so-called “Yield Enhancement Strategy (YES),” marketed as a conservative and low-risk strategy to risk-averse investors with mostly bonds in their portfolio, racked up heavy losses late last year. Well, at least people weren’t completely wiped out like the poor sobs in the OptionSellers mess. But a purported 20% loss (about $1b) is still a hard pill to swallow for investors that were told that this is completely safe. Sure, if you were 100% invested in the S&P500 last year and lost 20%, then yeah at least you knew what you’re getting into. But for the average mom-and-pop muni bond investor, a 20% loss is pretty epic. And not in a good way!
Of course, looking at the low-yield environment right now – in some places we even have a negative-yield environment – I don’t blame investors for shopping around for higher yields. But be aware of the charlatans. If they tell you that higher yields come with no side effects run away! There is always a catch with a higher yield! Even if it’s your trusted personal wealth advisor at a shop as famous as UBS!!! This yield enhancement strategy involved a risky options trading strategy. With 5x leverage! And most of the investors didn’t even know what they were getting into unless they had read the pages with the fine print! So, let’s do a post-mortem for this strategy. What were they doing and how and why did this go so horribly wrong?
Right around the time when I wrote my options selling update a few weeks ago was when everyone in the option seller circles talked about the blowup of OptionSellers.com. Option Sellers, LLC was a Tampa, Florida based Registered Investment Adviser and CTA (Commodity Trading Adviser). They managed money for 290 clients. Considering the minimum investment was $250,000 and most investors likely had more money with them, I’d surmise that they were managing around $150m. On November 15, 2018, they informed their investors that not only was all their money lost but that clients would likely owe more money. Wow, let that sink in: they had a loss of more than 100% and clients are left with debts they have to cover now! Bad news for the clients who invested all their money with OptionSellers!
A failure of a small obscure adviser probably would have stayed under the radar but the co-founder published a tearful apology video, confessing that all customer accounts were wiped out “by a rogue wave.” The movie was since taken down – probably the lawyers didn’t like the idea of this kind of mea culpa so much – but it’s still available on YouTube. The story went viral (or at least as viral as something as obscure as options trading can go) and was then picked up even by the national news media, including the Wall Street Journal, CNBC and many others.
Quite intriguingly, their strategy imploded over the span of just a few trading days. And just to be sure, this wasn’t fraud a la Bernie Madoff but investors actually lost their money “fair and square” if there is such a thing. Is this something all option sellers should worry about? Yes, if you are as reckless as Option Sellers. If you had bothered to check what these clowns were doing it was clear that this debacle was all but unavoidable. Let’s take a look at what they did and the five obvious mistakes that lead to the meltdown…
As a follow-up to yesterday’s guest post, here are a few of my own thoughts about the challenges and opportunities. For full disclosure, I don’t currently own or have ever owned Bitcoin or any other cryptocurrency myself. I reached Financial Independence (FI) years ago the old fashioned way with equities and a little bit of real estate. Only a few weeks away from early retirement, I have no need to throw “Hail Mary passes” with my money! But just because I’m interested in finance and technology I should have an opinion, of course, so here are some of my random thoughts in random order on Bitcoin and Cryptocurrencies… Continue reading “Some of my Thoughts on Bitcoin and Cryptocurrencies”→
Last week we made the case for generating passive income through option writing. A quick recap of last week: buying puts to secure the downside of your equity investment is a bit like casino gambling: pay a wager (put option premium) for the prospect of winning a big prize (unlimited equity upside potential). Unfortunately, the average expected returns are also quite poor, just like when you gamble in the casino or buy lottery tickets.
Since we can’t beat the casino, let’s be the casino!
Being the casino means we act as the seller of put options. Let’s see how we implement this: