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Capital Safety in the Market Lane

June 28, 2012

The Perpetual Bond (B)® is a patented replication technology that correctly partitions any “basket of equities” – let’s call it a “market” – into a part that behaves like a “risk-free” bond (B) and its exact complement, (N), that behaves like an equity. Moreover, the demonstrated properties of The Perpetual Bond (B) are that it is “Alpha-smart with 100% Capital Safety and 100% Liquidity” guaranteed.

The Perpetual Bond (B)

“Alpha-smart with 100% Capital Safety and 100% Liquidity”

Guaranteed

It’s possible that either (B) or (N) can be empty, that is, that the entire market is very well-received and “liked”, and everything is (B), or very disordered and uncertain, and everything is (N), and we have found that the real markets of real equities can, in fact, exhibit both types of behaviour for a substantial part of the “market” over long periods of time.

The Capital Assets Pricing Model (CAPM) is also a replication technology in the above sense. It equates “bond-like” behaviour with a low correlation of expected or forecast returns of the equity to the expected or demonstrated market return and “equity-like” behaviour with its opposite, that is, with a high correlation to the expected market return. The “correlation coefficient” (β) could, of course, be any positive or negative number, -∞<β<+∞, although a more narrow range, such as -0.5<β<2.5, is typical and one might say that “low beta” and “bond-like” behaviour is signified by -0.5<β<0.5, and, therefore, a low correlation with the market, and “equity-like” behaviour on either side of that.

CAPM also produces, for each stock in the market, an “alpha” (α) which is usually expressed in percentage terms (positive or negative) and is a measure of the expected “excess return” of that equity above or below the expected “market return”.

One would say, then, that a “risk averse” investor should buy only those stocks that have a positive alpha and a low correlation with the market – a positive but low correlation, one supposes, if one is “bullish” on the market, and a negative low correlation if one is “bearish” on the market (effectively “shorting” the market).

Exhibit 1:  CAPM in Real Time for the Dow Jones Industrial Companies

Source: Wikipedia – Alpha and Beta Normalized as Returns

It’s an odd presumption because the hapless “risk averse” investor is immediately drawn into speculation on the market and is constrained to leave the best part of it (if any) behind. One cannot sensibly say anything about the individual equities in the market (please see the above chart) and one might as well buy the whole market (please see, for example, The Dow Jones Industrial Companies – (B)(N) There And Done That, June 2012, and Exhibit 2 below) but on which part of the market returns are we? Are we in the high and pricey part or the low and cheap part?

Based on the above chart, Intel, Proctor & Gamble and Boeing could be bought by a “risk averse” investor, but not Verizon and not any of the rest of the market. And, one doesn’t really know whether any of that is actually true (or correct) now.

In contrast, we say that the “risk averse” investor demands that their capital be safe –  “100% Capital Safety”™ – and hopes for a positive return that might exceed inflation, neither of which, obviously, is even a factor in the market model that is provided by CAPM.

For example, what good is positive alpha if the whole market is sinking and we’re sinking with it, though possibly not as much as our peers because of our low positive or (even) effectively (although we never know, do we) negative beta? If (and, again, we never know) the market is sinking, and possibly sinking fast as it is wont to do from time to time, then alpha doesn’t matter and we might wish that we had more of those high negative beta stocks, wouldn’t we.

It is, in fact, beyond our ability (and we might be talking only about ourselves) to forecast whether the market is going up or down, even today, and we have no insight at all into why a stock price is what it is even though investors who are buying and selling the stock now must think that it should be something else.

Based on that simple observation of risk aversion, we were able to buy and hold most of the market most of the time and obtained an average 16% return compounded over three years, 2009 through 2011, plus earned dividends (please see our recent Letter, What’s a girl to do?, June 2012).

Exhibit 2: The Dow Jones Industrial Companies – (B)(N) There And Done That – 2009-2012


One would think that the narrow band of  “risk aversion” and “capital safety” that is provided by CAPM – let’s call it the Market Lane – is not a safe place for our money to be. It is dark, fast, narrow, and totally lacking in light or illumination that might be provided by our investment advisers. What, in fact, can we hang on to if not even our money?

Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”.

Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability.

We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now.

The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”,  ”price of risk”, “risk price”, and the symbols “(B)” , “(N)” and N*.

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