Investing in Dividends

Dividends are an important part of the total return stream of S&P 500, contributing one-third of long term total returns. S&P 500 linked index derivatives have meaningful exposure to dividend risk.

The chart illustrates peaks and troughs in dividend points, highlighting the importance of dividend risk management tools.



The figure illustrates the breakdown of S&P 500 dividend points across sectors over the past decade. At the beginning of the decade, dividend point contribution is more evenly split across the sectors relative to the end of 2008. The top three dividend weights at the beginning of the decade were financials, consumer staples, and energy, which accounted for 44.4% of the total dividend points of the S&P 500. At the end of the period, the top three dividend point contributors were financials, consumer staples, and industrials, which in total accounted for 48.5% of the total dividend points of the S&P 500.




The chart plots the relationship between the S&P 500 dividend growth and the headline CPI rate during the last 20 years. It suggests that dividend growth remained elevated during periods when inflation spiked above trend levels. To take the example of 1990-91, this is the last time the US experienced a phase of above-trend inflation and below-trend growth, or “stagflation-light”. Dividends per share rose by as much as 15% that year and closely followed the trend in inflation. In more recent years, with the commodity boom, dividend growth has persistently remained above 10%, providing decent inflation protection at a time when year on year headline CPI growth has moved above 4%. Recently, as the economic recession deepened and CPI number dropped dramatically, dividend growth has plummeted and entered the negative territory. The positive correlation with inflation may be attractive to investors – particularly those attempting to hedge longer-dated inflation-linked liabilities – where there are because low real yields on index-linked securities.



Hence, dividends may prove to a strong alternative asset to provide inflation protection. The advent of the exchange-traded futures on index dividend market seem likely to eventually rehabilitate equities as an inflation hedge, largely because dividends provide a portion of equity total returns free of the inveterate volatility caused by swings in equity valuation.
Besides using the index dividend as a sole inflation-hedging investment vehicle, the index dividend can also be used to improve the risk-return profile of a portfolio hedging against inflation. Using a future on index dividend, one can achieve a reasonable dividend exposure, providing inflation protection and diversification. As an example we build a portfolio including Commodities (S&P GSCI Index), Inflation-Linked Bonds (Barclay Capital US TIPS Index), and the S&P 500 Dividend Growth data. As shown in the figure, this portfolio exhibits less volatility and higher Sharpe ratio with respect to a portfolio that doesn’t include the S&P 500 Dividend Growth.





For those readers who are interested in the idea of investing in dividends, please refer to a paper I wrote recently on the topic of dividend investing on ssrn.com

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1425518

What to be blamed for the current crisis?

Today, Bernard Madoff was sentenced to 150 years for masterminding the largest Ponzi scheme in history, six times longer than the penalties meted out to the chief executives of WorldCom Inc. and Enron Corp.

When this case is finally driven to a close, there is certainly something that we can learn from it, not only the lessons that we should bear in our minds that how obvious the crime can be conducted without being noticed for years before people finally get burned by the burst of the Ponzi scheme; but also the deeper understanding the link between the case of Madoff and the origin of the current crisis.

What causes the current crisis? There could be a number of answers to the above question, such as the home price bubble, the weak transparency of mortage back securities, corporate malgovernance, excessively loose monetary policy, etc. These answers might be good to explain one aspect of the current crisis, however, to my opinion, they are just the apparent phenomeno reflecting a deeper origin of the current crisis - Mistrust.

Why Madoff can conduct the Ponzi scheme for years before being caught? Because most people are relying on the judgements of others when they make their investment decisions. For years, Madoff had been a star in the investment community, and was trusted by so many people, especially by those so-called smart people (celebrities and investment bankers). The more people trusted Madoff, the easier for him to gain the trust of others. It is like a snowball which is intially small in size but grows into a huge size of trust from other people. Most of the trust involved is not based upon the truth, the firsthand information, instead, it is based upon the idendities adn reputation of those people who already trusted Madoff. Yes, it is a Ponzi scheme, but it is not only a Ponzi schme of money making, but also a Ponzi scheme of mis-trusts by so many people.

In the run-up to the current crisis, a similar process of Ponzi sheme related to information cascades, because a great many retailed investors have put excessive trust in highly leveraged banks and other business plans, because the central bankers have put excessive trust in the well functioning of the market economy, because a large number of professional investors (institutions) have put excessive trust in the optimistic expectations of others.

Another classic example of "Greed and Fear"!

Day Trading the Currency Market : Technical and Fundamental Strategies To Profit from Market Swings?

As a following article to the previous one "Currency Volatility and the Disparity of Currency Outlook", I dig out the following book from Google, written by Kathy Lien, a seasoned FX analyst and trader, which could be useful for designing specific FX trading strategies that try to capitalize the heighted volatility in the market place.

Here are some interesting contents taken from her book:

Asian Session (Tokyo): 7 P.m.–4 A.m. EST

FX trading in Asia is conducted in major regional financial hubs; during the Asian trading session, Tokyo takes the largest market share, followed by Hong Kong and Singapore.

For the more risk-tolerant traders, USD/JPY, GBP/CHF, and GBP/JPY are good picks because their broad ranges provide short-term traders with lucrative profit potentials, averaging 90 pips. Foreign investment banks and institutional investors, which hold mostly dollar-dominated assets, generate a significant amount of USD/JPY transactions when they enter the Japanese equity and bond markets. Japan’s central bank, with more than $800 billion of U.S. Treasury securities, also plays an influential role in affecting the supply and demand of USD/JPY through its open market operations. Last but not least, large Japanese exporters are known to use the Tokyo trading hours to repatriate their foreign earnings, heightening the fluctuation of the currency pair. GBP/CHF and GBP/JPY remain highly volatile as central bankers and large players start to scale themselves into positions in anticipation of the opening of the European session.

For the more risk-averse traders, AUD/JPY, GBP/USD, and USD/CHF are good choices because they allow medium-term to long-term traders to take fundamental factors into account when making a decision. The moderate volatility of the currency pairs will help to shield traders and their investment strategies from being prone to irregular market movements due to intraday speculative trades.

U.S. Session (New York): 8 A.m.–5 P.m. EST

New York is the second largest FX marketplace, encompassing 19 percent of total FX market volume turnover according to the 2004 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004, published by the Bank for International Settlements (BIS). It is also the financial center that guards the back door of the world’s FX market as trading activity usually winds down to a minimum from its afternoon session until the opening of the Tokyo market the next day. The majority of the transactions during the U.S. Session are executed between 8 a.m. And noon, a period with high liquidity because European traders are still in the market.

For the more risk-tolerant traders, GBP/USD, USD/CHF, GBP/JPY, and GBP/CHF are good choices for day traders since the daily ranges average about 120 pips. Trading activities in these currency pairs are particularly active because these transactions directly involve the U.S. Dollar. When the U.S. Equity and bond markets are open during the U.S. Session, foreign investors have to convert their domestic currency, such as the Japanese yen, the euro, and the Swiss franc, into dollardominated assets in order to carry out their transactions. With the market overlap, GBP/JPY and GBP/CHF have the widest daily ranges.

For the more risk-averse traders, USD/JPY, EUR/USD, and USD/CAD appear to be good choices since these pairs offer traders a decent amount of trading range to garner handsome profits with a smaller amount of risk. Their highly liquid nature allows an investor to secure profits or cut losses promptly and efficiently. The modest volatility of these pairs also provides a favorable environment for traders who want to pursue long-term strategies.


European Session (London): 2 A.m.–12 P.m. EST

London is the largest and most important dealing center in the world, with a market share at more than 30 percent according to the BIS survey.

Most of the dealing desks of large banks are located in London; the majority of major FX transactions are completed during London hours due to the market’s high liquidity and efficiency. The vast number of market participants and their high transaction value make London the most volatile FX market of all. Half of the 12 major pairs surpass the 80 pips line, the benchmark that we used to identify volatile pairs with GBP/JPY and GBP/CHF reaching as high as 140 and 146 pips respectively.

GBP/JPY and GBP/CHF are apt for the risk lovers. These two pairs have an average daily range of more than 140 pips and can be used to generate a huge amount of profits in a short period of time. Such high volatility for the two pairs reflects the peak of daily trade activity as large participants are about to complete their cycle of currency conversion around the world. London hours are directly connected to both the U.S.

And the Asian sessions; as soon as large banks and institutional investors are finished repositioning their portfolios, they will need to start converting the European assets into dollar-denominated ones again in anticipation of the opening of the U.S. Market. The combination of the two reconversions by the big players is the major reason for the extremely high volatility in the pairs.

For the more risk-tolerant traders, there are plenty of pairs to choose from. EUR/USD, USD/CAD, GBP/USD, and USD/CHF, with an average range of 100 pips, are ideal picks as their high volatilities offer an abundance of opportunity to enter the market. As mentioned earlier, trade between the European currencies and the dollars picks up again because the large participants have to reshuffle their portfolios for the opening of the U.S. Session.

For the more risk-averse participants, the NZD/USD, AUD/USD, EUR/CHF, and AUD/JPY, with an average of about 50 pips, are good choices as these pairs provide traders with high interest incomes in additional to potential trade profits. These pairs allow investors to determine their direction of movements based on fundamental economic factors and be less prone to losses due to intraday speculative trades.

U.S.–European Overlap: 8 A.m.–12 P.m. EST

The FX markets tend to be most active when the hours of the world’s two largest trading centers overlap. The range of trading between 8 a.m. And noon EST constitutes on average 70 percent of the total average range of trading for all of the currency pairs during the European trading hours and 80 percent of the total average range of trading for all of the currency pairs during U.S. Trading hours. Just these percentages alone tell day traders that if they are really looking for volatile price action and wide ranges and cannot sit at the screen all day, the time to trade is the U.S. And European overlap.

European–Asian Overlap: 2 A.m.–4 A.m. EST

The trade intensity in the European–Asian overlap is far lower than in any other session because of the slow trading during the Asian morning. Of course, the time period surveyed is relatively smaller as well. With trading extremely thin during these hours, risk-tolerant and risk-loving traders can take a two-hour nap or spend the time positioning themselves for a breakout move at the European or U.S. Open.

Currency Volatility and the Disparity of Currency Outlook

I saw an article on Bloomberg today, discussing the Dollar Forecast Disarray Leading to Higher Volatilityin the currency market (the quoted text are displayed in Italic).

"Redtower Asset Management sees the currency strengthening to $1.16 per euro by year’s end, from $1.3849 today, as the world economy recovers from the first global recession since World War II. Standard Chartered Plc predicts a more stable economy will weaken the dollar to $1.55 as the Federal Reserve keeps its benchmark interest rate near zero to sustain growth, prompting investors to sell greenbacks for higher-returning assets. The 39-cent gap between the high and low calls in Bloomberg’s strategist survey is almost double August 2007’s 20- cent divide. Wider fluctuations increase the risk for so-called carry trades, where money borrowed from countries with low rates is used to invest for higher yields."

Currency volatility has increased dramatically since the credit crunch outbreak in 2008. As shown in the following chart from Bloomberg, over the short term, the 12 week volatility for Euro/USD peaked in December 2008 and then touched the bottom in March 2009, since then, the volatility has picked up significantly by more than 50%. Over the mid term and long term, the 26/52 week volatility followed a rather different pattern as they continued to trend upward into 2009. Nonetheless, the current level is well above its historical norm before 2008 when the crisis began.



Volatility can have a devastating impact on corporate performance, as exporters try to protect overseas earnings. Pittsburgh-based H.J. Heinz Co., the world’s biggest ketchup maker, said on May 28 that its profit fell in the previous three calendar months in the face of “significant FX-related cost headwinds.” Similarly, the heightened volatility in the currency market could put additioanal headwinds for those international airliners, who are already struggling for their diminishing profit base as the economy crisis deepened over time.

Moreover, higher currency volatility could restrict the international investment activities further, in the sense that it makes the cost of international merger and acquisition less predictable and inceases the cost of funding dramatically. The US conglomerate GE announced the £5.7bn deal of acquiring Amersham, the UK medical diagnostics company in October 2003. By the time the deal was completed in May 2004, the dollar had fallen 12 per cent against sterling and GE was forced to pay almost $350m more to close the deal.

Another victims of this heightened currency volatility are probably the emerging market currencies, which have had “a pretty good run” might suffer from increased volatility, as investors flee to safety investments and close their carry-trade posisions quickly.

Deflation or inflation is the question

Today on Bloomberg, there is an article talking about the 36 South Investment Managers Ltd., whose Black Swan Fund gained 234 percent in 2008, is raising money for a new hedge fund, betting that government efforts to pump money into economies could result in hyperinflation.

"Black swan" alludes to the once-widespread belief that all swans are white -- proved false when European explorers found black swans in Australia. A black-swan event is something extreme and highly unexpected.

U.S. President Barack Obama is selling record amounts of debt to try to end the steepest U.S. recession in 50 years, while Japanese Prime Minister Taro Aso has unveiled three stimulus packages worth 25 trillion yen ($261 billion) since taking office in September. Governments around the world selling record amounts of debt may devalue currencies against assets and spark inflation.




Time to think about inflation play?

In the classic investment cycle different types of industry rotate in and out of fashion as the economic cycle progresses, in response to the various stages the profits of each kind of company are most likely to outperform.

Here is a inflation/deflation timing strategy I have developed to help users maximise returns by exploiting this industry rotational phenomenon.