The modern world is awash in a multitude of electronic gizmos and gadgets; and despite their amazing array of functionality, all of these devices are ultimately composed of simple components designed by electrical engineers to re-direct current flows and redistribute voltage drops. Similarly, the modern investor is confronted with a bewildering line-up of financial instruments, but all of these products are ultimately composed of simple components built by financial engineers to re-direct cash flows and redistribute risks. The main market mechanism to do this is described below:
Let’s look at a toy model of a volatile asset, a widget that is worth $100 today. In the future, it could grow in value to $200 or fall to $50. The widget’s future is uncertain, but the financial world has developed a way to carve new products from this widget that can appeal to both risk-averse and risk-seeking investors – creating a hierarchy of claims on the asset. First, a risk-averse investor could purchase a senior claim on the asset that will pay $50 dollars in the future. Second, a risk-seeking investor could purchase a junior claim on the asset that will pay whatever is leftover after the senior claim is satisfied – in this model $150 or $0. Thus, from one volatile widget, we have created a risky asset and “safe” asset – safe only in the toy model world.
The process above is repeated over and over again in the real world. For example, a business and its future cash flows are a volatile asset. But they can be divided up into senior claims (those who lend the business money) and junior claims (those who buy equity in the business). Equity owners can get higher returns on their stakes if the business thrives, but they also have greater risk of losing their money. Similarly, a house can go up and down in value, and if a person gets a mortgage to buy a home, the mortgage provider has a more stable, senior claim on the property while the home purchaser (or mortgagor) has a riskier, junior claim.
Claims on assets are also easily composed in finance. Banks own a large collection of business loans and mortgages, and they can issue claims on these assets. The most senior claims are bank deposits, while the junior claims are bank equity. Thus in an abstract sense, a bank account is the composition of a senior claim on another group of senior claims.
However, the composition doesn’t stop there. Banks can sell their loans and mortgages to other parties who can compose and decompose these assets into products that fall into the general category of collateralized debt obligations (CDOs). In the early 2000s, CDOs could get very convoluted with offerings that were senior claims on junior claims of seniors claims of a pool of sub-prime mortgages. This complexity brought a lot of confusion about the true risk involved in owning the assets, and it was this capacity for opacity that helped contribute to the subprime mortgage crisis in 2007 – 2008. Thus, while in electrical engineering the ability to create complex compositions of simple parts has provided the world with smartphones and cloud computing, the societal benefits of financial contrivances is far less certain.
On Tuesday, October 12th, the fixed income portion of the Fortunatus Asset Allocation models made an adjustment to its holdings to increase its duration. On Wednesday, October 13th, the Fortunatus Emerging Growth Companies equity model added a new position in the solar energy industry.
There were no other trades in the Fortunatus models during the week ending on October 16th, 2021. The major equity market sectors remain in a long-term favorable trend, and the Fortunatus Asset Allocation models are near their maximum allowable equity exposure with domestic stocks favored over international shares.
Past performance is no guarantee of future results. Trend signals are proprietary research of Fortunatus Investments, LLC, a Registered Investment Advisor with the Securities and Exchange Commission (SEC). Reference to registration does not imply any particular level of qualification or skill. Prior to June 2014, Fortunatus Investments was a wholly owned subsidiary of Executive Wealth Management, LLC and they continue to share common ownership and control. Data source for returns is FactSet Research Systems Inc. This chart is not intended to provide investment advice and should not be considered as a recommendation. One cannot invest directly in an index. Executive Wealth Management does not guarantee the accuracy of this data.
Quote of the Week
To believe the American economy has suddenly entered a new inflation regime, one must shut the door on 40 years of economic history and venture off into the unknown. It will take a lot, and by that we mean several quarters, if not a few years, of hot inflation data to alter market perceptions.
Nicholas Colas, co-founder of DataTrek Research, responding to growing concerns that the U.S. has entered a new era of stagflation – a combination of economic stagnation and inflation.
On a Lighter Note
Due to the felonious nature of its founding stock, most people have assumed that Australia’s unsolved crimes had human perpetrators. Not so fast. Recent research in forensic science has concluded that a koala’s fingerprints are indistinguishable from a human’s, even with the use of a microscope. This makes us wonder what we actually know about the koala – the so-called “teddy bear of the trees.”
Well, first of all, the koala bear isn’t even really a bear – that is just an identity it assumed back in the 1980s in attempt to land a role in the movie Crocodile Dundee II. Wikipedia says the koala is actually a marsupial, and what do marsupials have? Hidden pouches, no better place to stash ill-gotten goods. And scientists say that koalas are always seen sleeping in the trees because they are nocturnal. But who else is nocturnal? That’s right, burglars.
I think we need a gumtree gumshoe to go sleuthing around these slothful tree dwellers to find out their true intentions. It is just sad that koalas may have taken this pilfering path because historically Australia’s animals have been diligent in upholding law and order, kangaroo courts are well known in legal circles for their unique jurisprudence.
Unfortunately, attempts to confront the koala about the unsolved case of the eucalyptus leaf thief were met with nothing but hostility:
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Returns are calculated as indicated below with reinvested dividends not considered except for the Barclays U.S. Aggregate Bond Index. Data source for returns is FactSet Research Systems Inc. The London Gold PM Fix Price is used to calculate returns for gold.
1 Week = closing price on October 8, 2021 to closing price on October 15, 2021
1 Month = closing price on September 15, 2021 to closing price on October 15, 2021
3 Month = closing price on July 15, 2021 to closing price on October 15, 2021
YTD = closing price on December 31, 2020 to closing price on October 15, 2021
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