Don’t believe all the hype about record Wall Street bonuses.  (The Big Money)

Taking a longer term look at implied volatility.  (Barron’s)

Bond default rates continue to rise.  (DealBook)

Mortgage REITs are the new vehicle of choice to invest in beaten down real estate.  (WSJ)

Welcome back the uptick rule.  (NYTimes)

What is the best way to assess investment performance?  (New Rules of Investing)

In defense of target-date mutual funds.  (Morningstar via felixsalmon)

Burton Malkiel believes in indexing and China.  (Barron’s)

Just how much trouble is Harvard facing?  (Vanity Fair)

“Big banks present the major risk going forward – to both the economy in general and to smaller banks in particular.”  (Baseline Scenario)

There was a time when banks bailed out the US and not the other way around.  (The Reformed Broker)

How AIG Financial Products brought down the global economy.  (Vanity Fair, Felix Salmon)

The markets want a real turn in the economy.  (Breakingviews)

High unemployment may be with us for awhile.  (FT, The Atlantic)

A surge in inflation is off the table for now.  (Real Time Economics)

The state of Florida just a gust of wind away from running to Uncle Sam.  (finem respice)

“Extraordinary events, both good and bad, can happen without extraordinary causes, and so it is best to always remember the other factor that is always present—the factor of chance.”  (WSJ)

The blogosphere is professionalizing.  (Ezra Klein, Marginal Revolution, 11D)

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What do average sector correlations tell us about future market performance?  (Aleph Blog)

How aggressive are ETF providers in their proxy voting?  (WSJ)

Norway gets it.  (behavior gap)

General Motors says please don’t buy our stock….until next year.  (footnoted, WSJ)

Prime broker ratings.  (FT Alphaville)

Does “crash risk” help explain the returns to the currency carry trade?  (SSRN)

Let’s hope Larry Summers does a better job with the US of A’s finances than he did with Harvard’s.  (Felix Salmon)

A look at a new Economic Momentum Index.  (Carpe Diem)

By a broad measure unemployment has hit 16.5%.  (Real Time Economics also Curious Capitalist, Calculated Risk)

Forget unemployment rates, check out the aggregate hours worked figures.  (Freakonomics)

What?  (Alea Blog)

“The question is whether our financial system is willing and able to extend the credit that would fuel the recovery.”  (Econbrowser)

Where is the Consumer Reports for the financial industry?  (Free exchange)

Is America poised to become a nation of renters?  (The Atlantic)

The Chinese continue their search for a global reserve currency that is not the US dollar.  (FT Alphaville)

Ron Insana starts his newsletter ahead of the game.  (LongShortTrader via agwarner)

The fallout from the Dennis Kneale blog rampage continues.  (DealBreaker, Daily Options Report)

Should finance bloggers write more for a general audience?  (Felix Salmon)

Part one of an interview with Barry Ritholtz.  (Wall St. Cheat Sheet)

Justin Fox on the Daily Show.  (Curious Capitalist)

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“Equity investors’ hope should be that the ennui continues until the economic news catches up with the rally.”  (Breakingviews also Market Talk)

Another measure indicates investor complacency.  (Trader’s Narrative)

Handicapping the next possible bubble.  (The Pragmatic Capitalist)

The MacroShares housing ETPs are more complicated than they look.  (Daily Options Report, ibid)

“High correlations are a signal to start treating market signals with extreme prejudice.”  (Felix Salmon)

Do correlations matter when the world is on fire?  (Abnormal Returns)

Do emerging market bonds still offer value?  (WSJ)

The world’s safest (and riskiest) sovereign debt.  (Alea Blog, ibid)

International REIT performance is beginning to diverge.  (IndexUniverse)

The existence of dark pools of liquidity continue to “pose a continuing challenge to transparency.”  (Dealscape)

Are any and all IPOs getting done so as to boost bank earnings?  (Dealscape)

Should we fear the IPO mania in China?  (Time)

“Madoff was not the biggest crook of this stock market cycle.”  (Dasan)

Not surprisingly the finance industry wants to kill the proposed consumer finance protection agency.  (NYTimes also Atlantic Business)

Is Wal-Mart’s (WMT) support of employer-required healthcare a cynical attempt to hurt its competition?  (Clusterstock, ValuePlays)

“The answer is capitalism’s dirty little secret: excessive lending was the only way to maintain the living standards of the vast bulk of the population at a time when wealth was being concentrated in the hands of an elite.”  (FT via Infectious Greed)

Scoring the debate over the culpability of the CRA for the housing crisis.  (Curious Capitalist)

“By most measure like price-to-income, price-to-rent and real prices, a large portion of the probable [home] price declines are behind us.”  (Calculated Risk)

Zero Hedge vs. Dennis Kneale.  (Crossing Wall Street, Zero Hedge, Market Ticker, Wall St. Cheat Sheet, Clusterstock)

How many kids do you know are running a hedge fund out of their dorm room?  (DealBreaker also FT Alphaville)

Seven interesting investment sites.  (New Rules of Investing)

“I think that the general difficulty that many people have in understanding statistics is an important problem, because it leads people to misinterpret the world around them.”  (Baseline Scenario)

Moneyball the Movie is dead.  The story behind the story.  (NYTimes)

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It is now well documented that asset class correlations tend to one during times of economic and financial market distress.  2008 was nothing if not characterized by economic distress and financial market instability.  Indeed as we exited 2008 an economic depression and the end of the global financial system were at the top of the minds of investors and political leaders alike.

In that sort of environment correlations are, and should be, an afterthought.  As we exited that time of extreme fear we should see a bounce back in the prices of risky assets.  So the high correlations we are seeing are a natural result of the steep fall and equally steep ascent in investor sentiment and market prices.

Let’s think about risky assets for a moment.  By this we mean traditional asset classes like equities, corporate bonds and even commodities and non-traditional assets like private equity, venture capital and things like timberland.  All of these asset classes are dependent on one or both of the following:  a growing global economy and functioning financial markets.

The past year has been characterized by serious doubts about both of these underlying assumptions.   So no matter how far removed a risky asset class is from the mainstream it is dependent on these two factors.  So over time when these are non-factors the underlying correlation structure reflects the dynamics of the underlying asset classes.  These correlations are usually well below 1.0.  When the foundations of the global economic system are in flux, all risky assets trade off of the risk of the entire system.  Hence we see high correlations.

These twin assumptions of a well-functioning global economic system were in part the downfall of the so-called endowment model of investing.  Craig Karmin at WSJ.com documents the difficulties facing the university endowments of the Ivy League and others.  Over the past decade or more their diversification into alternative asset classes and hedge funds has been seen as a means for higher returns, lower risk and a growing stream of income for their respective institutions.  As Felix Salmon at Reuters.com writes:

Big university endowments like to think that their returns constitute alpha — a simple outperformance of the market. But it looks increasingly as though in fact there’s a large component of beta — outperforming when the market goes up and underperforming when it goes down.

The endowment model seems to have failed for two reasons.  The first as we discussed is that this diversification is illusory when the entire system is in flux.  Therefore the overall endowment portfolio was riskier than it appeared based on historical data.  The second is that many of these endowments assumed that they would be able to fund future commitments to private equity and venture capital out of future cash flows.  When the value of every asset declined this implicit leverage was exposed.

Asset class correlations cannot continue to tend towards 1.0 ad infinitum.  Eventually the historical market data of 2008 and 2009 will fade from the calculations.  Economic conditions will (eventually) return to some sort of new normal.  Correlations will fall and traditional portfolio models will again indicate pretty pie charts full of all manner of asset classes.  However what is the thinking investor to do?

Unfortunately there are no simple answers here.  We discussed earlier how one approach might be making your portfolio more active.  Actively timing the market and engaging in sector rotation are ways investors can try to generate active returns that are less correlated with a traditional asset mix.  However take note that active investing necessitates active risk.  This is the risk that your decisions are going to detract from portfolio performance as much as add to it.

An investor could also say:  “Look we escaped a new Depression.  Times will get better and things will revert back to some sort of new normal.  In that case the traditional asset allocation looks pretty good.”  That time may come, but it is not on the horizon any time soon.  One can argue how optimistic or naïve this viewpoint may be.

If traditional portfolio optimization doesn’t work in this environment, what does?  It may be as simple as putting your portfolio into as few as three risk buckets.  The first simply being a risk-free bucket.  By that we mean Treasuries (domestic and foreign and ignoring duration risk), TIPS, insured deposits, etc.  In short, taking as little system-wide risk as possible.  The second bucket would include all risky assets.  By risky we are talking about anything that is vulnerable to economic or financial turmoil.  (We must include commodities here.)  In the third bucket one might put active strategies.  That is if these strategies are flexible enough to move across assets, sectors and into cash, if need be.  One could put many hedge fund strategies in this bucket.

There is nothing particularly sophisticated about this breakdown.  The biggest decision is how much to put into the risk-free bucket.  Near zero cash yields make these assets unattractive for any one needing to generate meaningful returns to meet intermediate and long-term goals.  However that might be the price of operating in an environment where our underlying assumptions about the global financial system no longer hold.

There is a good chance that your portfolio prior to mid-2008 was riskier than you thought.  The assumptions used to construct the asset mix were ultimately proven flawed.  Worrying too much about the fine points of portfolio optimization inputs at this point is probably wasted effort.  As we noted correlations in the future will fall, but that will not erase the risks uncovered in the past year.  We are all now in uncharted territory when it comes to portfolio construction.  Regrettably at this point the questions outnumber the answers.

Does the “golden cross” in the S&P 500 provide any sort of edge?  (Trader’s Narrative)

What happens for the rest of the year after the Nasdaq outperforms the Dow though June.  (Bespoke)

What do overpriced options tell us about market performance going forward.  (Daily Options Report)

“In other words, the 3x ETF FAS is no more volatile or has more uncertainty in its stock price now than XLF did during the period from October through April. Tracking error aside, FAS is now effectively the ghost of XLF.”  (VIX and More)

The VIX is hitting post-Lehman lows.  (The Pragmatic Capitalist, Mish, Crossing Wall Street)

Layering on an inflation fear filter to a simple moving average model.  (The Technical Take)

Times are good on Wall Street.   No wonder salaries are going up.  (WSJ, Clusterstock)

Given their immense reach, how much slack should we cut Goldman Sachs (GS)?  (True/Slant)

Sheila Bair, national hero.  (Clusterstock)

“The poor performance of highly rated credit instruments, especially those tied to the subprime mortgage market, is great evidence that there was something deeply wrong with the ratings process.”  (Clusterstock)

“Financial products must be made more simple for consumers to understand.”  (Aleph Blog)

The new MacroShares home price securities are by no means simple.  (Bespoke, IndexUniverse,  greenfaucet)

The rate of decline in the Case-Shiller is slowing.  (Calculated Risk, Free exchange, Clusterstock, Caveman Forecaster)

High equity portfolio weights hurt private pension funds around the world in 2008.  (Economix)

Emerging market savers financed a spending boom by US households.  (Brad Setser)

“One sign of good judgment is the ability to make wise decisions when information is incomplete.”  (Falkenblog)

Interviews with Denise Shull and Corey Rosenbloom.  (Wall St. Cheat Sheet, Afraid to Trade)

“Monkeys might not deal in stocks and shares, but they do trade commodities, and now it seems that monkey exchange rates are influenced by supply and demand.”  (New Scientist)

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Has the high yield rally run its course?   (WSJ)

“Many ETF investors do far worse than a buy-and-hold strategy.  Essentially, the ETF facilitates all of the worst psychological traits of the individual investor.”  (A Dash of Insight)

Indexing isn’t perfect, but it beats the alternative.  (The Psy-Fi Blog)

Is there a better three-factor model out there?  (Journal of Finance)

General Electric (GE) is benefiting greatly from the TGLP.  (WashingtonPost)

Why are the banks reluctant to see a public auction for their TARP warrants?  (Baseline Scenario, Felix Salmon)

The PPIP is limping along as both buyers and sellers fail to commit to the program.  (WSJ, Atlantic Business)

The $100,000 CRA Challenge goes out.  (Big Picture, John Carney)

The CMBS market is facing a big downgrade.   (Clusterstock)

“A consumer-finance agency is a good thing, but it would do well to teach consumers a simple lesson: if you don’t understand the deal you’re making, don’t make it.”  (NewYorker)

The Chinese like to spend money as much as we do.  (Atlantic Business, Fund My Mutual Fund)

How much longer will the world tolerate US fiscal policy? (Economist’s View)

“Government has no profit motive.”  (Jeff Matthews)

Free is not the only business model in the Internet age.  (NewYorker)

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How the rising number of dark pools of liquidity affects individual investors.  (Barron’s also MarketBeat)

A sentiment overview for the week.  (Trader’s Narrative, Technical Take)

VIX in the mid-20’s here we come.  (VIX and More)

Why do investors continue to bet on the stocks of bankrupt companies?  (NYTimes)

Five reasons why buy-and-hold investing is dead.  (Minyanville)

Why TIPS funds are a hot commodity at the moment.  (WSJ)

REIT funds have done nothing for those investors seeking portfolio diversification.  (Marketwatch)

The iShares All Peru Capped Index Fund (EPU) is heavily weighted towards commodity stocks.  (TheStreet)

Start-up hedge funds are doing things differently to attract investors these days.  (DealBook)

How should we interpret the big jump in the domestic savings rate?  (Infectious Greed, Research Reloaded)

Tough to find many GDP growth highlights in 2009.  (Bespoke)

“If Summers winds up running the Fed, mark my word, inflation will follow.”  (Accrued Interest)

Goldman Sachs (GS) execs have lost their stomach for public service.  (Felix Salmon)

More on the CRA as primer mover in the subprime mortgage meme.  (The Audit, Rortybomb)

An interesting interview with Barry Ritholtz in welling@weedon.  (Big Picture)

Five questions for Justin Fox.  (Free exchange)

Does economics need a new model for human behavior to describe market booms and busts?  (Scientific American, Calculated Risk)

A rising stock price does not absolve the Apple (AAPL) board of directors from the duty to disclose.  (Silicon Alley Insider, Barron’s)

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A longer term look at global equity risk premia.  (Value Expectations)

Individual investors have gotten pretty bearish.  (Bespoke)

The VIX has dropped too far, too fast.  (VIX and More)

Combining the rotation and timing systems.  (World Beta)

Looking back on why some stock picks perform and others don’t.  (Kirk Report)

Evidence that the ETF industry is becoming more competitive.  (greenfaucet)

“..so the mysterious allure of the exotic ETF is undermining the original purpose of these investment vehicles. As usual the investment industry has worked its magic and turned a really useful investment tool into a method for speculating in snake oil.”  (Psy-Fi Blog)

Are their benefits to sector-specific emerging market ETFs?  (IndexUniverse)

A guide to currency ETFs.  (ETF Trends)

It is difficult to find evidence of forced selling of “fallen angel” bonds.  (SSRN)

Commercial paper outstanding continues to fall.  (EconomPic Data, FT Alphaville)

Is there a thaw in the ABS market?  (Atlantic Business)

KKR is not altogether mis-valued.   (Breakingviews)

Some evidence showing that venture capital investments are both risky and profitable.  (SSRN)

Is “plain vanilla” consumer finance going to hurt bank profits?  (WSJ)

“As long as money funds are able to keep bank-like features without bank-like scrutiny, they should keep everyone wide awake.”  (Economist)

Do regulators really know best?  (Time)

The CRA was largely irrelevant to the housing/mortgage crisis.  (Big Picture)

“(I)f hedge funds dig in too deeply with “the crisis was not our fault” position, that is just asking for trouble – and to be scapegoated – down the road.”  (Baseline Scenario)

Using taxes to control bank size.  (Free exchange)

Paul Volcker is the odd man out in Obama administration plans for financial regulatory reform.  (Big Picture)

“If the green shooters are proven correct, the odds of upheaval are close to nil. However, if things get worse, the US may reach a tipping point.”  (naked capitalism)

Why the Internet may be making GDP a less relevant measure.  (Clusterstock)

First interview in a series:  the women of StockTwits.  (Wall St. Cheat Sheet)

Ron Insana is now in the investment newsletter business.  (Dealbreaker)

Reason #237 to drink coffee.  (The Skeptical Hypochondriac)

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Country P/E ratios.  (Bespoke)

“The multi-billion dollar IPO is back - at least in Brazil.”  (Breakingviews)

Have earnings expectations moved ahead of reality?  (The Pragmatic Capitalist)

“Even the best made trading plans and analysis can be ignored after the market throws you a curve ball and administers the equivalent of a punch to the face.”  (Bull Bear Trader)

Target-date mutual funds need some supervision.  (Felix Salmon also NYTimes)

Will rule changes make money market mutual funds “safe again”?  (Atlantic Business, BusinessWeek)

AQR Capital Management gets deeper into the mutual fund business.  (Reuters)

Can mutual funds following hedge fund replication strategies really get the job done?  (market folly)

Two different approaches to building a Buffett-like mutual fund portfolio.  (Morningstar)

“The endgame of the KKR listing is for Kravis and his fellow partners to monetize their stakes in KKR… And if Kravis is to be selling, why should you be buying?”  (Deal Journal also WSJ)

If we shrink Wall Street too much are we at risk of “relinquishing global dominance in finance”?  (WSJ)

A great deal of chatter about the Matt Taibbi article that examines how Goldman Sachs (GS) has been at the forefront of every bubble since the Great Depression.  (Zero Hedge also Felix Salmon)

The Fed engages in a debt-for-equity swap with AIG.  (DealBook)

Is there a relationship between prior stock market momentum and currency appreciation?  (SSRN)

On the relationship between unemployment exhaustion and credit card charge-off rates.  (Big Picture)

Just how strong is foreign demand for Treasury bonds?  (Fund My Mutual Fund)

Economic uncertainty is showing up in forecaster data.  (macroblog)

Don’t scoff at an afternoon nap.  “Numerous studies have now demonstrated that REM sleep is an essential part of the learning process. Before you can know something, you have to dream about it.”  (The Frontal Cortex)

Dan Lyons on why we need Steve Jobs.  (Newsweek)

What does our collective obsession with Steve Jobs’ health say about us?  (GigaOM)

Expanding cap-and-trade…for fish.  (Scientific American)

“Juicing the best picture pool is Hollywood’s version of a stimulus package.”  (The Big Money also Roger Ebert, Clusterstock, Felix Salmon, Marginal Revolution)

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Tracking the natural gas/crude oil ratio for trades.  (Caveman Forecaster, FT Alphaville)

Is the bloom off the Warren Buffett rose?  (Bespoke)

Why are some hedge fund still limiting redemptions?  (WSJ, ibid, DealBreaker)

Country equity performance since the June 2nd top.  (Bespoke)

Some one official finally notes the risk of leveraged ETFs.  (Daily Options Report, Bespoke)

The ETF options space is getting more competitive.  (WSJ)

“Overall, we always felt that iShares operated as a fairly autonomous group within the Barclays umbrella, and it is our belief that it will continue to do so under the BlackRock organization.”  (Morningstar)

Taking a closer look at the iShares Emerging Market Infrastructure Index Fund (EMIF).  (TheStreet)

Adding a transportation twist to the golden cross strategy.  (MarketSci Blog)

Applying a simple momentum strategy to sector funds.  (World Beta)

You can’t trade volatility without delta hedging.  (Condor Options)

Taking a longer term look at the divergence between Russell 2000 and S&P SmallCap 600 performance.  (IndexUniverse)

Start-up hedge funds are finding capital hard to come by.  (WSJ)

Another mutual fund enters hedge fund turf. (DealBook)

Huntsman (HUN) wins by not being acquired.  (Breakingviews )

KKR is going public, now via an exchange for its KPE affiliate traded in Amsterdam.  (DealBook)

Name that bank!  “Basically, there’s nothing right with this bank. It’s got the wrong CEO, the wrong strategy, and it’s got no appeal to investors, while still carrying monster risk for us the taxpayer. It’s time to end this one.”  (Clusterstock)

All hail the brain drain on Wall Street.  (Felix Salmon)

It’s still early, but we are now looking at a “lost decade” for stocks.  (EconomPic Data)

“According to Nishimura’s schema, in less than two and a half years, the U.S. has experienced as much trauma and recovery as Japan did in about 12 years.”  (Newsweek)

Speaking of lost decades, check out what has happened to job growth.  (BusinessWeek also Fund My Mutual Fund)

“The main reason we think the economy is improving is because many of us think the economy is improving.”  (Econbrowser)

A bit of international economic organization schizophrenia.  (FT Alphaville, Clusterstock)

The growing gap between new and existing home sales.  (Calculated Risk)

“Appraisal fraud was an enormous contributor to the unsustainable run up in prices during the boom period.”  (Big Picture)

“These days I’m a bit embarrassed for people continue to deny the CRA encouraged crappy lending practices. The evidence is unequivocal.”  (Clusterstock)

“You think Californians are pissed off now? Imagine the state is literally unable to make payroll. The political backlash would be severe.”  (Accrued Interest)

“The days of calling the dollar almighty may be numbered.”  (WashingtonPost)

Meet the Bank of Canada’s “boring” Governor Mark Carney.  (Walrus Magazine via Freakonomics)

Should Mexico stop exporting oil?  (Gregor Macdonald)

Taking a closer look at the returns to shipping IPOs.  (SSRN)

“Our jobs and the entire airline industry is about to implode, just so you can have your $99 fare.”  (Freakonomics also MarketBeat)

“(T)he health-care industry’s reluctance to digitize its records is rooted in a desire to keep medicine’s lucrative business model hidden.”   (Technology Review via Instapundit)

Coming to terms with Twitter.  (VIX and More)

Should more firms be like Apple (AAPL)?  (Daring Fireball)

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