Thursday, December 31, 2009

What Could Go Wrong in 2010?

Yesterday’s entry listed a number of things that could go right in 2010, and that could potentially be catalysts to extend the cyclical bull market. While the list is valid and all the points are worth considering, there are also many counterbalancing risks that we are faced with as we enter the new year. Below are some concerns that we will be keeping a close eye on:

  • A wave of Option-ARM mortgage interest resets has the potential to kick off a fresh round of mortgage defaults, which could put renewed pressure on housing, the financial sector, and credit conditions (see chart below).

  • A re-bubbling of energy prices could potentially push gas prices over $3/gallon and dampen economic growth.

  • The sugar high emanating from Cash for Clunkers, homebuyer tax credits, and other creative stimulus initiatives may simply wear off and leave the global economy facing the possibility of a double-dip recession.

  • The cyclical economic upswing could begin to run into the stiff headwinds created by the “new normal” (more regulation, higher taxes, continuing deleveraging, higher domestic savings, etc).

  • Tariff wars between the U.S. and China could intensify, which has the potential to increase geopolitical tensions, stoke inflationary pressures, and would give China another reason to use their vast holdings of Treasuries as a financial weapon.

  • The nascent improvement in employment could stall, leaving wages and consumption constrained, and preventing top line growth in earnings from materializing.

  • The commercial real estate market could continue to erode and overwhelm small banks that don’t have government backstops.

  • Parts of the Eastern European banking system could collapse. This has the potential to cripple the global banking system and could test the Euro’s status as a secondary reserve currency.

  • A major rise in the value of the dollar (based on credit concerns) could bring back deflationary conditions, while a disorderly dollar drop (based on money printing and massive deficits) could create a spike in interest rates that would be a disaster given the amount of debt in the system.

  • Inflation expectations could begin to rise and put pressure on the authorities to begin removing stimulus too early.

    The above are only some of the items we will be watching closely in 2010, which will be taken into account as we shape our view for the next few quarters. The entire Pinnacle Team would like to wish everyone a happy, healthy and prosperous New Year! See you on the other side…

  • Wednesday, December 30, 2009

    What Could Go Right in 2010?

    2009 is about to become a memory, and as Carl Noble recently wrote, what a remarkable year it was! Over the next week the investment team will be wrestling with many issues that will impact our future outlook and asset allocation; such as will inflation or deflation be a bigger force over the next six months? Can consumer spending make a comeback in spite of stiff headwinds? When will the monetary and fiscal authorities begin to remove excess liquidity? Today I thought it would be fun to put together a list of things that could potentially turn in a positive direction and keep the bulls running in 2010:
    • Confidence could build on a foundation of continued healing in credit markets, rising asset prices and net worth, and the general feeling that monetary and fiscal authorities have successfully avoided Armageddon.
    • The steep yield curve and rise in financial assets prices could continue to aid banks and the financial system by building in a profit backstop and helping to keep capital ratios healthy.

    • Employers, after slashing payrolls to the bone, could go one step beyond firing less and begin to hire back employees.
    • Higher employment could fuel wage growth and bolster spending. This could stick a stake in the heart of the “new normal” theory, and potentially unleash a wave of new buying from previously defensive investors who may be at risk of underperforming a benchmark, or are simply tired of hearing about how much more money their friends made at the latest cocktail party.
    • Capital spending could increase markedly based upon improving profits, rebounding corporate confidence, and low capital costs. Earnings could continue to improve based on top line revenue growth as opposed to relentless cost cutting.
    • The demand for credit could increase, banks could start lending more, and the velocity of money could begin to expand and give fresh legs to the upturn currently in progress.

    • The slack created by the deep recession could keep inflation at bay for some time and give central banks plenty of room to avoid withdrawing stimulus too quickly.
    • Economic data could continue to steadily improve, to the surprise of those who are counting on a double dip recession or a post-stimulus economic relapse.
    • The aggregate of all of these inputs could simply create more confidence, more spending, and more earnings, and yes, a positive feedback loop could emerge…

    Investors must always retain a healthy appreciation regarding downside risks to their forecast and allocations, particularly given the asymmetric law of numbers that exists. But risks are not a one way street, and being too early to withdraw volatility can be just as wrong as being too late to get defensive. Those who manage money can’t just focus on the negative scenarios, which is one reason we will be thinking about what could go right in 2010.

    Tuesday, December 29, 2009

    Remarkable Year for Stocks

    With 2009 winding down, it seems like a good opportunity to look back at what a remarkable (to put it lightly) year it’s been for stocks. The S&P 500 Index opened the year at 903, in the midst of an historic bear market after tumbling by more than 600 points from its October 2007 high of 1,565. Stocks closed higher for the first two days of 2009, but then suddenly turned and crashed to new lows as the financial crisis intensified, before ultimately reaching a bottom at 666 on March 6th. The top to bottom decline in the S&P was a staggering -57%, making the 2007-2009 bear market the worst since the Great Depression.

    Since then, however, stocks have rallied nearly uninterrupted for more than 9 months. Yesterday, the S&P closed at a fresh 2009 high of 1,127, having rebounded by almost 500 points from its March nadir, which has certainly been welcome relief for investors. While impressive, stocks have merely returned to where they were last October. They still haven’t fully recovered their pre-Lehman Brothers level, which was 1,250 on the S&P 500.

    In percentage terms, the S&P has soared by 69% since March, but remains -28% below its October 2007 high. Based on how the math works it actually requires a 39% gain to get back to the old high from here. While anything’s possible, we don’t view that as a high probability outcome in 2010. We believe that stocks may be able to grind somewhat higher as the economy continues to recover, but investors need to prepare for the possibility of a deeper correction as the current bull market ages.

    Chart: S&P 500 Index 2007-09

    Thursday, December 24, 2009

    Steep Yield Curve Signals What?

    Many astute investors follow the shape of the Treasury yield curve for clues as to the future direction of the economy. The yield curve is simply the difference in yield between Treasury securities of various maturities. When it’s steep, meaning that yields on longer-dated securities are higher than yields on shorter-term securities, it’s typically interpreted as a signal of strong future economic growth. On the other hand, when the difference, or spread, is very narrow, or even “inverted” (short-term yields higher than longer-term yields), it’s believed to be warning of an oncoming recession. While seemingly quite simple, the yield curve has proven to be a very reliable indicator over time.

    Recently, the 2-Year/10-Year U.S. Treasury yield curve reached its steepest level ever. This means that the difference in yield between 10-year and 2-Year Treasuries grew to its widest margin in history (approximately 2.75%, as shown on the chart below). This seems odd, since the current consensus seems to be that we’re destined for several years of a “New Normal” with lower than average growth potential. So is the consensus just wrong, or is the yield curve signaling something different this time?

    One scenario with a growing following has more to do with the latter. With high unemployment and extremely high debt levels, a growing number of economists are becoming increasingly worried about so-called “sovereign default risk,” or the previously unthinkable chance that the U.S. (and other major countries) may not be able to fully meet their ballooning obligations in coming years. Consequently, investors are demanding higher compensation in the form of higher yields on longer-term securities due to the perceived increase in risk, while the Federal Reserve keeps rates on short-term securities artificially low, resulting in the wide spread. In addition to sovereign risk, worries of rising future inflation expectations due to central banks around the world pumping liquidity into the system through all of the various Quantitative Easing strategies may also be pushing yields on longer-term securities higher. Whatever the true reason may be, the record-steep yield curve is just another indicator that we’re watching very closely at this critical juncture.

    Wednesday, December 23, 2009

    “This or That is Going to Happen”

    I have often written about the industry’s insistence on denying that professional investing has anything to do with making forecasts. Making forecasts is all about making market “predictions” and market predictions seem to be no different than selling snake oil to the suckers who will do anything to believe in a cure. Here is what one of our favorite fund managers, John Hussman, has to say about forecasts in his Weekly Market Comment (Clarity and Valuation, Dec 21, 2009):

    Probabilities, however, are not certainties. If the probability of a given event is “p”, then the probability of “not that event” is (1-p). This, in my view, is what makes probabilities and average outcomes different from forecasts. When people forecast, they say, “this or that is going to happen,” and very often they establish investment positions that will do them a great deal of harm if they are incorrect…”

    There is no doubt that an investor who makes asset allocation decisions based on a forecast that says, “this or that is going to happen,” is taking on a very large risk that his or her forecast could be incorrect. At Pinnacle, our asset allocation is based on our best assessment of the economic and market data as we see it in “real time.” We are all about assessing the risks to our forecasts, if that’s what they are. We want to better understand our level of conviction in our forecasts, because if we have a low conviction forecast we are going to allocate assets closer to our pre-agreed benchmarks for risk that we’ve established with our clients, and we are going to be more diversified in our approach to sectors, countries, industries, etc. As we get closer to being able to say, “this or that is going to happen,” our conviction is higher in our forecast and we can have large deviations from our benchmark and more concentrated positions in the portfolio.

    So, Pinnacle makes a different kind of forecast. Instead of saying “this or that is going to happen,” we say, “We have a high or low conviction in the probability of this or that happening.” I guess I’ll stick to my guns and proudly say that our statement about the probabilities of future events occurring still constitutes a forecast, and I will let others deny that they make them at all. Either way, we strongly believe that our approach gets to the heart of the matter, which is that no one can know the future with certainty. Those who invest as though they do should beware.

    Tuesday, December 22, 2009

    Behavioral Psychology: Admitting You Are Wrong Can Save You Money

    “In this business if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.” – Peter Lynch

    Investing is a demanding profession that requires constant attention to a multitude of perpetually moving parts. As hard as many investors work to come up with well-formed theories that lead to intelligent and accurate forecasts and ultimately profitable trades, the reality is that no one is correct all of the time. As human beings, we are always at risk to heuristics, which are ingrained traits that explain how people solve problems and make decisions, but can also lead to systematic errors and biases. An example would be anchoring, which according to Wikipedia occurs when people place too much importance on one aspect of an event, causing an error in accurately predicting the utility of a future outcome.

    As a practical example, earlier this year the investment team here at Pinnacle made a decision to hedge our portfolios with an Exchange Traded Note (ETN) that attempts to mimic an index of implied equity market volatility. At the time, we were concerned that several different market indicators were warning of a possible market decline. If the correction occurred, we believed there was a high probability that market volatility would rise, and the value of the ETN along with it, which presumably would have helped offset some of the decline in other parts of the portfolio.

    As it turned out, the correction was shallower than expected, and we were quickly down on the trade. At that point we were faced with reassessing the position given the most up to date market conditions. Had we anchored to our previous view based on outdated information, we could have decided to simply hold the security and hope our view panned out in the longer term. But hope is not a strategy, and as it turned out it was our willingness to assess the newest information available and admit that we were wrong that aided us in making the decision to sell the security. It wasn’t an easy decision and it felt awful to book the loss. But as bad as it felt to sell at a loss and admit to a failed trade, it would clearly feel worse if we were still a holder of the ETN today, given that it’s down an additional 20% from where we sold it.

    Successful investing is largely about having a repeatable process, doing the homework, having conviction, paying attention to detail, and not being afraid to go against the crowd. But it also takes a certain amount of humility to admit when one is wrong. Make no mistake about it, knowing when to admit you are wrong can save you money.

    Friday, December 18, 2009

    Technical Take: Keep an Eye on New Lows

    Technical analysis is one of the main building blocks of our forecasting process, along with fundamental macro analysis and valuation. It involves the study of many different market-based indicators, including momentum, sentiment, breadth, volume, divergences, etc. We believe that different market environments require different levels of emphasis on each part of our process, and I think it’s fair to say that today’s liquidity-driven market requires that we devote more attention than normal to the technical condition of the financial markets.

    During the current stock market rally, one of the strongest technical measures has been market breadth, which gauges the number of advancing versus declining stocks. Typically, in a healthy bull market advancing stocks significantly outnumber declining stocks, and in bear markets the reverse occurs. One market breadth measure that we’ll be keeping a particularly close eye on is the number of new 52 week lows in the marketplace. The indicator is fairly straightforward – as the name implies, it’s simply the sum of the number of individual stocks that have fallen to a new 52-week low.

    Below is a chart that plots the Bloomberg New 52 Week Lows on U.S. Exchanges Index (blue line) against the S&P 500 Index (red line). It shows that as the market began to rebound in March, new lows fell dramatically and have stayed very subdued ever since. Lately, however, new lows have been slowly rising, and even closed above some key moving averages. At the moment it’s too early to tell if new lows are in the early stages of an important trend change, or if this is another false breakout like we’ve already seen several times this year. Either way, we’ll be watching new lows closely for signs that the current bull market is running out of steam.

    Thursday, December 17, 2009

    European Warning Signs

    With the help of the European Central Bank (ECB), Austria announced on Monday that they were nationalizing its sixth largest bank, Hypo Group Alpe Adria. The bank was relatively small with assets of over 40 billion euros; however, it was considered a subsidiary of the German state controlled bank Bavaria BayernLB. BayernLB is much bigger with 416 billion euros in assets on its balance sheet, which is why this news sent systemic risk shivers down the ECB’s spine. This event certainly adds to recent fears surrounding the stability of the European banking system, and coupled with sovereign (individual country) risk has brought the European Union into the limelight.

    Some of the ominous headlines over the past few weeks have included “Dubai’s Debt Default Shakes World,” “Credit Agencies Downgrade Debt Linked to Greece and Dubai,” and “Ireland, Greece May Leave Euro.” The accompanying stories highlight the serious risks that exogenous, or external, events contain. Central banks worldwide recognize that they must continue to flood the system with liquidity in order to maintain asset price levels and avoid contagion. Loan losses and debt burdens are still important issues that nations must face as we move into a “real” recovery. The hope is that all the stimulus “juice” will lead to this real recovery before the debt burdens cause sovereign defaults, which would have very negative implications if they occur.

    At the moment, the market seems to be handling the news quite well. There were a few hiccups directly after the Dubai and Greece announcements, but stocks quickly recovered to their recent highs. Currency movements have been a little more noticeable. The U.S. dollar has started to move higher versus the Euro, although the downtrend started in March remains intact. Bearish bets on the U.S. dollar have been decreasing lately as investors take profits in that trade and cautiously position themselves for year end. This is an interesting development and we will be watching closely since many positions held by Pinnacle have benefited from a falling dollar.

    Monday, December 14, 2009

    Why? Because.

    Over the weekend I was reminiscing about a college professor, Dr. Hill, who actually asked the all-feared question on our philosophy final – “Why?” Being angered at the time at the stupidity of this question I wrote “Because” and walked out of the classroom. I later came to learn that anyone who actually attempted to answer the question got a “C” on the exam. The answer “Why not?” earned a “B,” and my well considered “Because” earned me an “A” on the final. I’ve been thinking about that answer lately because in the investment business, it’s important to know what investors believe in answering the question “Why?”

    In the early 20th century, the French mathematician, Bachelier, gave us the first quantitative model for pricing options that relied on the idea that since it is impossible to figure out why prices move in a mathematical formula, it’s best to assume that price changes each day are the same as flipping a coin. He used the mathematics of his day for price movements (Brownian motion) and for volatility (standard deviation) to derive a formula for option pricing that looks very similar to the Black Scholes option pricing model used today. Using the mathematics of probability and statistics to make assumptions about the probability of price changes has been the rule for academics ever since. Markowitz’s Modern Portfolio Theory relies on the same assumptions and the same math to give us the notion of efficient portfolios. For academics, the answer to “Why?” would be to say, “Wrong question.” Modern Portfolio Theorists assume we can’t know “why,” and so they use past data to make inferences about future returns – a process called the stochastic method in science.

    For active portfolio managers and value investors of every stripe the answer to “Why?” probably falls into one of two categories. If the answer has anything to do with interest rates, fiscal and monetary policy, earnings, currency, geopolitical news, etc, then we would consider these investors to be traditional value investors who find the answer to the question “Why?” in these and many other well known metrics of economic and financial health. If the answer to “Why?” is determined by the study of market prices, then we would characterize these investors as technical investors. At Pinnacle we expend enormous effort to find both traditional and technical answers to the question of why prices move. The academic approach is misused, misunderstood, and frankly dangerous for investors who think that the answer to “Why?” can be found in past data without understanding the “because.” I agree that actually finding the one reason that prices move is an impossible objective. But ignoring the news and the behavior of investors can only make you money in a long-term bull market, a state of affairs that may not be in the cards for quite awhile.

    Friday, December 11, 2009

    Accounting Rules in the Spotlight – Again

    Earlier this year, a lot of attention was paid to “mark to market” accounting (officially, FASB rule 157). The debate was heated, as critics of the rule blamed it for dramatically worsening the financial crisis, while proponents argued that it improved transparency. The rule was ultimately relaxed in March largely due to pressure from Congress (even though the Financial Accounting Standards Board is supposedly an independent organization). That change helped stem the losses flowing out of the financial sector and helped spark the huge turnaround in financial markets.

    Now, a new set of rules from the FASB is ruffling some feathers again. FASB rules 166 & 167 require financial companies to bring many of the assets held in off-balance sheet entities back onto their balance sheets by early next year, which could impede the healing in that sector by requiring additional capital to be raised by those firms.

    It remains to be seen exactly what the impact of the rules will be, but the market may already be anticipating a negative outcome. After rocketing off the March low and leading the market higher for several months, financial stocks have recently been underperforming. Whether that’s directly related to the new rules or is just a temporary pause isn’t entirely clear yet. We currently have only a very modest weighting in Financials due to the many ongoing challenges in the sector, and will be paying close attention to how they act as the rules take effect.

    Chart: Financial Sector ETF (red line, top panel) vs. S&P 500 ETF (blue line, top panel) with relative strength (green line, lower panel) – Financials have been underperforming since 10/14

    Thursday, December 10, 2009

    Risk Management: The Markets Never Sleep

    When we came into work on Monday, we were greeted with the news that Jeffrey Gundlach, the long-time portfolio manager of the TCW Total Return bond fund and the TCW Strategic Income closed end fund, had been “relieved of his duties” over the weekend, according to reports. While we don’t know the full details of what happened, it appears that there was some sort of disagreement with upper management, and they decided to take action and replace him with a new, outside portfolio management team.

    Mr. Gundlach is widely respected as one of the leading experts of mortgage-backed securities. We purchased his fund late last year with the thought that his fund would be the best way to invest in beaten-down mortgage securities, which we believed were offering a very attractive investment opportunity at the time. Indeed, as shown on the chart below, his fund is up over 20% this year, which is a tremendous return out of a bond fund. We were certainly disappointed to learn of his departure. When we also learned that his top assistants had also stepped down, we decided we needed to take action and sell the fund, since there was clearly a material change at the top involving those managing the fund.

    Bombshells like these don’t occur very often, but when they do it requires an immediate review of that holding. In today’s environment the news comes fast, and markets never sleep. This is an example of the sort of risk management that Pinnacle provides for its clients.

    Monday, December 7, 2009

    We Don’t Sell Performance Here

    Pinnacle Advisory Group, like most private wealth management firms, doesn’t “sell” our portfolio performance. The broader industry doesn’t sell performance because they are strategic, buy and hold, asset allocators and investment performance is considered to be completely random depending on the whims of the investment markets. It is far better to “sell” relationships. The relationship sale is much less dependent on volatile market performance that can be good or bad in any year, and much more dependent on selling things like trust, communication skills, dependability, organization, and financial planning benefits of all kinds. We understand the difference between selling features versus selling benefits, and clearly investment returns fall under the category of features. What are the benefits that we sell? It turns out that they are pretty much the same as those sold by the rest of the industry. In addition to the benefits mentioned above, how about less stress, more confidence in the future, and the ability to be happy in your life worrying about something other than finances. And of course, we sell ourselves.

    I know we don’t sell investment returns, but it’s interesting to note that Pinnacle’s investment analysts got every major turn in the market correct since the end of the bear market in 2002 when we first started to actively manage money. The net result of overweighting risk in managed accounts in early 2003, underweighting risk by the summer of the 2007, and adding risk back to the portfolios by the beginning of 2009 has been a huge BENEFIT to our clients. They have earned higher returns with less risk than an unmanaged benchmark of stocks and bonds with similar risk/reward characteristics. Our moderate growth portfolios are generally only a few percentage points away from making all-time highs. A comparison to Morningstar’s Moderate Allocation universe of funds, which are managed with a similar risk exposure to our moderate growth portfolios, would result in our being ranked among the top 5%…if we were a mutual fund. This propensity to outperform is an interesting FEATURE to keep in mind.

    For consumers of Pinnacle’s investment services, they will have to evaluate exactly how we managed to outperform. Is our process systematic and repeatable? What is the likelihood that we will continue to make good decisions in volatile markets? If we make a mistake, is it likely to be a big mistake or a small mistake? Could our clients do better themselves, or can they find another firm that does it better? These are all good questions and we stand ready to provide the answers to the best of our ability. But don’t misunderstand us…we don’t sell investment performance here.

    Friday, December 4, 2009

    Is the Pace of Recovery Slowing?

    The economy has made significant strides over the course of this year. In fact, as most are aware, it returned to a positive 2.8% growth rate in the third quarter, after four consecutive quarterly declines. Of course, there is still much work to be done before the economy returns to a healthier overall state, but it’s been encouraging to see progress being made. We’ve been in the camp that believes the recession most likely ended sometime during the summer, and have highlighted many indicators along the way that were signaling an imminent recovery. However, one of those indicators has recently rolled over, causing us to question whether the pace of recovery is slowing.

    The Citigroup Economic Surprise Indicator is a quantitative measure of whether or not daily economic reports are exceeding economists’ expectations. Prior to most economic releases, dozens of economists are usually polled for their predictions. A median of those results is then calculated, which serves as the “consensus” view. If the actual result is higher, it’s considered to be a “positive” surprise, and vice versa. This indicator is designed so that it rises as positive surprises outpace negative surprises. In other words, economic momentum is building. On the other hand, when it’s declining, as it is now, economic data is falling short of expectations, indicating that economic momentum has stalled, and that the economy may soon weaken.

    As shown on the chart below, the indicator bottomed last December, several months before equities, and soared higher into early June – clearly ahead of actual improvement in the economy. It then moved in a volatile, sideways fashion during the summer, but has recently rolled over and fallen back to where it was in March. This has certainly caught our attention, but since other economic measures and market-based technical indicators we follow are still holding up, we remain cautiously optimistic for now.

    Thursday, December 3, 2009

    Is the Job Picture Improving?

    Yesterday, the ADP National Employment report, named so because it was created by Automatic Data Processing, measured employment as falling by 169,000 jobs from October to November, on a seasonally adjusted basis. ADP’s report is considered to be a good gauge of what to expect from the Bureau of Labor Statistics’ (BLS) employment report, which is released two days later. November’s drop in the ADP report was the 23rd straight month in which the economy shed jobs; however, it was also the 8th straight month in which jobs cuts were less than the previous month (the low for the series was in March of 2009 with a decline of 736,000). Below is a chart of the monthly change in ADP employment, with the 0 level marked by the red line.

    There are two lines of thinking when viewing this chart and job losses. The first would be the bullish case that employment is a lagging indicator, so the recent progress proves that the economy has been improving since the March lows, and very soon the report may show the economy actually gained jobs (many analysts believe that may occur by February 2010). The second line of thinking is the bear case and focuses on the other side of the labor market – hiring. From their point of view, this has been the mother of all jobless recoveries and business hiring has still not shown signs of improvement.

    It will be interesting to see how the market reacts to the BLS data tomorrow. If we get a better than expected number (125,000 job losses are expected), then the bull case of improving economic conditions could finally push the S&P 500 above the 1,100 to 1,115 range it has been in for the last two weeks. If the number disappoints, however, it could serve as the catalyst to drive an overbought market lower.

    Wednesday, December 2, 2009

    Dubai, Divergences, and a Santa Claus Rally?

    Late last week, the markets hit a pocket of turbulence on news that Dubai World requested an extension on debt payments of approximately $60 billion. The knee-jerk reaction was that stock markets tanked, the dollar rose, gold, oil, and commodities fell, and risk assets were roiled, for a day. News networks heated up and talk of a possible second wave of credit losses cascading through markets like the 1997-98 Asian Contagion was the concern du jour. Personally, I don’t think it’s much of a shock that Dubai is having some problems. I mean come on, anyone that’s watched the Discovery channel has probably seen the documentary about the creation of the Palm and World islands. Not that the place is not really neat, but it doesn’t take a genius to know that indoor ski slopes, manmade islands, and spectacular office structures may seem a tad extravagant in good times, never mind while much of the world has just suffered through the worst economic crisis since the Great Depression.

    Perhaps more concerning to me than Dubai is that there are a number of technical divergences that are building within the marketplace. Some examples are that neither the Dow Transportation Index nor Small Cap stocks have kept pace with the S&P 500 Index recently, previously healthy breadth (advancing vs. declining stocks) has caught a case of halitosis as the A/D line is sagging, the number of stocks making new lows is creeping higher after a long slumber, and volume is steadily falling. We aren’t the only ones noticing these divergences – some of the most bullish analysts we follow are beginning to change the tone of their bullish commentary, with the market rally beginning to look a bit weary after its torrid rise. Add a short-term extended market to the mix and you could make a good case to simply get defensive right now.

    But it’s never that simple with markets, and there are a few things keeping us from getting more defensive just yet. Liquidity in the marketplace remains buoyant, momentum is still positive, the trend of most economic data is continuing to improve, and we are coming into the season of the so-called Santa Clause rally, which is the moniker Wall Street uses to describe the historical tendency for stocks to rally at the end of the year. The bottom line is that we are diligently monitoring incoming data (as always), and our strategy remains flexible, but for the time being we are cautiously keeping portfolios positioned for neutral volatility.

    Chart Source: Jim Stack, InvesTech Research

    Monday, November 30, 2009

    Risk Management and Money Markets

    I recently watched a video where a Chief Investment Officer stated that by utilizing a risk management methodology that allowed them to go to cash or money markets, “they were making the type of risk management used by large investors available to small investors.” Let me be clear about this. Large institutional investors will NEVER take a portfolio to a 100% cash position in order to best manage risk. I can think of two major reasons why that is the case.

    First, institutional portfolio managers of large state, union, and corporate pension funds, endowment funds, and family offices for very large private accounts, are virtually all well-schooled in modern portfolio theory. These MBAs, Ph.D.s, and CFAs, believe that time diversification and asset diversification are the best methods to manage risk. Second, large institutional pension funds use an actuarial approach to managing risk by matching the maturity of their liabilities with the duration of their investment assets. For employees retiring 25 years in the future the investment with the highest return premium and the longest duration is common stock. For these investors, owning cash represents an unacceptable risk of mismatching assets and liabilities. The closest institutional investors might come to “going to cash” is to allocate some small and manageable portion of the portfolio to money managers that run strategies that allow them to zero out their “long” stock positions. Hedge funds in the market neutral and long-short space often get to 0% long exposure to stocks. However, these allocations typically represent a small allocation in an institutional size portfolio. In Pinnacle portfolios we call these managers “eclectic managers” and they currently represent about 10% of our total portfolio allocation.

    Pinnacle Advisory Group does not go to 100% cash for reasons that having nothing to do with the views of institutional investors. I believe the basic idea that stocks will always deliver a premium to bonds and cash over long time periods is a dangerous proposition that can’t be proved by past data. Buying stocks at high valuations offers the virtual certainty of underperformance over long time periods. However, the reason that we don’t go 100% to cash is for the simple reason that doing so implies that you have 100% certainty that your forecast is correct and I don’t believe investors should take that risk. I realize that cash offers safety of principal in volatile bear markets and I also realize that certain investors will find comfort in a timing strategy that allows them to get 100% out of the stock market. I have no problem with their definition of risk or with a money management firm that offers it to their clients. I have often stated that active management comes in many flavors and consumers will choose managers that they believe in. But I do take issue with the idea that implementing extreme asset allocations at market turns is bringing the best risk management techniques of large investors to the masses. It is the little guys who go to cash. For the largest investors, it would never happen.

    Monday, November 23, 2009

    Contrarian Thinking

    “Nevertheless, clearly there have been periods when the crowd and the consensus is right, particularly in extended bull markets, contrary opinion seems to be of greatest value at market extremes (lows and peaks).” - Steve Leuthold, View from the North Country, November 2009

    Steve Leuthold is one of our favorite analysts and we also happen to own his fund, the Leuthold Core Investment Fund, in many of our managed accounts. I believe that his views on the consensus are right on the button. Value investors are always looking to invest differently from the consensus, but sometimes doing so results in missing out on large investment gains easily available through momentum investing, the very definition of investing with the consensus. I thought it would be an interesting exercise to list out a few of the consensus views of today’s investors:

    • The economy moved from recession to expansion sometime in June or July.

    • The dollar is in a secular (long-term) downtrend.

    • Economic growth in the developed world will be subject to “the new normal,” meaning that it will be significantly lower than the historical averages for some time to come.

    • Economic growth will be led by emerging markets, especially China, as opposed to developed countries like the U.S. and Japan, England, or the Euro zone.

    • U.S. consumers will spend less and save more as they repair their personal balance sheets over a period of years.

    • The Federal Reserve will not raise interest rates for the foreseeable future.

    Because these are consensus views, investors have presumably priced them into today’s security prices. We happen to subscribe to the consensus view at the moment, but we are also on the lookout for those opportunities that occur when the consensus is wrong. As Leuthold says, contrary opinions have the greatest value at market extremes, but I don’t think we are there quite yet. Even so, we are currently hedging the consensus view with a variety of securities in the portfolio. The hedges won’t make us money while the consensus reigns, but they are essential ingredients of sound risk management when markets are trending as they are today.

    Friday, November 20, 2009

    Are Negative T-Bill Yields Cause for Concern Again?

    Yesterday, yields on T-bills that mature early next year traded at slightly negative yields. Amazingly, what that means is that investors are so desperate to park their money in these short-term instruments that they’re willing to lock in a loss on their investment! This is clearly unusual, to say the least. What could possibly behind this seemingly boneheaded investment decision?

    There is some speculation that large financial institutions are attempting to “clean up” their balance sheets before the books close for this year by transferring some of their immense cash holdings to short-term Treasury securities. If that’s the case, then maybe it’s no big deal. But, there may be some cause for concern, since the last time this occurred was during the worst of the credit crisis last fall, when distrust among financial institutions was at its peak. Demand for what was perceived as the safest possible investment option – a very short-term Treasury security, which is thought to have no credit risk and virtually no interest rate risk – was so high that it drove prices of T-bills higher, and their already miniscule yields into negative territory. As the crisis has slowly abated this year, yields on T-bills and other securities across the credit spectrum have been gradually normalizing as well, until the past couple of weeks when T-bills have again been in high demand.

    After last year’s credit disaster, we regularly review a host of credit market indicators and relationships. So far, the action in T-bills isn’t being reflected in other areas, like credit spreads or LIBOR rates, which were under tremendous pressure a year ago. Therefore, we aren’t too concerned yet, but we’ll certainly be paying close attention to see if other signs of possible stress reappear.

    Chart – Generic 3-month Treasury Bill Yield

    Thursday, November 19, 2009

    Credit Markets, Liquidity, and Potential Asset Bubbles

    Recently, one of the bearish analysts we read every morning alerted us to the fact that credit default swap premiums for government debt in the U.S., U.K., and Japan have been increasing in price lately. As a reminder, a credit default swap (CDS) is a derivative contract that is usually purchased by an owner of a debt security in order to hedge against a default by the debtor. For years we have lived within a system where government debt, particularly in the U.S., was assumed to have zero credit risk since it can not only borrow in the deepest, most liquid market in the world, but can also print money via the printing press should the need arise. However, as these CDS spreads rise, the market is beginning to price in less faith that the large developed countries, including the U.S., are 100% credit worthy.

    Reasons for the recent rise in the cost of protecting against default seem quite reasonable, as the “Great Recession” has forced many developed countries to borrow vast sums of money to help patch together the financial system. And while things have worked so far, and the global economy seems to be slowly recovering, the markets are acknowledging that new imbalances are currently building and new risks are rising. Some analysts argue that there is room for debt to rise before public borrowing crowds out the private sector, while others are convinced the public debt binge has us on the precipice of a death spiral for the U.S. dollar.

    I think it’s fair to say that the new imbalances and risks are the price we are paying for pulling out all the stops to contain the bleeding within the global financial system. But I also think it’s important to keep things in perspective. Excesses and bubbles can take years to build before they unwind. Even as the risks build, one must respect that the amount of liquidity in the system, combined with very low yield levels, may produce new asset bubbles that run further and longer than most currently anticipate. We will continue to monitor fundamentals and be mindful of current risks in the backdrop. But we will also be watching for areas that may be in the midst of developing into the next financial mania.

    Wednesday, November 18, 2009

    Playing Chicken

    Playing chicken is a game where two players play and one wins if the other loses his or her nerve. An example might be two cars racing towards each other at high speed where both drivers know that one of them will have to turn in order to avoid a dangerous collision. The loser is the driver who turns first. Of course the loser is called the “chicken.” For most of us, avoiding dangerous games of chicken comes under the category of common sense, and for investors the idea of playing chicken is the opposite of sound risk management.

    Nevertheless, I can’t help but think that the current market environment for investors is something akin to playing chicken. The stock market is being driven by accommodative fiscal and monetary policy that can’t be continued indefinitely. The Federal Reserve has expanded its balance sheet with a dizzying array of programs called TARP, TALF, PPIP, and more, all designed to bail out banks that are too big to fail. In addition, the Fed is buying bonds in the open market to add even more liquidity to the mix. The resulting yield curve is very steep and cash yields nothing, driving investors into risk assets in the short run. Another not so surprising result of 0% interest rates is a falling dollar, which is another bullish development for corporate earnings - in the short run. Third quarter GDP was a strong 3.5% fueled in large part by stimulus programs that distorted both new home sales and auto sales. Finally, momentum investors and carry traders who borrow dollars at 0% interest rates and invest them in stocks, commodities, and bonds worldwide are having a field day. After all, we’ve seen this play before. The last time the central bank reduced interest rates to such low levels for such a long period of time was in response to the 2000-2002 market crash/recession, and the result was a five year bull market in virtually every risk asset class around the world. The stock market is exhibiting all of the symptoms of a momentum and liquidity driven bull market. After last year, who wants to miss out on this action? In fact, many institutional managers simply can’t afford to miss any of these gains considering the horrifying results they turned in last year.

    But….the stock market is beginning to get expensive. The ten-year normalized P/E ratio for the S&P 500 has climbed over 20 times earnings from a low of 13 times earnings in March. Stimulus programs are due to end. At some point the dollar is sure to rally. Higher taxes, higher regulation, and higher savings rates are looming in the near future. It’s hard to find an analyst who thinks this bull market will take out the 2007 highs. So investors are nervously trying to stay invested, looking to see who will be the first to get out of the game. It feels like a game of chicken to me. We are hurtling towards the market top at the end of this cyclical bull market….and if you are the first one out and the market continues higher you lose. However, of great interest to investors is that in this game of chicken, being the last one out of the market will create the biggest loser.

    Friday, November 13, 2009

    Consumer Confidence Slipping

    The preliminary reading of November’s University of Michigan Index of Consumer Sentiment was released this morning, and it declined for the second month in a row. The index fell to 66 (versus estimates for an increase to 71). After reaching 96.7 in January 2007, it fell sharply for the rest of that year and through most of 2008, before hitting bottom at 55.3 last November. The index is based on a survey, with two underlying components – Current Economic Conditions and Consumer Expectations, with Expectations receiving about twice the weight.

    There’s been a lot of discussion recently regarding the eventual withdrawal of some of the tremendous fiscal and monetary stimulus that’s been unleashed on the financial system. Consumers’ spirits have certainly been lifted over the past few quarters by some of those efforts, including the rebound in asset prices, tax cuts, the homebuyer’s tax credit, Cash for Clunkers, etc. But as the recovery continues and authorities eventually try to wean the economy off of some of these temporary supports, consumers’ reactions will be critical. So far, it’s not overly alarming that there have been back to back monthly setbacks. But if consumers react poorly as various stimulus measures wind down, it could be an important sign that the economy is still too fragile to grow on its own.

    Wednesday, November 11, 2009

    Transparent Portfolios and Hedge Transactions

    Last week we put on a hedge transaction in our managed accounts by buying an Exchange-Traded Note (ETN) designed to track the VIX volatility index. Like many institutional money managers, we have been cautiously participating in a bull market characterized by enormous liquidity-driven momentum. As the price of the stock market continues to float well above both its short-term and long-term trend lines, each dip in price raises the specter that the market will finally take a well deserved breather, having rallied by close to 70% in the 8 months since the lows set in March of this year. Last week, for the first time in months, the market closed below its 50-day moving average and we thought it was prudent to manage the risk that the market might continue to correct down to its 200-day moving average, a normal event for a correction in a bull market, but would result in a further 11% or greater market decline.

    By choosing the VIX (Chicago Board of Options Exchange Volatility Index) as our hedge we were betting that if the market sold off, then volatility would dramatically increase from very depressed levels. Having watched the index jump by about 15% as the market fell to its 50-day moving average, we were betting that it could move an additional 30% or more if the correction continued. Unfortunately, we stopped out of this trade with a 12% loss as the market turned on a dime and headed higher again. Our 4% position lost 12% resulting in a “cost” for putting on the hedge of approximately 0.48%, plus transaction costs, plus the cost of whatever interest we lost from selling cash and bonds to put on the trade (which were minimal in our estimation). We view this “cost” as a very acceptable price to pay for managing the risk that the market is due for a significant correction, even if it didn’t turn out to occur last week. In our view, it certainly was better than selling our current risk positions in an attempt to time a short-term market decline. Buying and selling the VIX was an easy transaction to put on and take off, and while the results didn’t work out, I view the risk and reward of this transaction as not only acceptable, but necessary in volatile markets like these.

    In my book, Buy and Hold is Dead (AGAIN), The Case for Active Management in Dangerous Markets, I write that one of the challenges that active portfolio managers must meet is transparent portfolios. By transparent, I mean managed accounts where clients can see the transactions in their portfolio, in contrast to investing in say a hedge fund or a mutual fund where the client does not see the transactions in the fund. The reason that transparency represents a challenge to active managers is that each client can view portfolio transactions through the lens of whatever their personal investment biases happen to be. In this case our hedge position has resulted in a very short-term transaction that resulted in a loss. We will have certain clients reasonably asking for an explanation for this trade…..concerned that the transaction lost so much in so little time. And we will have some of our wealth managers asking the same questions…since they have to explain this to our clients (SIGH). I don’t think anyone will be thrilled when we do a similar transaction the next time the market rolls over so far above its long-term trend line.

    Friday, November 6, 2009

    A Letter to “Do –It- Yourself” Investors

    I was on a radio show today and I was asked, once again, to give advice to listeners who were contemplating active management for their portfolios. This may sound self-serving, but I’ve given the matter a great deal of thought and the best advice I can give is don’t do it. If you are going to invest your own funds and you are not willing to spend hours studying the financial markets each day, then my best advice is to diversify your portfolio and buy and hold. Yes, I am the author of a book called, Buy and Hold is Dead (AGAIN), but it simply makes no sense to attempt to tactically or actively manage a portfolio without a huge investment of your time.

    Why? Because actively managing money today is one of the most difficult crafts you could possibly try to learn. The combination of being in a secular bear market where risk assets are likely to deliver less than average returns combined with a financial environment fraught with any number of new and hard to understand risks makes active management itself a high risk proposition - if you don’t know what you are doing. I have spent the last decade unlearning buy and hold investing strategies and learning how to actively manage money. I do it for a living. I am surrounded by professional analysts who do nothing but eat and sleep investment research all day long. And when we meet to discuss today’s bewildering market environment where there are so many variables to consider, so many risks to discount, and so many possible outcomes to consider, our discussions require our very best in terms of experience, expertise, and judgment. I know that individual investors don’t want to hear this, but for the most part they should stay out of the way. Professional investors like me will take your money in the arena of the marketplace.

    It’s time to let a professional actively manage your portfolio. I know you’ve managed your portfolio by yourself for years, and yes I know that you had a bad result with financial advisors in the past. But if truth be told you probably haven’t made much money over the past decade, and there is a good chance the financial markets won’t bail you out for years to come. It’s time to let someone who knows what they are doing manage your money. If you still insist on doing it yourself, then buy and hold. Diversify your assets and take what the market will give you. It isn’t the best strategy, and it could cost you your retirement if the bear market continues, but at least you won’t screw up and make a big mistake trying to actively manage your portfolio in difficult markets like these.

    Thursday, November 5, 2009

    Indexes Often Mask Underlying Trends

    It’s an accepted practice in the world of investing to report investment performance or trends based on broad indexes. That’s why you typically hear media outlets reporting the Dow Jones Industrial Average or the S&P 500 Index as representative of the overall stock market. While there’s certainly nothing wrong with that, simply focusing on these broader indexes can mask important underlying trends taking place. For example, the S&P 500 Index consists of 10 broad sectors. So far this year, the top performing sector (using sector ETFs) is Technology, with a 36.6% return. On the other hand, the worst performing sector is Utilities, with a mere 1.3% gain. Of course, if you take this a step further and focus on the individual stocks, the discrepancy is much, much wider.

    The same holds true with commodities. We’ve owned a broadly diversified commodities fund that tracks the Dow Jones/UBS Commodity Index for several years. The index consists of 19 underlying commodity futures contracts. The security we own (which is an Exchange Traded Note) has performed fairly well this year; it’s up 15.8% so far. But since we know that several individual commodities are up much more than that, we were curious what's been holding it back. As shown on the chart below, it turns out that the very economically-sensitive base metals (aluminum, copper, etc) have performed the best in response to the unfolding economic recovery, energy (oil, gasoline, etc) and precious metals (gold, silver) have also done very well, but the agricultural commodities (corn, wheat, soybeans, etc) have lagged.

    The point here is that drilling down below the surface can often reveal important underlying trends that can be much different than what’s implied at the broader index level. And with a growing number of more targeted investment choices, we have more options than ever to try and take advantage of this effect, which may provide additional opportunities to add value for our clients.

    Chart - Base Metals (red), Energy (blue), Precious Metals (green), Agriculture (pink)

    Wednesday, November 4, 2009

    Well…That Was Easy

    The Pinnacle investment team has been patiently waiting for a serious correction in the recent torrid bull market for months. To us, a correction in a bull market means something like a 10% - 15% decline – enough for us to feel good about buying a dip in an upwardly trending market. Unfortunately, the market has not given investors the opportunity to jump in and buy a dip for months, with the closest thing to a correction being a 7% decline that occurred from June 12 to July 10 earlier this year. But now, for the first time since July, the tone of the market seems to be changing with the market once again declining 6% from its high of 1097 on October 19th. We are going to implement a hedge position as a trade to take advantage of a possible nasty short-term correction. It seems like it aught to be easy enough to do, but…

    • Should we hedge by buying a 2X position in the U.S. dollar assuming the dollar will rally on a market decline, or buy a 2X inverse S&P 500 Index fund that should earn two times the decline in the market, or buy the VIX volatility index (Chicago Board of Options Exchange volatility index)?

    • If we choose the VIX, can we be comfortable with the tracking error between the exchange traded note for the VIX Index (ETN available through iPath called VXX) and the actual underlying VIX index?

    • If we put on the hedge, where do we get the cash to execute the trade? We have some cash in our managed portfolios for the buy, but what else needs to be sold to take a 4-5% position in the hedge?

    • We first looked at this transaction last week and since that time the VIX has had a big move to the upside. Is it too late to buy it now that it moved more than 10% higher last week?

    • We executed a complicated transaction in our fixed income allocations last week and now we can’t execute the hedge trade until the prior week transactions settle. Will the market allow us to still get in while we wait the extra days for the prior trades to settle?

    • One of our analysts feels like we have seen the ultimate top to this cyclical bull market that began in March of this year and so he likes the hedge trade. Another analyst is worried that we won’t get much more on this correction and doesn’t like the trade. Another analyst thinks the trade works as is.

    For Pinnacle’s investment team, the details of this transaction are just business as usual.

    Tuesday, November 3, 2009

    ISM Manufacturing Continues to Signal Economic Healing

    Yesterday, the Institute for Supply Management’s manufacturing survey, an important growth barometer that we monitor, exceeded expectations (55.7 versus analyst estimates of 53). The Institute was founded in 1915, and is a non-profit trade group with a membership base of more than 40,000 supply management professionals and associations. On a monthly basis it releases separate surveys that measure activity in both the manufacturing and service sectors of the economy. Yesterday’s manufacturing report was constructed by surveying more than 300 firms on different aspects of manufacturing conditions (see table below for the composite (PMI) and its underlying components). Readings above 50 represent expansion and readings below 50 indicate contraction. Some might question why investors follow the survey due to the shrinking percentage of GDP that is derived from manufacturing, but we feel that manufacturing still captures the ebb and flow of the business cycle, and therefore is well worth watching.

    What the survey does well is capture the directional movement within manufacturing, what it doesn’t do well is measure the magnitude of the growth or contraction. For example, 50 and above implies growth, but tells you nothing about how robust that growth might be. Some of the individual components of the report were encouraging, particularly employment and production, which had robust gains for the month. The bears may take solace in the weaker new orders component, which could be spun as a harbinger of what will occur as Cash for Clunkers and other stimulus programs expire. At Pinnacle, we don’t put too much emphasis on any one data point, as there is a lot of noise that can occur. However the trend of the data is very important. The latest data point is the third in a row above 50, which seems to confirm that the strong leading indicators we have written about previously correctly anticipated future growth.

    Currently, the market appears to be in the middle of a long overdue correction where good data is being brushed over. That’s not all that surprising given recent overbought conditions, and it’s possible that negativity may intensify before this market adjustment is complete. Right now seems to be a time for investors to tune out the headline noise, and focus on the overall weight of the evidence coming out of the data we are following. There’s no guarantee how the data will unfold going forward and we will continue to remain flexible in our forecast, but the ISM data seems to reinforce the idea that the economy is in the midst of healing after a particularly nasty down cycle. If that’s true, than the cyclical bull market should have room for further upside after we work through the current rough patch.

    Friday, October 30, 2009

    Pinnacle’s Proprietary Investment Process

    Of late, for one reason or another, I’ve spent a lot of time describing Pinnacle’s investment process. For the record, the best explanation of our process is that we have a multi-faceted approach to decision making that considers fundamental or traditional valuation analysis, analysis of business and market cycles, as well as technical analysis of investor behavior. This is but another example of why we believe in diversification, although in this case it results not only in portfolios with diversified asset holdings, but a portfolio where decisions are based on more than one kind of analysis.

    I’ve written previously in this space that I believe that investors who are interested in active management will first explore the technical method of tactically allocating portfolios. Using technical analysis has many benefits, perhaps the most important of which allows the advisor to develop several “rules” for following favored indicators. These rules then become a quantitative approach to decision making that is relatively simple and relatively effective. Most of the active managers that I’ve reviewed are using some type of quantitative system based on simple trend following or momentum rules – all of which are based on technical investing techniques such as relative strength, oscillators, trend lines, etc. The resulting system becomes a “proprietary decision making process,” a very valuable product to sell to investors. For the record, a proprietary process implies a secretive, valuable, exact, scientific, repeatable process that no one else can duplicate.

    At Pinnacle we have also developed a proprietary investment process. It’s called “doing the work.” Unfortunately our process requires us to make qualitative as well as quantitative decisions about asset allocation. And to my knowledge, there is no easy way to make a decision based on the weight of the evidence as determined by our judgment, experience, and expertise. For us it means slogging through the 100-plus economic releases each month to find clues regarding the market cycle, Fed policy, currency direction, etc. It also means reading daily, weekly, and monthly research reports from dozens of brilliant analysts who disagree with each other all of the time. Marrying this process with our own proprietary quantitative approach is nothing but hard work. But it sounds a lot better when we call it our proprietary investment process. For the record, our proprietary process is inexact and messy, but I have a great deal of confidence that it is the lowest risk method for making investment decisions.

    Thursday, October 29, 2009

    Portfolio Construction – Embracing Different Expressions of the Same View

    I have the unusual mandate of being the lead portfolio manager for both our most aggressive (Dynamic Ultra Appreciation) as well as our most conservative (Dynamic Conservative) model portfolios. Some might think that managing the tail ends of the risk spectrum is a recipe for a mental breakdown, as one has to have an almost schizophrenic mindset that changes from an emphasis on maximizing investment returns to minimizing potential losses, depending on which model is being analyzed. Actually, it doesn’t bother me a bit, because our process is tailor made to deal with such a job. Our investment team is constantly evaluating our three primary building blocks (macro fundamentals, market technicals, and valuation) in order to develop a forecast. While our forecast certainly directly influences overall portfolio allocation, it doesn’t mean that we have to buy and sell the same securities or execute trades at the same time in policies that have very different objectives. In fact, our process and philosophy encourage us to treat each model independently when applying our forecast.

    As an example, right now we are cyclically bullish due to improving fundamental data and the positive technical condition underlying the financial markets. As a result, we’ve tilted most portfolios towards reflationary assets, which we believe have the most appreciation potential in the current environment. We have the highest percentage of these explosive assets in our most aggressive portfolios, because we think they will make the most money if we are correct that the bull market has more cyclical running room. However, we also clearly recognize that these assets (like emerging markets, late cyclical equity sectors and commodities) are typically very volatile, and simply don’t synch up with our mandate to protect principal for our most conservative clients. Therefore, our Dynamic Conservative model has almost no reflationary assets in the portfolio. Instead, for those clients, our pro-cyclical view is reflected mostly in the fixed income arena in the form of a material percentage of lower quality credit. This is just one example of how we can have one unified view but two very different policy objectives, which require very different portfolio allocations.

    At Pinnacle, we manage all of our portfolios using the same philosophy, process and investment views, but we never lose sight that our clients are different people with different goals and risk tolerance. Therefore we embrace having both a unified view of the world, and many ways to express that view through our portfolio construction.

    Wednesday, October 28, 2009

    Consumers Facing Rising Gas Prices – Again

    Bad news for the already fragile U.S. consumer – gas prices are on the march again. They mostly drifted sideways throughout the summer during the initial stages of the economic recovery, but they’ve climbed to $2.68/gallon over the past few weeks (using the AAA Daily National Average Gasoline Price from Bloomberg). Last year’s rollercoaster ride is probably still fresh in most drivers’ minds, when crude oil soared to $145/barrel and pump prices rose to over $4/gallon during the summer, only to collapse to $1.62/gallon by December as economic activity ground to a halt.

    It’ll be worrisome if the recent rise continues, since consumers are already struggling under the weight of several well-documented issues, including rising unemployment, falling home prices, restricted access to credit, and falling wages. Now, they again face the prospect of higher gas prices, as businesses bring more and more idle resources back online, causing demand for commodity inputs to increase. U.S. consumers have certainly proven to be a resilient bunch for a long time, but they are being challenged mightily at present. It will not be a welcome development to see gas prices surge appreciably higher, since they effectively act like a tax by siphoning off additional dollars that consumers are already being more discerning about as they tighten their belts in the current environment. A surge in energy and other commodity prices similar to last year’s is on our list of risks to watch for that could short-circuit the economic recovery.

    Friday, October 23, 2009

    Smart Money

    There are a few indexes that are very useful in confirming an existing trend. As the market continues to rally, it is perceived to be a good sign when these confirmation indexes are also rallying to new highs. One such index is the Smart Money Flow Index, which is an offshoot of other last hour indicators published by Wall Street Courier. The index measures the market movement in the first 30 minutes and the last hour of trading. The first thirty minutes of trading is generally considered emotional trading, driven by greed or fear based on the overnight news. Therefore it is used a contrarian signal, which means that the index will subtract market gains or add market selloffs during this period. The last hour of trading is dominated by large institutions, or smart money, as they take the day to evaluate price action and execute orders in a big way. These big traders have the best research or information available to them, and therefore you would want to trade with them. The index will add market gains or subtract market selloffs during this period.

    Below is a chart of the Smart Index from 11/1/08 to 10/22/09. As you can see from the chart the smart money is rallying with the overall market and confirming the strength in the market. This index has also been very useful in calling market bottoms and market tops. Going into the March lows, the index did not reach new lows when the Dow kept falling which signaled that most sales were due to ‘dumb’ money. That was an important sign as the heavy hitters were less fearful than other traders. We will keep monitoring this index for signs of divergences. If the market continues to rally and this index flatlines then it might be a signal that a near term top could be forming.

    Thursday, October 22, 2009

    Earnings Watch – Start Paying Closer Attention to the Top Line

    It’s hard to believe, but another earnings season is underway, and at this point about 30% of S&P 500 Index companies have already reported quarterly results. So far, the quarter is mirroring the prior several quarters in that actual earnings are down for 7 out of 10 sectors, but 9 out of 10 sectors have reported positive earnings surprises (earnings that were ahead of consensus analyst estimates). What may be different this quarter is what investors are expecting in order to keep the rally moving. For two straight quarters positive earnings surprises were enough to move an oversold and nervous market higher. But going forward, additional gains are going to require an improvement in “top line” growth for companies, meaning a pickup in core business sales and not just better earnings based on cost-cutting.

    Looking at the sales numbers so far gives a far less rosy picture than earnings, particularly when it comes to expectations (see data from Bloomberg shown below). The good news is that the Conference Board’s Leading Economic Index was up again today, and continues to imply improving economic growth and a pickup in sales at some point in this recovery. However, this common sense logic only works if the leading indicators function as well as they used to, given the current credit-constrained and deflationary environment (last I checked the velocity of money is not included in any of the leading indicators).

    Let’s hope the leading indicators are still reliable, because after the rally we’ve experienced off the bottom, the market is no longer undervalued or oversold. In fact, it’s fair to say that on a short-term basis the market is very overbought. Momentum investors can certainly prop up markets temporarily, but they can also turn on a dime given the right catalyst. The bottom line is that we better see a pickup in sales sometime soon, otherwise a lack of organic growth may become the negative catalyst that causes a long overdue correction in the financial markets.

    Tuesday, October 20, 2009

    Found: A High Conviction Forecast

    Task number two this weekend was to catch up on my investment research, a seemingly endless proposition that punishes my weekly tendency to procrastinate in my reading. Task number one was to write a marketing brochure for Pinnacle to use in a potential new venture. I have written our story so many times that it’s difficult to get overly enthusiastic about doing it again, but I am the Chief Investment Officer and explaining what we do is a big part of the job. An important part of our story is our belief that relative value investing makes sense. For us, relative value essentially means that we will vary our portfolio construction based on our conviction in our investment forecast. We measure our success in earning excess returns for our clients by comparing our results to a portfolio with a fixed asset allocation. The special name for this hypothetical portfolio is our benchmark, and if we are successful in identifying good investment values we will earn excess returns relative to our benchmark.

    While pondering (once again) how to explain the intersection of benchmarks, value investing, tactical asset allocation, and high conviction forecasts, I decided to take a break and read a research piece from Lombard Street Research called, Deflation to hit Germany and America. Charles Dumas is the well respected analyst who penned this somewhat technical and very detailed piece on his views regarding the outlook for deflation in the U.S. and Germany. While I shouldn’t have been rewarded for deviating from task number one to dally in task number two, I couldn’t help but be struck by the certainty in Dumas’s forecast. In fact, the Pinnacle investment team reads hours and hours of research, and I can safely say that Dumas went way out on the limb of high conviction writing. Here are a few examples:

    “For the time being, with stock and house prices down some 30-40% from their peaks, people worrying about booming asset prices causing inflation have to be seriously detached from reality.” Or, “In these conditions, financial collapse centered on the dollar is verging on the impossible.” And my personal favorite, “To talk of inflation resulting from this is plain stupid.” I say bravo to Mr. Dumas. We highly value analysts who advance clear points of view and back them with sound analysis. This is not to say that I personally agree with Lombard’s deflationary case for the world, which is by the way, rather gloomy reading. However, it is a good reminder of how our investment process works. When we occasionally have the same level of conviction as Mr. Dumas, Pinnacle clients can expect larger rather smaller deviations from our benchmark portfolio. And if our forecast is correct, it is from these conditions that we would typically generate the most excess returns for our clients.

    Friday, October 16, 2009

    International Demand for U.S. Debt Remains Steady

    Each month, the U.S. Treasury Department issues their Treasury International Capital report, which contains detailed information on international demand for U.S. securities. Normally, the report is not a headline grabber, and may only get a passing reference (if that) by most media outlets. But lately, some investors are paying more attention to this report, since the value of the U.S. dollar has come under increasing scrutiny. Since March 9th, which was the same day that equities bottomed, the dollar has fallen by -15% (on a trade-weighted basis), while the S&P 500 Index has rallied +62%. Since some countries (particularly China and Japan) have purchased very large quantities of U.S. Treasury debt, they aren’t exactly thrilled that their dollar holdings are falling in value, and have been very vocal lately about their desire to create some sort of new, global currency as an alternative to the greenback.

    But for all the rhetoric, it seems that demand for U.S. debt has remained fairly steady. On a 12-month rolling average basis, foreign entities purchased $337 billion of U.S. Treasury notes and bonds in the year through August. As shown on the chart below, net purchases have held in a range of roughly $200 - $400 billion for the past several years, and foreigners haven’t been net sellers since earlier this decade. Part of the issue is that despite public statements, some countries have such large reserves that they don’t have realistic alternatives to Treasuries right now.

    We’ll continue to monitor this data to see if these countries begin to back up their words with actions going forward, which could have very negative implications for the buck. But for now, it seems to be just a lot of posturing.

    Thursday, October 15, 2009

    Are Contrarian Signals Flashing?

    Behavioral studies in finance are a fascinating subject that attempt to prove how irrational we as humans can be, and how those traits carry over to the world of investing. At Pinnacle we try to use this valuable information to be contrarian investors at times. A contrarian by definition is a person who invests contrary, or opposite, to popular opinion when crowd behavior moves market prices to extremes, either too high or too low. As investors stampede into or out of different “hot” investments, the market often catches the masses off guard by making sudden, violent moves in the opposite direction (Tech stocks in 2000 are the most glaring example). This week, we have picked up on a few signals that have raised our contrary antenna.

    Barron’s Magazine is a respectable journal in the finance community, but nevertheless they are still a part of the media and are subject to over exuberance at times. On October 12th, the magazine ran a story about the salvation of Bill Miller, the famous mutual fund manager who struggled mightily the past few years, titled “It’s Miller Time.” The article explains that the Legg Mason Value Trust Fund managed by Mr. Miller is “up a whopping 37.52% so far this year, putting it in the fifth percentile of all large blended-fund returns.” First, congratulations to him on the big rebound, but come on, “It’s Miller Time?” His fund cratered by -72% from the top of the market in October 2007 to the bottom in March, which was much worse than the S&P 500’s frightening -55% plunge. That means his fund is still down 45% from the market top! If that’s “Miller Time,” then I’ll be reaching for the Silver Bullet.

    We switched TV stations in our office from CNBC (disparagingly referred to as “Bubblevision” by some critics) to Bloomberg, coincidently right at the March lows. However, yesterday even Bloomberg surprisingly paraded the Dow 10,000 hats normally reserved for Bubblevision. We hear the argument that 10,000 is a very important psychological level, but more and more people seem to be partying like it’s 1999. CNN has an article this morning titled “Stocks look beyond Dow 10,000.” With bullish excitement building, it would not be surprising to see a short-term market peak sometime soon. And then it will be time to see if the fundamentals justify this run, or if it is time to become a contrarian and head for the exits in the face of the rapidly growing enthusiasm.

    Wednesday, October 14, 2009

    Retail Sales, Spending & the Magnitude of the Rally

    Yesterday, a weekly retail same-store sales report was better than expected, with a +0.6% monthly gain versus expectations of a -2.2% decline. The chart below shows the Johnson Redbook Same Store Sales Index on a year over year basis, and as you can see it recently climbed into positive territory. This index is a sales weighted index of same store sales, or sales in stores continuously open for 12 months or longer. It is broad based, and according to Bloomberg, it represents over 80% of the official retail sales data collected and published by the Department of Commerce. Just this morning the Census Bureau published the advance retail sales numbers for the month of September, and they were better than expected, but still fell by -1.5% for the month, and -5.7% over the past year. Much of the pullback from the prior month’s gain came in the form of Cash for Clunkers payback, as auto sales was the biggest contributor to the monthly decline.

    We’ll continue to watch retail sales and consumer spending closely, as spending may hold the key to the duration and ultimate magnitude of the current bull market rally. If the stimulus that fueled the current cyclical rally can create a sustained upturn in spending, than there is a chance that a material healing in top line revenue growth could be in the offing. Stronger revenue growth could feed into better profits, firmer employment, healthier income and net worth, higher assets prices, and ultimately the creation of a self-reinforcing feedback loop that keeps this bull market humming for longer than most anticipate. This would be the best case scenario and we would love to see it unfold. But as investors, we need to constantly look forward with objective analysis and healthy skepticism. We are encouraged by recent numbers, but are also fighting against growing complacent regarding the recent improvements, particularly since some of the stimulus that has supported recent spending has already been withdrawn (Cash for Clunkers) or is scheduled to wind down over the next quarter (first-time homebuyer’s tax credit and the Federal Reserve’s Treasury purchases). Enjoy this rally, but don’t get too comfortable.

    Friday, October 9, 2009

    Are Bonds and Stocks Telling Us We Are in a Sweet Spot?

    The dollar continues to fall, reflation trades rage on for the moment, and risk assets are currently in vogue. But has anyone noticed that Treasury bonds have been rallying, too? How could it be that government bonds, which usually thrive off poor economic news and financial misery, could rally at the same time as the high-flying equity markets that benefit from economic and profit growth? Some of the technical (non-fundamental) reasons for the rally we’ve seen recently include ultra-low returns on cash causing nervous investors to seek something safe with a better yield, central banks that continue to park large reserve balances in bonds because of a lack of better alternatives, and banks that would rather buy Treasuries because they’re still reluctant to lend. Some will look at the divergence between bonds yields and stocks and conclude that one market has to be wrong - either bonds are correct and the economy is softening, which is good for bonds and bad for stocks, or stocks are correct and the economy is improving, which is good for earnings and stocks but bad for bonds.

    I have a different view, which is that lower yields may be just be signaling that inflation is currently not a problem. One only has to look at the very low levels of capacity utilization, the large negative output gap (the difference between potential GDP and actual GDP), and slack in the labor markets to realize that the economy has plenty of room to grow before inflation pressures build. That has created a sweet spot for equities, allowing them to rally in unison with a cyclical rebound in economic activity without having to worry that the Federal Reserve will be pressured into prematurely tightening monetary policy. We won’t always be in this sweet spot, and at some point much higher or lower yields will probably portend either a tightening environment or very poor future economic growth, neither of which would be good news for the equity markets. But for the limited window that this goldilocks sweet spot exists, I suppose we should all try to enjoy it!

    Wednesday, October 7, 2009

    Consumer Credit Still Declining

    Today, the Federal Reserve announced that total U.S. consumer credit fell by $12 billion in the month of August (a drop of $10 billion was expected). The index, which covers most short term and intermediate term credit including credit card debt, has now declined for the seventh consecutive month as consumers are borrowing less money, saving more, and paying down their existing debt (see chart below). It is not surprising to see this behavioral change as unemployment continues to grind higher, and hopes for a consumer led recovery are slowly crushed.

    As the consumer is currently 70% of the economy in the U.S. this is definitely a near term headwind as we recover from the worst recession in 70 years. And most experts expect this decline to continue as unemployment will remain at elevated levels, banks continue to reduce credit lines available to the consumer, and new credit card reforms hinder their growth. However, this is a very important trend leading to long term, positive fundamentals in our economy. Americans are starting to get their budgets in order and ridding themselves of excessive debt but watch out world – you will have to pick up the slack in demand!

    Monday, October 5, 2009

    Thoughts on Investment Time Horizons

    Sometimes I pine for the good old days at Pinnacle when the prime ingredient for measuring investor success was patience. Back in the day when we were strategic buy and hold investors, the returns of the asset classes that we owned in our portfolio were assumed to be a given, as long as we waited long enough for them to appear. Since the underlying theory suggested that markets were always efficiently priced, and since our clients agreed that returns could and should only be measured over the “long-term,” we could asset allocate our portfolios based on past returns. With the backing of the financial media and virtually all of our industry pundits and thought leaders, everyone involved agreed that patience was the key to success.

    Times have certainly changed for the Pinnacle investment team (Truth be told, in the old days we didn’t have a Pinnacle investment team because there wasn’t a need for one!). Today we actively manage portfolios to take advantage of changes in asset class valuations, changes in the market cycle, and changes in market internals such as investor sentiment. The challenge of this strategy is that in today’s markets the data comes fast and furious and the financial markets can be influenced by the news in unforeseen and unpredictable ways. The inevitable result of such fluid market conditions is that the holding period for securities in the portfolio continues to shrink. Where we used to hope to hold equity positions for periods of years, we now would be happily surprised if that were the case. The market rally since March 9th is a good case in point. As the markets have violently rotated from defensives to early cyclicals to late cyclicals, investors who were not nimble enough to follow the cycle missed out on excellent opportunities for excess returns.

    Last week, our portfolio manager for our Dynamic Ultra Appreciation portfolios, Rick Vollaro, put on a trade to possibly take advantage of what we perceive to be the short-term overbought condition of the market. He sold a position in an exchange trade fund that owns the Materials sector and bought a 2x inverse position in the same sector, effectively reducing our equity exposure in that portfolio by 10%. He intends to take the trade off as soon as we get the correction that he is anticipating. The good news for me is that Pinnacle has the expertise and the technology in order to execute such an innovative transaction with ease. However, I can’t help but smile at the gigantic changes that have occurred in our portfolio management philosophy over the past 7 years. We wouldn’t have considered this trade, even in our most aggressive portfolios, as little as two years ago. Today we consider these kinds of transactions to be a reasonable and necessary part of our risk management process and an integral ingredient in our quest for excess returns in difficult markets. We’ve come a very long way from patience being the primary strategy we rely on to earn expected returns for our clients.

    Thursday, October 1, 2009

    Our Own Overbought Analysis

    The SPDR S&P Metals & Mining ETF (ticker: XME) created a near term peak at just over $50/share on September 17th, 2009. It’s risen from $20.55 on March 2, 2009 for an incredible gain of 143% over a six month period. We initially bought this fund for three of our models on April 27th and have enjoyed the ride higher as it has been our best performing holding since then. Recently, this position has also provided us with a very important look into overbought market conditions.

    At Pinnacle, we utilize a rebalancing software tool called iRebal to streamline our trading process. To avoid boring every reader I’ll stick with the point at hand and not dive into the overly complicated world in which I live using this tool. iRebal uses band thresholds, which is a fancy term for how it determines when to rebalance a security after periods of either under or out performance. For example, if our model position size is 3%, iRebal will signal that a rebalancing trade is necessary if market movements cause the position to change by 1% or more from its intended target, in either direction. In this case, thanks to outsized gains since our purchase, XME was rebalanced (sold) back down to its target for a majority of our client portfolios – right at the short term peak on September 17th!

    It is hard to be this exact when monitoring overbought conditions but this does give us one more tool in evaluating market conditions. Materials, and especially Metals & Mining stocks, have been a leader since the market bottom in March. As Rick Vollaro recently wrote, we could see a short term correction here as the market catches its breath. The recent rebalancing trades in Metals & Mining might be an important clue that a broader correction is developing, because when market leaders pause or begin to correct after a strong move like the one we’ve seen, the rest of the market often follows.

    Wednesday, September 30, 2009

    Will a Dollar Reversal Coincide With a Pause in the Reflation Trade?

    While the stock market has rallied +57% since the March 9th low, the value of the U.S. dollar, measured against a basket of currencies of our largest trading partners, has dropped by almost -14%. This inverse correlation (statistically measured as -0.66, indicating a strong inverse relationship) isn’t something new; if one looks at the correlation between the market and the dollar it has been negative since the market top in October 2007 (measured as -0.49 since then). There are many theories as to why this is the case, such as the dollar’s reserve currency status in a time of crisis, the reflationary aspects of a weak currency, and the positive effects of a weak dollar on repatriation of earnings for multinational companies.

    As the dollar has fallen, it has helped ignite a trade that is commonly referred to as the “reflation” trade. Reflation is the act of stimulating the economy via monetary and fiscal stimulus to expand output. Typically as the stimulus is applied, lower real interest rates and deficit spending combine to weaken the currency, which makes exports cheaper and in turn fuels growth. We consider a number of sectors and asset classes to be particularly sensitive to reflationary policy as well as a weak dollar, including certain US equity sectors (like materials, energy, and industrials), emerging markets stocks, commodities (such as oil, copper, gold, etc.), and other hard assets like property. If one looks at the performance of those assets since the March bottom in stocks (shown in the table below), it’s clear that reflation trades have outpaced the broad market. But beware, since even strong market trends are subject to periodic adjustments, and these reflation trades have reached a point where they seem vulnerable if the markets correct and the dollar bounces.

    Our current view is that the cyclical bull market in stocks has not yet fully run its course. At the same time, some of the shorter-term technicals we monitor appear stretched, and a healthy correction would not be surprising. Should that occur, we won’t be surprised to see short term fireworks in the dollar and reflation trades.

    Friday, September 25, 2009

    Investing For Volatility

    The VIX, or the Chicago Board Options Exchange Volatility Index, measures the implied volatility of S&P 500 index options. It is commonly referred to as the fear index because a high value on the VIX implies that it is more costly to protect one’s portfolio. As one could guess the VIX soared to an all time high of 90 on October 24, 2008 near the height of panic. However, the index has steadily fallen from that peak to a reading just north of 25.

    Recently, Barclays introduced an ETN (Exchange Traded Note) called iPath S&P 500 VIX Short-Term Futures and trades under the symbol VXX. As there is no way to directly invest the VIX, they have provided an investible vehicle that will hold VIX futures contracts that are continuously rolled forward. Many of the analysts we read are looking for short term correction here as the market catches its breath and we did some surface research to see if the VXX could provide us with a short term hedge. Although it does not seem like a good fit at the moment, we are pleasantly surprised with innovations in the investment world and will continue to scour the world for ways to enhance our portfolios for our clients.