Friday, July 31, 2009

What Would You Tell a 60-Year Old About to Retire?

A journalist recently asked me this question in an interview. To be honest, I might as well have been asked what the causes were of the Civil War. From the perspective of a trained financial planner and the Chief Investment Officer of a private wealth management firm, the question is, well….difficult. The writer was writing for the Wall Street Journal, and he was looking for some sound investment advice for folks who have been buy and hold, strategic investors for their entire investing life. Now they are faced with the rapidly changing paradigm in the investment community that buying and holding is actually a high risk strategy in expensive markets. As you may have guessed, I flunked the test. My answer wandered all over the place, and I didn’t make it into the article. However, I’ve been thinking about it a lot since then, so let me try again.

Mr. or Mrs. 60-Year Old, don’t spend too much. Americans are used to a certain lifestyle which is apparent in the size of our homes, the amount of traveling we do, our taste in home electronics, our…everything. Spend the money to work with a legitimate financial planner (a Certified Financial Planner, CFP®) and find out what lifestyle you can afford and learn to live within your means. Next, actively manage your portfolio. You can’t afford to buy and hold if the financial markets are going to deliver less than average returns for the next five to ten years. No one can accurately predict the future, but smart people are worried about the amount of debt in the world, and you had better plan for a low return world early in your retirement. Low returns won’t last for the rest of your life, but the portfolio returns you earn early in retirement are disproportionately important to you, so be prepared. Active management can add two or three percent (or more) per year to your returns over time if executed successfully, which could be critical to your success.

If you’ve invested your own money for years and that’s why you’re reading the Wall Street Journal (or fill in the blank financial periodical), you have to invest the time and treasure to become a different kind of investment expert. You can’t be a successful active manager of your money by reading the morning paper and watching CNBC when you come home from work. If you can’t see yourself doing the work, then hire someone to do it for you. Find a professional wealth manager that specializes in building globally diversified, actively managed portfolios. You may have always been a “do it yourselfer” when it comes to investing, but beware. The market is not likely to provide a tailwind to your investment mistakes going forward. You have to know what you are doing in the tough market environment ahead. Good luck.

Thursday, July 30, 2009

Credit Default Swaps – like Dr. Jekyll and Mr. Hyde

Credit default swaps (CDS) are an example of a financial instrument that spiraled out of control during the latest financial crisis. CDS were created as a defensive hedging vehicle that allowed the buyers of the swaps to gain insurance protection against credit defaults, and sellers of protection received a nice stream of payments at a time of very low yields in the marketplace. Take this practical idea and add in models that said certain firms could never go out of business (think Lehman Brothers), a very loose regulatory environment with no counterparty accountability, and now introduce it into a banking system that ran casino-like strategies on 25-to-1 leverage. Suddenly, this once innocent product is transformed into the Frankenstein of financial products that threatened to bring down the entire financial system. Indeed, massive losses on CDS were largely to blame for AIG needing a government bailout.

Despite the fact that CDS became one of the “financial weapons of mass destruction” that Warren Buffet warned of, monitoring CDS prices can be useful as an early warning detection system for the credit markets. We routinely monitor the price of protection in the credit default swap market as one measure of overall credit market health, and to try to assess how much default and system risk is being priced into the marketplace. The chart below, from Ned Davis Research, shows the price (in basis points) of buying credit protection on different high yield bond indices. As the line goes up the cost of protecting against default rises to compensate investors for the increased risk of defaults, and when the line goes down it’s just the opposite. After peaking during the height of the bear market, the price of protection has come down markedly and across most risk markets (including investment grade bonds, high yield bonds, emerging market bonds, etc) which we take as a very good sign for credit markets, implying that there is much less system-wide risk than there was a few months ago.

We continue to believe the evidence is building that a recovery is close at hand, but we also acknowledge that conditions are still fragile. Some say system risk has simply been postponed temporarily, and if so we would expect an early warning signal to come from this credit canary. I suppose the good and bad wrapped into one instrument make CDS a little like Dr. Jekyll and Mr. Hyde.

Chartsource: Ned Davis Research

Tuesday, July 28, 2009

Is Everything Correlated?

Over the past few weeks it has become glaringly obvious to me that correlations between asset classes have become extremely high. Correlation is the statistical number that describes the degree of relationship between two variables. When the correlation is 1 then the two variables perfectly move in the same direction, and when the correlation is -1 then the two variables perfectly move in opposite directions. So, how much have correlations spiked, or moved closer to 1?

I analyzed the correlations from the market bottom on 3/9/2009 through yesterday 7/27/09. I used the S&P 500 Index as the constant for comparison (this is to represent the market) and used five other assets classes as my variables. I started with Russell 2000 Index and found a correlation with the S&P 500 Index of .98 which is a slight spike but the historical number is around .9 so that is not entirely surprising. I then measured the international markets using the MSCI EAFE Index and MSCI Emerging Markets Index and the correlation was .98 and .93 respectively which was also a slight spike from the .85 historical numbers. I then moved to commodities, REITs (Real Estate Investment Trusts) and high yield bonds to gauge asset classes with low historical correlations. Historically, these asset classes have shown a correlation with the S&P 500 of .2 for commodities and REITs and .6 for high yield bonds. However, during this last market rally the correlations have really spiked to .75, .85, and .9 respectively!

With most risk assets at extreme correlations it seems that one must decide to be in the market or out of the market. Diversification is breaking down and places to ‘hide in the market’ have diminished. If you have owned risk assets you have been extremely happy over the last few months since you have probably made a lot of money. But if this does turn and the market heads lower are you prepared for high correlations to the downside?

Monday, July 27, 2009

Here Come the “Tactical Overlays”

The avalanche of press this year about the death of buy and hold investing has surprised even me, and I have been forecasting this change in our industry for just about a decade. Now that financial advisors and professional pension and endowment investors are paying attention, I am watching to see how the industry is going to address this problem. You have an industry that is populated by professionals who have passionately followed the buy and hold dictums of strategic asset allocation for their entire careers, and all of the sudden they need to come up with “the quick fix.” What should they do as pragmatic business people when the status quo about the “right” way to invest has changed, virtually overnight?

When it comes to personal financial advisors, those Certified Financial Planners (CFP®) who are my peers in providing “sophisticated” asset management for affluent investors, I have long predicted that the solution will appear in the form of some kind of technical analysis-driven process. Clearly the least expensive method for active management, in terms of both time and treasure, is to focus on technical trading methods. I can see new institutional level software (i.e., expensive) that will cater to big firms looking to add a “tactical overlay” to their current buy and hold, strategic asset allocation portfolios. In the world of pensions and endowments, my partner, John Hill, recently told me that the consultants to a non-profit board that he sits on recently offered exactly that. The endowment investment committee could remain strategic (buy and hold), or they could purchase the new razzle-dazzle tactical overlay that would change the asset allocation based on their new, proprietary, techno-sizzle methodology. If professional money managers are afraid that their clients are going to demand active management, I think the tactical overlay will be an easy sale.

Of course, the technical solution will not require that the consultant firms that have advised their clients to buy and hold for decades have an actual track record in active management. Or, for RIA’s (Registered Investment Advisors) catering to affluent clients, their new tactical overlay will not require them to actually learn about market fundamentals, do the research, invest in knowledge and people, or be responsible for the asset allocation changes that are integral to active management. They will instantly have a credible, saleable, technologically marvelous, scientific, and relatively cheap, solution to their problem. Since we (Pinnacle Advisory Group, Inc.) are still slogging along reading the research and actually doing the work, a theme that is mentioned several times in my book, I wonder if we somehow got it wrong?

Friday, July 24, 2009

Rally Resumes on Positive Earnings Surprises

The S&P 500 Index has rallied an impressive +11% in just the past two weeks, after declining by -7% from early June through early July. The catalyst behind the resumption of the rally that began in March seems to be some underlying good news in another otherwise dismal earnings season.

According to Bloomberg, through yesterday, 181 (about 36%) of the companies in the S&P 500 Index had reported second quarter earnings. The results aren’t pretty, as earnings have fallen by -26% from the second quarter of 2008 thus far. But, encouragingly, there have been 136 positive surprises (meaning that earnings came in higher than forecast) versus only 43 negative surprises. Even better, as shown on the chart below, 9 out of 10 sectors have more positive than negative surprises (Technology is the lone exception, and there it is just about even – 14 positives to 15 negatives), implying that the phenomenon is broad based. Apparently investors have interpreted this as an indication that analysts have grown too bearish, and they’ve responded to the possibility of better earnings going forward by buying stocks.

An improved earnings outlook for corporate America, along with signs of stabilization in economic data, provides more evidence that the dark clouds hanging over the economy are gradually being driven out to sea.

Wednesday, July 22, 2009

Growth Watch – Another Notch Up the Ladder for U.S. Leading Indicators

On Monday, the Conference Board’s U.S. Leading Economic Index (LEI) was released, and it was higher for the third straight month: +0.7 in June, +1.3 in May, and +1.0 in April. The index is comprised of 10 different indicators (see chart below), of which 7 rose during June. The biggest gainers were the yield curve, building permits, stocks prices, initial jobless claims, and average weekly manufacturing hours. Surprisingly, real money supply, the single biggest component within the index, contributed negatively for the month.

At Pinnacle we watch numerous barometers of domestic and global growth, such as: several leading economic indicators (including the Conference Board’s U.S. Leading Index, ECRI’s Weekly Leading Index, OECD’s U.S. and global leading indicators, etc.), a host of market-based data (economically sensitive commodity prices, shipping rates, etc.) and conventional economic reports. The combined message from all of these measures recently is pointing towards a resumption of economic growth in our near future.

We are currently positioned at neutral volatility within our portfolio construction since we believe that the world economy has undergone some structural changes that will likely create long-term headwinds and put a lower ceiling on future growth. But we are encouraged that signs are appearing that cyclically the worst may be behind us, and if the recent improvement in leading indicators is painting an accurate picture, the resumption of economic growth may come sooner than the consensus currently thinks…

Monday, July 20, 2009

The Oh-So-Sweet Sleep of the Certain

Recently I had the opportunity to review the investment results of two different money managers who had correctly called the market top in 2007 and by January of 2008 had safely invested 100% of their investment capital in cash. The resulting investment results are, as you can imagine, spectacular. Both firms are quantitative in nature, meaning that they use proprietary technical-analysis-based methods to determine market trends in order to make their investment calls. In one case, the manager has a trade-marked trend identification system that protects their clients from downturns. While I tip my hat to these managers, I continue to view any portfolio construction that is either all-in in terms of stocks and risk assets, or all-out in terms of cash, as a somewhat high risk proposition.

To me, going 100% to cash screams that the investor has 100% conviction that his or her forecast is correct. I just don’t know how anyone can get to that level of certainty. I’ve often said that they must sleep the sweet sleep of the certain, with no doubts about their forecast, their trading system, their proprietary models, their decision making process, and the well documented irrationality of their fellow investors. I’m envious. When Pinnacle portfolios are positioned to be widely divergent with our benchmarks, as they were in January 2008 with our correct bear market forecast, I don’t sleep well at all. Experience has taught me that financial markets are notoriously fickle, and that making large bets about market direction…either direction….takes a certain amount of courage, or a certain amount of hubris. I suppose it is fair to say that we (Pinnacle) are either very wise in recognizing that the irrationality of markets should be approached with the greatest of respect, or we simply lack the courage of our convictions. I believe that the correct assessment is the former.

From a portfolio construction point of view, it turns out that being fully invested in risk assets still allows a portfolio manager a great deal of latitude to “hide in the market” and still manage risk. Being 100% in U.S. stocks but owning staples, health care, and utilities is likely to result in capturing 50% of the market’s volatility in a bear market. If the market rallies and you were wrong in your short-term assessment of market direction, you will still crush cash returns to the upside. On the other hand, going 100% to cash, when cash pays 1%, is truly a high risk proposition from the standpoint of generating total returns. There is no “repair strategy” from there that I’m aware of. Investors must be 100% certain that the market is not about to rally. For our part, we prefer to actively manage portfolios where our equity exposure varies with our forecasts but we don’t end up at either extreme of market timing. It allows us to sleep the oh-so-sweet sleep of the uncertain!

Friday, July 17, 2009

The Reflation Trade Back On

As we end this week with a strong 7% plus gain in the S&P 500, it is clear that the reflation trade is back on. These are generally stocks characterized as benefiting from rising inflation, which would be welcomed by some at this point in time. The usual suspects in this group include commodities and commodity related stocks, and emerging markets. Metals and Mining and steel stocks soared 15% this week, and natural gas posted a strong 13% in four days to provide some examples. So why was there a stampede back into these positions?

One reason is simple – the dollar has fallen this week due to increased action at the Federal Reserve. In the four weeks prior, the Federal Reserve held steady on its Quantitative Easing program and they did not increase their balance sheet. Now, this week the Federal Reserve increased its balance sheet by $80 billion mostly through Mortgage Backed Security purchases. This caused a 1.5% drop in the dollar and due to negative correlations commodities and related stocks were bought.

Secondly, perhaps the rebound in the Chinese economy contributed to the renewed enthusiasm for emerging stocks. The growth for the second quarter came in at an annualized rate of 7.9% which is stunningly close to the hoped for growth rate of 8%. (Insert generic disbelief about China economic statistics) This was enough to allow Chinese economists to declare that the ‘downturn has been successfully reversed’ and they are ‘leading the turnaround in the global economy.'

I’m sure there are other reasons behind the surge as well, but one thing for sure is that it occurred. Now it is time to see for how long.

Thursday, July 16, 2009

The Ongoing Perils of PE Ratios

One of the interesting things about writing a book is that you get feedback from lots of folks about what they liked and disliked the most about your writing. Recently, someone told me they read and re-read the chapter on P/E (price-to-earnings) ratios (The Incredible, Amazing P/E Ratio) several times and still “didn’t get it.” It’s not surprising that someone didn’t get it, because clearly the huge majority of investors don’t “get it” either. If you are a proponent of value investing, and one of the basic tenants of your portfolio construction is to be wary when the market is expensive, then understanding this basic valuation measure is very important. Unfortunately, as I say in the book, it’s also an ongoing mystery where bulls and bears will look at the same data and reach vastly different conclusions.

At Pinnacle, we look at a wide variety of valuation measures involving earnings and price. Last week we routinely updated our valuation data and came up with the following P/E measures: (Note: we actually look at more than a dozen earnings-based indicators.)

The current range of P/E’s is fairly wide from a low of 10.83 based on a variation of John Hussman’s price-to-peak earnings methodology, to a high of 18.47 based on a ten-year average of S&P earnings. Obviously different investors using different methodologies will reach different conclusions from this data. Even investors who get the same numbers will reach different conclusions. For example, the 10-Yr normalized GAAP (Generally Accepted Accounting Principals) P/E ratio looks expensive when comparing to the median P/E of around 15 going back to the late 1800’s, but if you exclude the Great Depression and only compare to post WW-I data the median rises to about 17 and the current 18 figure doesn’t look too bad.

The bottom line: Buy and Hold investors who are looking for a simplistic, quantitative solution to fundamental value investing will be hard pressed to find it. It turns out that finding value is as much “art” as it is “science.”

Wednesday, July 15, 2009

Keep an Eye on the Transports

With the economic debate currently divided into the so-called “green shoots” or “brown weeds” camps, one of the things that we’ve been paying particular attention to lately is the Dow Jones Transportation Index. It consists of 20 companies that operate in some of the most economically-sensitive industries – railroads, airlines, truckers, air-freight, ocean shipping, etc. Therefore, the performance of this index can be viewed as a real-time economic indicator, offering important clues about the direction of the economy by either confirming or contradicting official economic reports.

So, what are the Transports telling us right now? Over the past few months, the index has rallied in tandem with the rest of the market as stocks have responded to tentative signs of economic stabilization. After taking a breather and moving sideways for several weeks, the Transports are now hovering in a critical spot on their chart where two key moving averages are converging. Whether the Transports succumb to the downward longer-term trend (blue line, 200-day moving average) or if they’re able to ride to new highs on the back of the rising shorter-term trend (brown line, 50-day moving average) should help determine if it’s the green shoots or the brown weeds that will have the upper hand in the coming months.

Tuesday, July 14, 2009

Investors are Scrambling?

I couldn’t help but notice the headline for Tom Lauricella’s front page article in the Wall Street Journal, called Failure of a Fail-Safe Strategy Sends Investors Scrambling. The article does an admirable job of covering the basic problems and issues with traditional asset allocation…the themes that I cover in the first half of my book. Here’s a quote: “The financial crisis has sent many financial advisers, academics and investors back to the drawing board.” For financial advisors whose business model is to charge fees to manage their client’s assets, this really IS a crisis. They will have to change the culture of their firm, change the message to their clients, and potentially endanger a very profitable business model, all in the pursuit of a solution to a problem that is not easily solved.

Let’s start with culture. All of those advisors with crystal balls in their lobby that they use to explain why buy and hold investing avoids having to “predict the future” will be putting that crystal ball away. They will be left to explain to clients who have been taught over the past 25 years that market forecasts are futile why it is that they (or fund managers that they buy) are now going to engage in exactly that pursuit. Since we made the same transition in 2002, I don’t envy them these conversations, especially for the firms who most vociferously defend passive, buy and hold strategies. To change the underlying fundamental approach to investment strategy is no small matter to registered investment advisors who earn their fees based on the confidence of their clients that their advisor is professional, scientific, “state of the art,” and trustworthy.

But it gets even worse, because once advisors leave “buy and hold” behind, they will have to “scramble” for another investment approach. It is the scrambling that results in major problems for the industry, because advisors literally don’t know what to do next. I believe that advisors will begin a desperate search for quantitative models that will relieve them of the responsibility of making investment decisions. They will turn to much larger allocations to hedge funds and other alternative investments that they can “buy and hold” but offer a different approach to asset allocation. Unfortunately, neither of these approaches will solve the problem of becoming a different kind of investment expert, where the ability to change portfolio asset allocation is done “in-house” based on the expertise of the advisor. Of course, at Pinnacle, we’ve been engaged in writing, lecturing, and executing active management for years. I will be interested to see if the media is interested to talking to us as experts, or if they want to keep interviewing the advisors who “are scrambling.”

Monday, July 13, 2009

Range Bound Dollar

Over the past few weeks, the Dollar Index Spot Currency has been stuck in a range bound trading pattern between roughly $79.25 and $80.90 (see chart below). If this range bound trading continues for much longer there could be strong technical pressure on the dollar in whatever direction the breakout occurs. Technical traders will usually play the breakout for the length of the range which means the dollar could fall or rise $2 past the support and resistance lines. (I thought the usual mind set of short term traders might be of interest to you even though we at Pinnacle are more concerned of longer term trends). But which way will the dollar move? Some recent statistics have come out that might shed some light on the short term path of least resistance.

On Thursday, China released the latest data on their export activity. Year over year Chinese exports have fallen 21.4%, which was slightly worse than expected and the eighth straight month that the series has fallen. For an economy that relies on exports for roughly 1/3 of GDP growth this stagnation in export activity can’t continue without worry entering the markets. It is no wonder the government has thrown a large stimulus package at the system. If the stimulus does not ease the fall and worry were to enter the emerging markets then the currencies of those countries could have a setback and provide additional short term interest in the dollar. The dollar proved in 2008 that it remains the safe haven currency for the world (at least for now) regardless of anti-dollar rhetoric from certain countries.

Second, the US current account deficit as reported in May had the smallest reading since December 1999. No doubt there were many factors leading to this small number including the US consumer buying less and saving more and even exports outpacing imports. Nevertheless, a natural global re-balancing is occurring and that should ease some of the short term concern regarding the stability of the US dollar whether or not there is any correlation between them. And even though long term dollar bearishness remains I believe the dollar could have good support in the near term.

Friday, July 10, 2009

“Crystal Ball Gazing” and the Horrors of Subjective Forecasting

Bill Gross, the Chief Investment Officer of PIMCO, is always a must read here at Pinnacle. His monthly Investment Outlook is one of those amazingly well written pieces that inspires all of us to try just a little bit harder to clearly describe what is happening in the financial markets. I encourage you to read it yourself by going to This month’s piece, July 2009, is called, “Bon” or “Non” Appetite?” and in it Gross continues to describe Pimco’s somewhat negative view of the future that they call the “new normal.” I’ll let you read the piece for yourself, but I couldn’t resist commenting on one paragraph that strikes close to home. Here is what Gross says about efficient markets and subjective forecasting:

“The efficient market hypothesis was always dead from the get-go, but academic tenure and Nobel prizes were food for the unwilling or perhaps unthinking. Pimco and yours truly are not masters of the antithesis, a subjective approach which might derisively be called “crystal ball gazing,” but we try to focus on what might be legitimate changes in the way economies and financial markets are affected by seemingly irrational or “non-normal” behavior and events….”

Yes, Bill, I’ve written a book that describes in great detail the problems with the efficient markets hypothesis (more properly called the rational expectations pricing theory). But what is interesting is that even Mr. Gross is squeamish when it comes to making subjective market forecasts. Instead, PIMCO focuses on the results of “irrational” or “non-normal” events, which of course can’t be rationally modeled using past data, and result in…you guessed it….subjective forecasts. It is precisely PIMCO’s ability to make better forecasts than the consensus in a world of uncertainty, which is truly in the realm of qualitative analysis, or experience, or good judgment, or crystal ball gazing, which allows them to consistently beat the markets and create positive returns for investors. Investors have to learn that they don’t need to defend their use of subjective skill, judgment, and experience in making good forecasts. If the “new normal” consists of lower than historical average returns, then these are the skills that will command a premium in the investment marketplace.

Monday, July 6, 2009

No Surprise and a Wonderful Opportunity

Rob Heubscher is the publisher of the Advisors Perspectives e-letter, and as the name implies it is widely read in the financial planning community. What isn’t as obvious is the quality of the contributors to the letter which is rapidly becoming one of the most influential in the advisory business. All of which is why I was thrilled when Rob offered to reprint Chapter 7 of my book, Buy and Hold is Dead (AGAIN) as a lead article in Advisor Perspectives. I just checked the site and the article, called Compelling Evidence that Active Management Really Works remains the number one most read article by advisors over the past 14 days. Thank you, Rob, for such a wonderful opportunity to introduce financial advisors to my book.

It is no surprise that financial advisors are fascinated with the topic of the chapter, which refers to one of the longest ongoing debates in the planning profession. Simply put, can an active money manager, constrained to one management style, outperform a passive benchmark representing that one style? The chapter reviews the work of Yale Professor’s Cremers and Petajisto and their seminal work on Active Share, which is a method of measuring both the difference in portfolio performance (tracking error) and portfolio holdings (active share) in determining a manager’s performance. Their surprising conclusion is that active management, as measured by active share, actually adds persistently and significantly to fund performance. In the planning industry, where active managers are typically bought and held strategically to invest in only one asset class, this news is dramatic and important. Theoretically it proves that asset classes should not be indexed but should instead be invested by actively managed mutual funds, separate accounts, etc.

Ironically, I’ve always felt that this was the least relevant chapter in the entire book. My thesis is that there is a difference between portfolio managers who can invest in the entire universe of asset classes, and money managers who are constrained to only invest in one asset class, be it large-cap value, small-cap growth, emerging international, etc. The important question is not whether a style constrained money manager can beat a single performance benchmark, but instead whether a non-style constrained portfolio manager, with almost unlimited access to every asset class, can identify value in a world of mispriced asset classes. If so, then active management is necessary in order to earn excess returns. I hope the distinction between the roles of money managers and portfolio managers is not lost on the readers. I also hope that portfolio managers will allow themselves the freedom to move money from overvalued to undervalued asset classes, something that strategic asset allocators insist cannot be done successfully.