Thursday, August 27, 2009

A Tax Test May Be Coming Soon

In my book, Buy and Hold is Dead (AGAIN), the Case for Active Management in Dangerous Markets, I devote an entire chapter to portfolio tax planning. The tax chapter is called, The Tax Tail and the Portfolio Dog. The title refers to an old saying about taxes that basically means that investors shouldn’t let tax considerations outweigh value considerations when making asset allocation decisions. The chapter borrows heavily from the work of Michael Kitces, Director of Research at Pinnacle Advisory Group, who points out that unless you die with appreciated securities in a taxable portfolio and get the currently allowed step up in tax basis, the value of most tax strategies is limited to the value of tax deferral. The chapter goes into great detail to show that the value of tax deferral is not as great as most people think it is, and the resulting conclusion for value investors is simple…don’t let tax considerations keep you from selling overvalued assets.

It is possible that this year will put many investors to the test regarding realizing capital gains in actively managed portfolios. The speed and magnitude of the current stock market rally is such that investors will be forced to look at the value proposition of holdings that may have doubled in value since March of this year. If by year-end investors conclude that holdings are overvalued, and if they were purchased within the past 12 months, then they will have to weigh the tax cost of short-term capital gains versus the risk of holding securities for the full 12 month period needed to get the more favorable long-term capital gains tax rate. For savvy investors who bought the market after the severe post-Lehman Brothers market decline in September, they will be “playing chicken” with the markets as they approach their 12 month holding period. Investors with the best market timing will have to hold until next March to get to the favorable long-term rate.

For the record, if you own a security with a 20% gain it only has to retrace 3.06% of its value to completely wipe out the benefits of short-term versus long-term capital gains (assuming 28% short-term gain rates and 15% long-term rates). For 50% gains the breakeven pullback is 7.65% and for 100% gains the breakeven is only 15.29%. Students of market volatility would conclude that the potential for losses from overvalued levels should lead investors who want to protect their profits to go ahead and take them without worrying too much about tax costs in the transaction. Of course, investors may have large amounts of loss carryforwards, or unrealized losses that can be realized in their portfolios in order to offset gains this year. It will be interesting to observe investor tax behavior as we approach the end of the year.

Monday, August 24, 2009

Looking for the Right Word

I have no problem with describing Modern Portfolio Theory as science. After all, Markowitz’s work did win a Nobel Prize for Economics, and for that matter, so did Bill Sharpe’s work on the Capital Asset Pricing Model. I believe that investor’s want to pay for science…and all that it implies. Science implies certainty, exactness, facts versus opinion, expertise, proof, and so on. Since investor’s want to buy science, it should be no surprise that investment advisors want to sell science. For four decades now the financial industry has successfully sold strategic asset allocation as science. But now that the problems with MPT are becoming well known, consumers of investment advice need to reevaluate the value proposition of any investment process that claims to be scientific.

I am still looking for the right word to describe active portfolio management where the decision making process is driven by a subjective, qualitative approach to asset allocation. I have described it as “art,” the antithesis of science. In my book, Buy and Hold is Dead (AGAIN), I contrast art with science as saying that art “lies in the eyes of the beholder.” One investor’s interpretation of the economic facts of the day can and will be different from another investor looking at the exact same data set. The experience, judgment, and wisdom that help an investor reach a conclusion are art, I said. The problem being that art conjures up all of the wrong images. Artists are erratic; art is hard to measure and impossible to repeat. If investing is art than it must be about guessing, hunches, flashes, intuition, and other non-sellable attributes.

So this morning I want to suggest active management as a craft. Yes, craftsmen are still artists, but it seems to me that we value craftsmen. If investing is a craft to be learned, then we imagine that it takes skill and not luck. We expect craftsmen to apprentice for years before they practice on their own because a craft takes judgment and experience, in a context that we value and appreciate. So for now on, I think I’ll describe investing as a craft to be learned. While everyone is not an equally good craftsman, we can all agree that the best of them deserve our respect and are worthy of our patronage.

Friday, August 21, 2009

Recovery to Be Stronger Than Expected?

Lately it seems that there’s general agreement that some sort of economic recovery is underway, thanks to the massive doses of financial stimulus that have been unleashed to halt the recession. Now, the debate has shifted to whether or not we will experience a typical post-recession recovery pattern, or whether we will enter a “new normal” of permanently lower levels of economic activity due to the severity of the recent downturn. The “new normal” crowd must be making headway, since according to Bloomberg, consensus expectations are for third quarter GDP growth of +2.2%, and for fourth quarter growth of +2.0%. Both of those are below-trend GDP growth rates, and are far less than the strong readings that are typically seen early in an economic recovery.

According to a leading indicator produced by the Economic Cycle Research Institute, however, a stronger than expected rebound in economic activity may be in store, which would come as a surprise to those predicting otherwise. ECRI is a private forecasting firm that has earned quite a reputation for being able to accurately predict major turning points in the economy, with an impressive track record going back many decades. We’ve been watching their U.S. Weekly Leading Index very closely, which is a proprietary leading indicator of the economy that they’ve developed, and over the past several months its growth rate has jumped from an all-time low of -29.7% to +17.5% (shown on the chart below), which is the highest reading since 1983.

The components of their index consist of the money supply, industrial materials prices, mortgage loan applications, corporate bond yields and spreads relative to Treasuries, stock prices, and initial claims for unemployment insurance. Almost all of these have been trending in a favorable direction over the past several months, causing the spike in the overall index. While there may in fact be powerful arguments by those who caution of a “new normal,” the message coming from ECRI’s leading indicator is to expect a much stronger rebound. Whether or not the rebound builds into a more sustainable growth cycle is the next piece of the puzzle for investors to wrestle with.

Thursday, August 20, 2009

China’s Wild Ride

In case you missed it, the Shanghai SE Composite (a capitalization-weighted index that tracks the daily performance of all A and B shares listed on the Shanghai Stock Exchange) entered a bear market in two weeks! From 8/4/09 to 8/19/09, the index fell almost 21% which is the classic measure of a bear market. It has certainly been one wild ride in the Chinese markets over the last few years as the index rose 500% from June 2005 to October 2007 and fell 73% from October 2007 to October 2008, but volatility has dramatically increased in just the last year.

We have to monitor the situation in China closely because this is a very big part of the bullish argument. The Chinese government has deployed a massive stimulus package that is 2.5 times that of the US when compared to the gross domestic product of each country. This has revitalized mining industries, global shipping barometers, and the global appetite for risk as the country has become drunk on easy credit. As a result, China met their GDP growth rate of 7.9% year over year, and the stock market exploded off the bottom in October with a 108% gain. The chart below shows the Shanghai SE Index since October 2007.

So we are left with the question of how to view this latest down move. The bears would argue that the 108% gain from the bottom was a small bull market rally in the overall context of a bear market started October 2007. The bulls would argue the latest sell off was a normal, albeit sharp, pullback during a strong bull run. Additionally, many argue that this could be a foreshadowing of what could occur in the US markets as China led us out of the bear but will lead us right back into it. (Read – decoupling is a myth!) Whatever your answer may be to this question, it is clear that China is an important part of the global market place and we will monitor their situation closely.

Tuesday, August 18, 2009

The Surprising Mathematics of Defending Market Declines

The mathematics of portfolio declines and recoveries are somewhat counterintuitive. You would think that if your portfolio declines by 50% that you would need the portfolio to rally by 50% to get back to even. But that’s not true at all. The following simple chart shows the relationship between portfolio declines and portfolio recoveries: When you consider how a 50% decline requires a 100% rally to break even, and a 70% decline requires a 233% rally to break even, you can see why defending against dramatic portfolio declines is important. As it turns out, the actual S&P 500 decline is 57% from the October 9, 2007 high of 1,565 to the March 9, 2009 low of 676 (including dividends the decline is 55%). The recovery as of last Friday’s closing price of 1,004 is 48.5%, or 50% including dividends. Even though the decline was 55% and the recovery has been 50%, the index still needs to rally an additional 56% just to get back to the October 2007 highs!

What would happen if an investor only captured 50% of the market decline and then captured 50% of the latest rally? Once again the numbers might be counterintuitive to some. An investor with a portfolio valued at $1,565 would have seen their portfolio value decline by 27.5% (one half of the 55% decline) to a value of $1,134. Then the portfolio would have rallied by 25% (one half of the S&P rally of 50%) to a value of $1,417. The portfolio would only be 10% below its starting value, as opposed to the current S&P dilemma of needing a 56% rally to get back to even. As it turns out, Pinnacle’s Moderate Growth portfolios have a similar ratio of downside and upside capture. Our Appreciation portfolios have done even better with the downside capture being contained but the upside capture being much higher as a percentage of the market. As we work through the entire cycle, defending against large losses has served our clients well.

Monday, August 17, 2009

Is the New Normal a Repeat of Decoupling?

Currently a theory that I believe is gaining acceptance amongst the investment community is the idea that we are entering a “new normal,” or a permanently lower state of economic growth than we experienced during the years prior to the recent financial crash. There are many good reasons why this makes great fundamental sense, including the possibilities of higher taxes, less financial innovation, increased savings, tighter credit, etc. Bill Gross of PIMCO would say that the theory has a high “common sense quotient,” and at Pinnacle we would agree.

As an analyst, one part of our job is to constantly question different market opinions, even if we happen to agree with the basic premise. As I look for flaws in this theory, I don’t think I find one conceptually on a longer term basis. Where they may be a flaw, however, is in investors’ interpretation of the timing. It seems to me that this is a long term story, which may play out over years and possibly even decades. That leaves plenty of room for shorter term cyclical upturns that could be as robust as or even more robust than the long term trend for GDP growth, which may be happening now.

In an odd sort of way, I believe this thesis is very similar to another theory from the not-so-distant-past referred to as “decoupling,” but from an opposite standpoint. The decoupling theory implied that the high-flying emerging market economies could “decouple” and continue to soar even if the developed world fell into a recession. Just like the new normal, there were good fundamental reasons that analysts were trumpeting to make their case - less debt, higher growth rates, high savings rates, expanding consumer base, etc. Back in the pre-crisis world the bulls took this theory and used it as justification for higher and higher prices of volatile securities like oil, commodities, emerging market stocks, materials stocks, energy stocks, etc., even as it was apparent that the developed world had in fact fallen into recession. For a brief period the theory was the force that allowed these assets to defy gravity and rise even as developed markets crumbled. It wasn’t until August 2008 that gravity returned and the decoupling of decoupling crushed these previously supported trades by a magnitude not seen in decades.

No one knows exactly how the new normal will play out and at Pinnacle we acknowledge that the world is still a risky place. However one would think the echoes of decoupling should keep investors from immediately accepting a new theory as fact and thus becoming overly bearish at a time when a cyclical recovery appears to be upon us.

Friday, August 14, 2009

Is it Time to Change the Benchmark?

One of the unfair facts of life for investment managers is that our clients insist on two different unofficial benchmarks for performance comparisons. In bear markets, when stock market values are plummeting, clients insist on comparing portfolio returns to cash. However, in bull markets, when stock prices are roaring ahead of other asset classes, clients want to change their benchmark and compare their returns to stocks. There is of course, nothing overly unreasonable about this state of affairs, at least in the eyes of our clients. Unfortunately, if you believe in managing risk by constructing diversified portfolios that own stocks, bonds and cash (and many other asset classes), you are virtually guaranteed to underperform cash in a bear market and underperform stocks in a bull market. This somewhat depressing state of affairs of having your portfolio underperform in both bull and bear market environments is the result of switching between two different benchmarks. We are seeing this unofficial “changing of the guard” with our clients’ perceptions occur now that the market rally is entering its 6th month.

Clients used to ask the question “how am I doin?” in the context of a massive bear market that took the S&P 500 Index down by 57% to its intraday low in early March. The market topped in October of 2007, and for the record it is still about 35% below its all-time high price. If you care to view performance in the context of the market top to current price, then our portfolio results of minus single digits are either very good compared to stocks, or very lousy compared to cash, where investors of all levels of experience can park their money without paying Pinnacle a fee. On the other hand, the stock market has rallied by 51% since the lows on March 9th, and the +25% gains in Pinnacle’s Dynamic Moderate Growth (DMG) portfolios look fantastic compared to cash, and pretty lousy compared to stocks, where investors of all levels of experience can park their money in an S&P 500 Index fund without paying Pinnacle a fee.

We continue to counsel our clients to view investment results over a complete market cycle. Once you take a step back and look at performance in a time horizon that includes both bear markets and bull markets, you can get a good perspective for how we are managing portfolio performance. Depending on time horizon, Pinnacle’s DMG portfolios have delivered between 200 basis points (two percent) and 600 basis points (six percent) of performance over and above our benchmarks, net of fees and transaction costs. This year we are having a phenomenal year relative to cash and a very good year relative to our blended benchmarks. In fact, at the moment most of our portfolios are beating the performance of the S&P 500 Index for the year to date period, which is entirely unexpected in a year where the S&P is delivering positive returns. However, we are trailing from the market bottom, which is entirely expected. So, “how are we doin?” It depends on your investment time horizon and what benchmark you care to use.

Thursday, August 13, 2009

Fed Seeing Signs of Improvement

The Federal Reserve released their latest assessment of economic conditions yesterday following a two-day meeting. There are legions of “Fed watchers” who always parse the language of the Fed’s statement following these meetings, looking for clues as to what the future direction of monetary policy is likely to be, since any changes can have significant investment implications. In general, it seems that the Fed is seeing signs of improvement in the economy, saying that “economic activity is leveling out” in the opening sentence of the statement, which was stronger than the June version that read “the pace of economic contraction is slowing.” They also pointed out that “conditions in financial markets have improved further in recent weeks.”

In more normal circumstances, the Fed’s change in the tone might be viewed as a precursor to higher interest rates. But, since this cycle is anything but normal, Chairman Bernanke and the rest of the FOMC members have consistently gone out of their way in the past several statements to reassure markets that interest rate hikes are a long way off by stating that the Fed Funds rate will remain between its current 0% - 0.25% “for an extended period.” They point out that any recovery is still threatened by many risks, including job losses, sluggish income growth, lower housing wealth, and tight credit.

They also commented on their quantitative easing program, where they’ve been printing new money to purchase Treasury, mortgage-backed, and federal agency debt in an attempt to keep market interest rates down. Recently many investors have been focused on this aspect of their policy and whether they were going to continue with it and possibly risk igniting inflation, or begin to wind it down in response to increasing signs of recovery. They basically said that they aren’t going to expand the size of the Treasury purchases that they previously announced, and that future purchases will be somewhat smaller but extended for an additional month through October.

All in all, the Fed seemed to do a good job of reassuring investors that policy will remain accommodative and supportive of still-fragile financial markets, while also laying the groundwork for the eventual removal of some of the unconventional programs they’ve implemented if recent improvements evolve into a more sustained recovery.

Thursday, August 6, 2009

Fixed Income Watch – All Bonds Are Not Created Equal

Mention the word bond to a friend and watch their eyes roll into the back of their head. I don’t think it’s a stretch to say that most of the world pictures a bond to be that safe investment that delivers a coupon, eventually matures, and should yield a little better than a money market, end of story. Most don’t realize just how volatile bonds can be. At Pinnacle Advisory Group we believe bonds can have many purposes in a portfolio, and we believe it is prudent to invest in bonds for total return, not just a yield. Once you get beyond yield clipping and embrace fixed income, it is surprising just how big a world opens up to investors. Investors must assess not only interest rate sensitivity that can cause fluctuations in bond prices (called duration), but also be aware of credit risk, valuation between different bond asset classes, currency risk (for foreign bond holders), etc.

Those who don’t pay attention to the bond market might say that paying attention to what bonds you own just can’t make that big a difference in accounts that are mixed between fixed income and equities. But one look at the returns of different bond classes over a couple of time periods reveals this thinking to be a fallacy.

The chart below shows a number of fixed income sectors and their corresponding returns from the start of the equity bear market to the current market bottom in March. It then lines up the total returns for the same asset classes from the market bottom to August 5th. A few things are notable. US dollar denominated high quality bonds with a high interest rate sensitivity did the best during the recession as the markets gravitated towards quality and shunned the entire risk spectrum. On the run-up we have seen just the opposite, with low quality and non dollar denominated bonds providing the highest return, while traditional “risk free” government bonds have posted returns that have been anything but risk free.

At Pinnacle we take the time to evaluate the bond market for both its message about the economic environment, as well as to look for what we think represents the best risk/reward in any given environment. Many may continue to think that bonds are just a boring asset class that isn’t worth the time or effort to explore, but we don’t agree with that thinking. All bonds are not created equal!

Wednesday, August 5, 2009

We Can We Get Rid of the Parentheses?

My long-time client, Diane, politely interrupted my possibly overly detailed summary of her portfolio returns with the question, “Just tell me when we will get rid of the parentheses?” Parentheses are used in our portfolio reports to separate negative portfolio results, and Diane was hoping we might be getting rid of them soon. She was referring to our trailing 1 year portfolio results, since for the year-to-date period (January 1 to the present) Pinnacle accounts are in robustly positive territory. However, the trailing 12 month returns for Pinnacle Moderate Portfolios remain about 5% in the red? (Note: See your wealth manager for performance numbers for other portfolio policies.) The good news is it appears that history is on our side.

The key to evaluating trailing 12 month returns is to realize that the starting number (12 months ago) changes every day. Unlike year-to-date returns where the January 1 price is always the same, the rolling 12 month return is just as much about what happened last year as it is about current market prices. If the stock market was declining one year ago then, all things remaining equal, 12 month performance is likely to improve as we measure from the lower prices after the decline. And guess what? We are rapidly approaching one of the biggest price declines in history, the stock market panic sell-off that followed the Lehman Brothers bankruptcy on September 17, 2008. So while the current trailing 12 month return for the S&P 500 Index is -20%, if prices were to stay the same the index would break even in terms of 12 month returns on October 7, 2009. Diane, if you own the S&P Index and the price doesn’t change between now and then; the parentheses go away on exactly that date.

The story for Pinnacle Moderate portfolios looks even better. Assuming that current prices don’t change, and considering all of the usual caveats about cash flows, fees, and different portfolio securities due to tax considerations, and considering that this is a completely unofficial, Sunday morning view of the matter, I’m guessing that Pinnacle accounts could break even as early as September 18th, the anniversary of Lehman collapse. Mark your calendars! Of course, there is the not so small matter of current prices, which most assuredly will not stay the same between now and then. Market rallies will take us to positive territory sooner, and sell-offs will postpone the date. Heck, if the stock market rallies 10% on Monday and portfolios gain 5%, we will break even by the time you read this post! All of which is my way of saying that hanging on to short-term performance numbers is best left to Chief Investment Officers with nothing better to do on a Sunday morning.

Tuesday, August 4, 2009

Pending Home Sales Higher

For the fifth straight month the Pending Home Sales Index compiled by the National Association of Realtors was higher. Pending Home Sales, which came in at a 3.6% gain month over month, is an index that tracks the number of home re-sales under contract. The index is designed to be a leading indicator of housing activity as most contracts become existing home sales between 1 and 2 months later.

Existing home sales, which will be reported on August 21st, have gained ground in the previous three months just as the pending home sales predicted. The National Association of Home Builders Market Index, which gauges sales, expectations and traffic, has more than doubled from a low of 8 in January to the current reading of 17. And New Home Sales have risen the last two months. The June reading of +11% was the largest month over month increase since December of 2000.

There are many reasons for the jump in housing data including lower prices, attractive mortgage rates, and the tax credit for first time homebuyers. But whatever the reason these are very encouraging signs for the devastated U.S. housing market that perhaps we have started to find a bottom. This is no more important than in the home construction stocks. Since July 13th, the homebuilders are up a very healthy 34%, and since the March bottom in the S&P 500 the stocks have risen over 100%. Certainly this has contributed to the overall sentiment in the market and helped break 1,000 on the S&P 500!

Monday, August 3, 2009

Cap-Weighed vs. Equal Weighted

We’ve been using Exchange-Traded Funds (ETFs) to implement many of our investment ideas for several years. ETFs offer the convenience of being diversified across many individual stocks, being highly liquid, and sporting very reasonable fees. They’ve exploded in popularity in recent years, and there are now hundreds of different funds to choose from, ranging from very broad market funds to more focused sector and industry funds. Therefore, we spend a lot of time analyzing the specifics of these funds to make sure we find a vehicle that best fits what we’re trying to do.

ETFs are designed to passively track an index, and many indexes are weighted by the market capitalization of the underlying stocks. All that means is that the largest stocks receive the largest weight in the index, proportional to their size relative to the size of the other companies. One of the downsides of this method that we’ve occasionally come across is that sometimes there might be one or two enormous companies in a particular sector or industry that receive an outsized weight in the index, meaning that the performance of that ETF is largely driven by the performance of a particular stock, basically defeating the purpose of owning a diversified ETF.

So, some ETF providers have solved this problem by offering equal-weighted ETFs. As the name implies, they simply take all of the members of an index give them the same weighting. The biggest difference is that this effectively reduces the weight of larger companies and raises the weight of smaller companies compared to a cap-weighted ETF, meaning that equal-weighted ETFs tend to have a smaller-cap bias. Since the market values of the companies fluctuate from day to day, causing them to drift from their equal weighting, they’re typically rebalanced back to the proper weighting on a quarterly basis.

Ultimately, investors should realize that not all ETFs were created equal, and there can be important biases built in to supposedly passive index products that they should be aware of, since they can have important performance ramifications.