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.

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.

Falling Baltic Dry

At Pinnacle we watch many different global growth indicators and one in particular has peaked my interest. The Baltic Dry Index is an index that measures dry bulk shipping rates in certain shipping lanes around the world, and therefore offers a glimpse of real time demand for infrastructure material. As the chart below shows, this index has recently fallen almost 50% from a May 2009 reading of 4300 to the present reading of 2175 (of course it did rise over 500% from November 2008 to May 2009). This fall is a direct result of an increase in shipping capacity and a decreasing demand for goods, particularly out of China.

As China poured the record stimulus into the market the demand for iron ore and other industrial metals experienced a rapid rise. This caused shipping rates as measured by the Baltic Dry to rapidly rise as well. But it also created an incentive to keep old ships in the shipping lanes to handle the rapid demand rise. And now the shipping companies are experiencing the hangover from artificial demand as the stimulus package is slipping and China’s appetite is waning.

The direct impact on the stock market is not being seen though. Clearly real demand for industrial metals is not present in the global economy, and this would normally portend a weak stock market. But during a liquidity driven market perhaps the index loses its forecasting ability. We will continue to monitor this and many more indexes to judge global economic health.

Technical Take- Fibanocci Charts Mixed, Intermediate Technicals Solid

At Pinnacle Advisory Group, technical analysis is one of the three pillars of our investment process (Macro Fundamentals, Valuation, Technical Analysis) that help us shape our forecast and set portfolio allocation. Technical analysis is a very broad term and we will define it loosely as anything non-fundamental. Some examples are following intermediate term trends (like the 200 day moving average), analyzing sentiment in the market place, and monitoring measures of investor fear (options volatility (VIX) & put/call ratios). One technical indicator we monitor is called Fibonacci analysis, which is based on the mathematical theory of Leonardo Fibonacci. It is used in practice to try and identify trend changes, and entry and exit points in markets undergoing countertrend retracements. Based on Fibonacci’s work, most counter trend retracements will peak somewhere between 50-61.8% before the retracement stalls and the major trend again resumes. If the countertrend retracement exceeds 61.8% it is usually assumed that there has been a trend change from bull to bear or vice versa. Utilizing this technical tool seems particularly valuable right now to help analyze a market that has recently seen a vicious long term down trend give way to a rip roaring rally.

Below is a chart of the value line index, which is a broad index that consists of 1650 equally weighted stocks. When looked at from a top to bottom basis the index has currently retraced more than 76% of the decline off the last market top. This chart would imply that we are currently in a new bull market, and not a bear market retracement. But hold on, depending on which index you look at (the S&P 500 or the Russell 2000, NASDAQ, Emerging Markets etc.) and what time you use to run the Fibonacci numbers (some might use a timeframe closer to the Lehman collapse in 2008 to present, others like the top of the market in 2007 to present) the retracement level may give an entirely different message. After running through a number of markets and different timeframes, the general message I’m seeing is mixed and muddled, which simply means this technical indicator is providing a non-conviction forecast. But one indicator does not make a market, and Fibonacci analysis aside, there area two different technical takes that appear to be more clearly defined. Number one is that the market appears to be overextended in the short term and is vulnerable to correction at any time now. Second, and more important, is that the weight of technical evidence seems to be improving on an intermediate term time frame. That won’t make a correction feel any better when we get it, but right now we are viewing any correction as a healthy consolidation within a bull market, not the beginning of the next bear market.

Portfolio Managers versus Money Managers

In my opinion there is an enormous amount of confusion about who the players are in the investment industry so here is my particular take on the subject. I define portfolio managers as investors who have the freedom to invest in multiple asset classes. Their portfolios are typically constructed with investments in U.S. and international stocks, U.S. and international bonds, U.S. and international real estate, commodities, and other exotic asset classes like managed futures, hedge funds, private equity, etc. While they have the freedom to invest in any mix of these assets that they like, in the traditional world of buy and hold strategic asset allocation virtually all portfolio managers subscribe to Modern Portfolio Theory to come up with the single best or most “efficient” mix of asset classes. The end result for portfolio managers is that the mix of the asset classes they choose never needs to be changed because markets are presumed to be efficient and investors are presumed to be rationale. In short, traditional buy and hold portfolio managers buy and hold asset classes in a fixed mix that changes very little over time while they patiently wait for the past performance of each asset class to materialize.

Portfolio managers invest with money managers like mutual fund managers or separate account managers to invest each asset class in the portfolio. A money manager usually is an expert in managing assets in one asset class, and his or her portfolio performance is compared to a one asset class benchmark. You can find money managers specializing in virtually any asset class, including all of the ones mentioned above. These are the managers who buy and sell individual stocks and bonds as institutional investors, and these are the managers you see on TV who comment on the current state of the markets. They have an immediate and vested interest in the financial news of the day as they actively manage their portfolios to try and beat their one style constrained performance benchmark. For example, a large cap value mutual fund manager who is trying to outperform the S&P 500 Index.

For most retail investors, their financial advisor acts as a portfolio manager. They invest in money managers in the form of mutual funds and separate accounts in order to own multiple asset classes in their client’s portfolio. If they are a traditional buy and hold advisor, once they buy these funds, there is little to do but explain how they perform to clients, check their relative performance once a year or so, and remind their clients to be patient until expected returns arrive, presumably some time in the future. Do not confuse these two types of managers. A portfolio manager who passively invests in money managers is not practicing “active” management. In contrast, Pinnacle Advisory Group actively manages portfolios at the asset class level. There is a huge difference between actively changing the asset allocation of a portfolio management versus passively owning active money managers in a portfolio. Don’t confuse the two.

Could Rising Net Worth Keep the Cyclical Rally Fueled?

Today the Federal Reserve Flow of Funds report was released and with it, the latest look at household net worth. Household wealth increased by $2 trillion in the second quarter on the back of higher stock prices and a firming housing market. This was the first gain in net worth since the third quarter of 2007. One of the more insidious features of the past bear market was the vicious negative feedback loop where each leg of lower prices forced more selling, causing net worth to drop to lower and lower levels at a dizzying pace. Not to get too excited, because the year over year look at this series is still quite grim, and the bears will no doubt be focused on the absolute wealth lost and the second derivative nature (less bad, but still negative numbers) of the move on a trend basis.

But I would contend that some of the feedback loop was produced by an increasing lack of confidence, some of which was the double whammy effect of both lower stock and housing prices. Some will say this is old news and already factored into stock prices. But if individuals begin to feel more confident they may just start spending again. And since spending is still the dominant part of US GDP growth, that could be the catalyst for better revenue, earnings, and a pickup in employment, all of which should flow into higher financial asset prices, and then back to even higher net worth. Essentially, if higher net worth leads to improved confidence and more spending, maybe there’s a chance that we are seeing the opposite of the negative feedback loop – which would make it a positive feedback loop, I suppose.

Chart above - Year over Year Change in US Household & Non Profit Net Worth

Source: Bloomberg

The Recession Is Over!

Everyone can breathe a deep sigh of relief – yesterday, Federal Reserve Chairman Ben Bernanke, in response to a question after a speech he gave, stated that the recession is “very likely over.” That’s great news, right? Not necessarily. First of all, although he’s the nation’s leading monetary authority, Mr. Bernanke is not part of the body that officially declares the beginning and end of recessions. That responsibility belongs to the National Bureau of Economic Research’s Business Cycle Dating Committee. The NBER is a private, nonprofit organization (of which Mr. Bernanke was once a member, but no longer). Second, he warned that the recovery is likely to be lackluster, mostly because the employment situation remains very challenging. And third, if you wanted to be really cynical about it, then perhaps you wouldn’t feel too confident about the predictive abilities of the Federal Reserve, since they certainly didn’t provide meaningful warnings prior to the historic financial crisis that we’re currently attempting to recover from. But we won’t go there.

The problem with the whole recession dating process for investors is that it tends to be very lagging, meaning that the stock market has probably already moved in a big way by the time you find out if a recession has either started or ended. It makes for great headlines, but that’s about it. Instead, we try to focus on various leading indicators and other measures that might give more advance notice of important turns in the cycle, many of which we’ve written about here. We’ve seen a growing number of those improve over the past couple of months, implying that the recession probably did in fact end sometime over the summer. Stocks have certainly anticipated that, since the S&P 500 has rallied an impressive 55% since the low on March 9th. Our focus now is on trying to respect the very powerful rally we’re enjoying, while also being careful not to get caught up in the euphoria that’s sure to build as the market climbs higher and more and more people pile on to the “recession is over” bandwagon.

China – Perception vs. Reality

Chinese stock markets bottomed out earlier than domestic stock markets (October 2008 vs. March of 2009 for the S&P 500), and have now rallied over 90% since then on a timely and well executed stimulus package. Proponents of the Asian emerging growth story cite that China has less debt, higher economic growth rates, and none of the financial balance sheet problems that have plagued their developed counterparts. But for every bull there is a bear, and the bears seem to believe this market is setting itself up for another boom/bust scenario. Many bears believe that China has huge excess capacity built up, and that its main driver of growth has been exports to the West, much of which was fueled by an overbuild in debt, a shadow banking system, home equity withdrawals, etc. The proponents of this view see no fundamental reason for China’s rally, especially since their main US customers are bound to be in a deleveraging cycle for years to come.

Recently I read a research piece that listed a breakdown of China’s growth drivers, and the numbers implied that China may be less export dependent than most investors perceive it to be. I have to admit that I was surprised to see that the percentage of Chinese GDP driven by exports currently represents less than 10% of the total, while consumption and investment represent approximately 92% of current growth (see chart below). Residential consumption itself is actually more than a third of total growth, though it has slowed as exports and foreign direct investment have accelerated in recent years. My view regarding China has been that there are still strong linkages between China and global consumption, and I think the last downturn reinforced to me that some connection clearly still exists. However, the facts are the facts, and investors (including myself) must always be mindful to not ignore them as they attempt to square perception versus reality on any investment thesis. To say that exports are not important to China would be a misstatement. However in this case it appears that the perception of China being primarily dependent on exports is also misleading and ignores the reality that China gets a significant percentage of growth from consumption. And that’s a percentage that may be bound to grow in future years given that the country appears to be in the early innings of a transformation that will take it from an emerging market into an industrialized nation.

Chart Source: Ned Davis Research

Paul McCulley Strikes Again

Paul McCulley is the managing director of Pimco (Pacific Investment Management Co., one of the largest bond investors in the world) and each month he writes a piece called Global Central Bank Focus. This month, in an essay called, “Because I Said So...,” McCulley discusses the “old” rules for Central Bank policy for fighting inflation and relates the “new rules” for inflation fighting to parents who sometimes tell their children, “Because I said so.” I can’t do full justice to the piece on the blog so please read it for yourself at:

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/McCulley+Sept+Because+I+Said+So.htm

For those of you who are not economic wonks, McCulley reminds us that for many decades our central bank has targeted inflation without regard to the prices of assets or the impact of potential future asset bubbles. The rule for inflation targeting is called The Taylor Rule after economist John Taylor. The rule suggests the elements for the inflation targeting equation are: 1) The neutral rate of inflation that would theoretically exist if inflation and employment were both at “target,” 2) The inflation rate itself, 3) The gap between actual inflation and target inflation, and 4) the gap between the actual unemployment rate and the theoretical “full” unemployment rate. McCulley points out that asset prices are nowhere to be found in this equation for targeting inflation, and that U.S. central bank policy has been to suggest that asset prices are implied by the other inputs to the Taylor Rule, so the Federal Reserve doesn’t need to forecast asset bubbles as they appear in the economy. The stated policy is to wait for the bubbles to burst and then use a “mop up” strategy when the bubbles actually do burst.

Well….its clear that something has to change in our approach to asset bubbles, and McCulley opines that in the future the Fed will have to take a countercyclical approach to policy that “leans against” boom bust cycles by changing capital/margin requirements for banks and by reforming the bankruptcy laws. But what really caught my eye were McCulley’s final thoughts about forecasting asset bubbles and creating new paths for central bank policy, since forecasting is a subject we spend a great deal of time studying here at Pinnacle. He says, “Yes, that will sometimes mean taking action that is not fully anticipated, based on old rules of the game. But just like parents, central banks (read money managers) must exercise judgment, and sometimes, good judgment does involve making decisions on the basis of where the gut says the brain is going.” Thanks, Paul. I couldn’t have said it better myself!

End of another Program

On September 19, 2008 the money market guarantee program was instituted following the Reserve Primary Fund breaking its $1 Net Asset Value. The program covered all money market mutual funds regulated under the Investment Act of 1940 which maintained a stable share price of $1. In essence the government was trying to calm investor fears after the second $1 break in US history, and prevent a strong run on the banking system. Broker dealers bought into the system and it worked well enough to prompt an extension of the program. Now that program is set to expire on September 19, 2009.

Currently there is $3.5 trillion invested in money market funds. The average money market, seven-day compounded yield is .06% according to the Money Fund Report. The government has hopes the program will slide out of existence under the radar but I don’t think that will be the case. For the past few weeks the dollar has been hammered, gold and commodities have soared, while bonds have remained relatively flat to up. With the enormous amount of cash in the money market funds, and the incredibly pathetic yield, perhaps treasuries are being bid to secure the government guarantee that is set to expire. We shall keep our eyes open on the 19th to see if it does indeed slowly fade into the night.

Go-Go-Go-Go-Go-Go GOLD!!

The world is going wild as gold continues to grind higher, and many believe this is just the beginning of a strong bull market. Gold has constantly been in the news and rightfully so. The Chinese have for a very long time expressed concern about the dollar as the world’s reserve currency, and now the United Nations has joined the parade. It has been acknowledged that the Chinese are even looking to invest in gold on dips to diversify their reserves. The developed world has started to fiscally destruct and the aftermath of the implosion of the western banking system is still being felt. Gold has so many benefits that make it appealing during these uncertain times. It offers protection from risk aversion and currency devaluation, defense against inflation and monetary experiments.

With this backdrop, over the last week gold has broken out to the bullish side of a technical trading pattern called a pennant (indicated by the white lines in the chart below). This suggests good things to come for the precious metal as the technicians are looking for a $60 gain on that breakout. Additionally, the widespread media coverage could lure investors to the metal and give another boost. But the bulls have to contend with a strong ceiling as gold is failing to hold $1000 per ounce for the second time this year (the horizontal red line). This seems to be an important psychological barrier to overcome so it will be interesting to see if the buyers or sellers win this short term battle.

While interesting, the short term move has little impact on our long term strategy. We feel confident in our decision to maintain a 5% hedge in gold. Longer-term, global fundamentals remain uncertain and gold provides security for many possible outcomes. After all, gold is gold.

Market Valuation – Is Intrinsic Value Higher Than the Current Market Price?

One measure of overall stock market valuation that we monitor is showing us that the intrinsic value of the market continues to grow, which is somewhat counterintuitive to what you might expect to happen after a 50% market rally. The methodology I’m referring to is a modified version of the Benjamin Graham intrinsic valuation model. This model was originally built for individual stocks, but The Leuthold Group, a well-respected institutional research firm, has modified it slightly to value a market index instead of individual companies. Recent calculations indicate that fair value on the S&P 500 Index is approximately 1,100. Since the S&P 500 is currently trading at about 1,000, it implies that the market is undervalued by approximately 10% (see chart below).

The increase in intrinsic value has been driven mostly by the dramatic improvements in credit markets that have occurred this year. As fear has abated and risk appetites have expanded, the AAA corporate bond yield has collapsed from 7.7% down to approximately 5%. This lower yield flows through the intrinsic value calculation and has driven the surge in fair value Some bearish pundits are screaming that the market is already overvalued after the equity rally we have experienced, and that is a reason to be underinvested in equity markets right now. Personally, I wonder how many of those pundits ignored the warning coming from credit markets before the financial collapse. Could it be that the credit markets are again well ahead of the equity markets in assessing the overall economic and financial landscape? If so, that might just leave further room for equity markets to firm and catch up to the positive message being projected by the corporate bond market.

Do You Hear That Sigh of Relief?

The stock market has come rocketing off the March 9th lows and the rally is now at 50%+ and counting. Buy and Hold investors who had been holding their breath and hoping that something positive would occur in the markets to rescue their portfolio are wondering if their prayers have been answered. Even though the S&P 500 is trading 35% below its October 2007 peak, and is still trading below its March of 2000 value, and even though portfolio returns have dramatically underperformed any reasonable and conservative estimate of growth for a decade, you can hear the strategic buy and hold crowd breathing a huge sigh of relief.

50% market rallies do a wonderful job of helping investors take their eye off the ball. While six months ago the media was screaming that buy and hold is dead, now that story is being put into mothballs while writers scramble to cover the next bull market. How sad. The buy and hold is dead story has nothing to do with short-term market fireworks in either direction, and everything to do with a theory that supposes that such extreme market volatility shouldn’t be happening in the first place. Active portfolio management is all about understanding the intersection of traditional market valuation, economic cycles, and investor behavior as measured by market sentiment and market breadth. It is worth repeating that classic modern portfolio theory and the efficient markets hypothesis (buy and hold) refute the need for any of the above. In theory, buy and hold investors can sit back and wait for anticipated returns to appear right on schedule, which is some unspecified time in the future. This remains a dangerous strategy for investors.

I am personally enjoying returning to my former status of investment genius as the bull market continues. The 2003 – 2007 bull market seems like it occurred a long time ago and I am not immune to feeling great about excellent year-to-date portfolio returns. But cyclical rallies in secular bear markets do not make the case for buy and hold investing. These are the rallies that need to be invested with caution and respect. Buy and hold investors who are just now looking up to see if the coast is clear just might be heart broken as structural headwinds inevitably crush buy and hold returns in a continuing secular bear market.

Another September Swoon In Store?

There are lots of studies that analyze the so-called “seasonality” of market behavior. The most well-known is probably that of “Sell in May and go away,” which is backed up by statistics showing that the market has historically produced most of its returns in a given year during the November-April period, implying that investors are better off to simply sell in May, and go away for the summer and early fall. Due to the events of the past year, however, that hasn’t played out as expected – from last November through this past April, the S&P 500 lost -10%. Meanwhile, it’s gained 17% since April. So, the current cycle is a good example that there are always exceptions to accepted wisdoms, and that things often play out much differently than historical averages might suggest.

Now that September has started, is there any reason for investors to be concerned, strictly based on the calendar? Some would say yes, and they would have plenty of ammo to back up their argument. According to Ned Davis Research, since 1926 the S&P 500’s average return in September is actually a loss of -1.1%, and positive returns have occurred in less than half of the 82 Septembers in the sample (45%, to be exact), making it the worst month out of the year by both measures. In addition, the September-October period in particular has hosted many of the most notorious events in stock market history, such as the “Black Monday” stock market crash in 1987. Just last year, Lehman Brothers failure on September 15th triggered a -40% collapse into the November 20th market bottom. Since that painful event is still so fresh in investors’ minds, it’s understandable that anxiety levels may be creeping higher as we enter fall, especially since the market has rallied +50% off of the March 9th low.

So, since the seasonal pattern seems to be changing to a historically unfavorable environment, is it time for investors to sell and get more defensive? While it’s important to be aware of, we don’t necessarily think that will be the case this time. With the market having moved up aggressively, it may be due for another breather, perhaps something similar to the -7% correction that occurred during June/July. But, with an economic recovery underway, we wouldn’t be surprised if this fall plays out much differently than last year, with a more favorable outcome for investors this time.

ETF Methodology in Practice

When deciding on which Exchange Traded Fund to buy, there are different methodologies from which to choose. Carl wrote about the differences in construction in his post called Cap-Weighted vs. Equal Weighted. As he mentioned, there can be important biases built in to the products which could provide benefits or downfalls in different markets. For instance, the equal weighting methodology lowers the market capitalization of the index and may be more beneficial in a bull market. However, it is important to realize that each fund can dramatically drift from the stated construction rules and performance could be affected.

We owned an ETF called the First Trust NYSE Arca Biotechnology ETF (FBT) which is designed to replicate the price and yield of that exact index. The index is an equal weighted, 20 member biotechnology index which includes well known companies such as Genzyme and Amgen. But it was through a lesser known, small cap company called Human Genome Sciences (HGSI) where we experienced the dramatic drift (beneficially) in construction. The company had successful Phase 3 trials for their new Lupus drug called Benlysta and the stock exploded from $3.30 a share on July 17th to $18.80 today.

The explosion in the stock price took the equal weighted index and propelled HGSI to a 22% weight from 5% (20 stocks equal weighted). And the fund had stated in its prospectus that it would only rebalance the stocks every quarter back to a balanced state. With a 22% weight HGSI would dominate the performance of the ETF and it would no longer provide us with the equal weight methodology for which we originally invested. We decided it would be prudent to sell the fund and capture the gains provided by HGSI, and find a better alternative. With the explosion of ETFs over the last few years there are several options for most sectors and we will continue to evaluate them to ensure that we are invested wisely.