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.