The above are only some of the items we will be watching closely in 2010, which will be taken into account as we shape our view for the next few quarters. The entire Pinnacle Team would like to wish everyone a happy, healthy and prosperous New Year! See you on the other side…
Investors must always retain a healthy appreciation regarding downside risks to their forecast and allocations, particularly given the asymmetric law of numbers that exists. But risks are not a one way street, and being too early to withdraw volatility can be just as wrong as being too late to get defensive. Those who manage money can’t just focus on the negative scenarios, which is one reason we will be thinking about what could go right in 2010.
Since then, however, stocks have rallied nearly uninterrupted for more than 9 months. Yesterday, the S&P closed at a fresh 2009 high of 1,127, having rebounded by almost 500 points from its March nadir, which has certainly been welcome relief for investors. While impressive, stocks have merely returned to where they were last October. They still haven’t fully recovered their pre-Lehman Brothers level, which was 1,250 on the S&P 500.
In percentage terms, the S&P has soared by 69% since March, but remains -28% below its October 2007 high. Based on how the math works it actually requires a 39% gain to get back to the old high from here. While anything’s possible, we don’t view that as a high probability outcome in 2010. We believe that stocks may be able to grind somewhat higher as the economy continues to recover, but investors need to prepare for the possibility of a deeper correction as the current bull market ages.
Chart: S&P 500 Index 2007-09
Recently, the 2-Year/10-Year U.S. Treasury yield curve reached its steepest level ever. This means that the difference in yield between 10-year and 2-Year Treasuries grew to its widest margin in history (approximately 2.75%, as shown on the chart below). This seems odd, since the current consensus seems to be that we’re destined for several years of a “New Normal” with lower than average growth potential. So is the consensus just wrong, or is the yield curve signaling something different this time?
One scenario with a growing following has more to do with the latter. With high unemployment and extremely high debt levels, a growing number of economists are becoming increasingly worried about so-called “sovereign default risk,” or the previously unthinkable chance that the U.S. (and other major countries) may not be able to fully meet their ballooning obligations in coming years. Consequently, investors are demanding higher compensation in the form of higher yields on longer-term securities due to the perceived increase in risk, while the Federal Reserve keeps rates on short-term securities artificially low, resulting in the wide spread. In addition to sovereign risk, worries of rising future inflation expectations due to central banks around the world pumping liquidity into the system through all of the various Quantitative Easing strategies may also be pushing yields on longer-term securities higher. Whatever the true reason may be, the record-steep yield curve is just another indicator that we’re watching very closely at this critical juncture.
I have often written about the industry’s insistence on denying that professional investing has anything to do with making forecasts. Making forecasts is all about making market “predictions” and market predictions seem to be no different than selling snake oil to the suckers who will do anything to believe in a cure. Here is what one of our favorite fund managers, John Hussman, has to say about forecasts in his Weekly Market Comment (Clarity and Valuation, Dec 21, 2009):
Probabilities, however, are not certainties. If the probability of a given event is “p”, then the probability of “not that event” is (1-p). This, in my view, is what makes probabilities and average outcomes different from forecasts. When people forecast, they say, “this or that is going to happen,” and very often they establish investment positions that will do them a great deal of harm if they are incorrect…”
There is no doubt that an investor who makes asset allocation decisions based on a forecast that says, “this or that is going to happen,” is taking on a very large risk that his or her forecast could be incorrect. At Pinnacle, our asset allocation is based on our best assessment of the economic and market data as we see it in “real time.” We are all about assessing the risks to our forecasts, if that’s what they are. We want to better understand our level of conviction in our forecasts, because if we have a low conviction forecast we are going to allocate assets closer to our pre-agreed benchmarks for risk that we’ve established with our clients, and we are going to be more diversified in our approach to sectors, countries, industries, etc. As we get closer to being able to say, “this or that is going to happen,” our conviction is higher in our forecast and we can have large deviations from our benchmark and more concentrated positions in the portfolio.
So, Pinnacle makes a different kind of forecast. Instead of saying “this or that is going to happen,” we say, “We have a high or low conviction in the probability of this or that happening.” I guess I’ll stick to my guns and proudly say that our statement about the probabilities of future events occurring still constitutes a forecast, and I will let others deny that they make them at all. Either way, we strongly believe that our approach gets to the heart of the matter, which is that no one can know the future with certainty. Those who invest as though they do should beware.
“In this business if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.” – Peter Lynch
Investing is a demanding profession that requires constant attention to a multitude of perpetually moving parts. As hard as many investors work to come up with well-formed theories that lead to intelligent and accurate forecasts and ultimately profitable trades, the reality is that no one is correct all of the time. As human beings, we are always at risk to heuristics, which are ingrained traits that explain how people solve problems and make decisions, but can also lead to systematic errors and biases. An example would be anchoring, which according to Wikipedia occurs when people place too much importance on one aspect of an event, causing an error in accurately predicting the utility of a future outcome.
As a practical example, earlier this year the investment team here at Pinnacle made a decision to hedge our portfolios with an Exchange Traded Note (ETN) that attempts to mimic an index of implied equity market volatility. At the time, we were concerned that several different market indicators were warning of a possible market decline. If the correction occurred, we believed there was a high probability that market volatility would rise, and the value of the ETN along with it, which presumably would have helped offset some of the decline in other parts of the portfolio.
As it turned out, the correction was shallower than expected, and we were quickly down on the trade. At that point we were faced with reassessing the position given the most up to date market conditions. Had we anchored to our previous view based on outdated information, we could have decided to simply hold the security and hope our view panned out in the longer term. But hope is not a strategy, and as it turned out it was our willingness to assess the newest information available and admit that we were wrong that aided us in making the decision to sell the security. It wasn’t an easy decision and it felt awful to book the loss. But as bad as it felt to sell at a loss and admit to a failed trade, it would clearly feel worse if we were still a holder of the ETN today, given that it’s down an additional 20% from where we sold it.
Successful investing is largely about having a repeatable process, doing the homework, having conviction, paying attention to detail, and not being afraid to go against the crowd. But it also takes a certain amount of humility to admit when one is wrong. Make no mistake about it, knowing when to admit you are wrong can save you money.
Technical analysis is one of the main building blocks of our forecasting process, along with fundamental macro analysis and valuation. It involves the study of many different market-based indicators, including momentum, sentiment, breadth, volume, divergences, etc. We believe that different market environments require different levels of emphasis on each part of our process, and I think it’s fair to say that today’s liquidity-driven market requires that we devote more attention than normal to the technical condition of the financial markets.
During the current stock market rally, one of the strongest technical measures has been market breadth, which gauges the number of advancing versus declining stocks. Typically, in a healthy bull market advancing stocks significantly outnumber declining stocks, and in bear markets the reverse occurs. One market breadth measure that we’ll be keeping a particularly close eye on is the number of new 52 week lows in the marketplace. The indicator is fairly straightforward – as the name implies, it’s simply the sum of the number of individual stocks that have fallen to a new 52-week low.Below is a chart that plots the Bloomberg New 52 Week Lows on U.S. Exchanges Index (blue line) against the S&P 500 Index (red line). It shows that as the market began to rebound in March, new lows fell dramatically and have stayed very subdued ever since. Lately, however, new lows have been slowly rising, and even closed above some key moving averages. At the moment it’s too early to tell if new lows are in the early stages of an important trend change, or if this is another false breakout like we’ve already seen several times this year. Either way, we’ll be watching new lows closely for signs that the current bull market is running out of steam.
With the help of the European Central Bank (ECB), Austria announced on Monday that they were nationalizing its sixth largest bank, Hypo Group Alpe Adria. The bank was relatively small with assets of over 40 billion euros; however, it was considered a subsidiary of the German state controlled bank Bavaria BayernLB. BayernLB is much bigger with 416 billion euros in assets on its balance sheet, which is why this news sent systemic risk shivers down the ECB’s spine. This event certainly adds to recent fears surrounding the stability of the European banking system, and coupled with sovereign (individual country) risk has brought the European Union into the limelight.
Some of the ominous headlines over the past few weeks have included “Dubai’s Debt Default Shakes World,” “Credit Agencies Downgrade Debt Linked to Greece and Dubai,” and “Ireland, Greece May Leave Euro.” The accompanying stories highlight the serious risks that exogenous, or external, events contain. Central banks worldwide recognize that they must continue to flood the system with liquidity in order to maintain asset price levels and avoid contagion. Loan losses and debt burdens are still important issues that nations must face as we move into a “real” recovery. The hope is that all the stimulus “juice” will lead to this real recovery before the debt burdens cause sovereign defaults, which would have very negative implications if they occur.
At the moment, the market seems to be handling the news quite well. There were a few hiccups directly after the Dubai and Greece announcements, but stocks quickly recovered to their recent highs. Currency movements have been a little more noticeable. The U.S. dollar has started to move higher versus the Euro, although the downtrend started in March remains intact. Bearish bets on the U.S. dollar have been decreasing lately as investors take profits in that trade and cautiously position themselves for year end. This is an interesting development and we will be watching closely since many positions held by Pinnacle have benefited from a falling dollar.
Over the weekend I was reminiscing about a college professor, Dr. Hill, who actually asked the all-feared question on our philosophy final – “Why?” Being angered at the time at the stupidity of this question I wrote “Because” and walked out of the classroom. I later came to learn that anyone who actually attempted to answer the question got a “C” on the exam. The answer “Why not?” earned a “B,” and my well considered “Because” earned me an “A” on the final. I’ve been thinking about that answer lately because in the investment business, it’s important to know what investors believe in answering the question “Why?”
In the early 20th century, the French mathematician, Bachelier, gave us the first quantitative model for pricing options that relied on the idea that since it is impossible to figure out why prices move in a mathematical formula, it’s best to assume that price changes each day are the same as flipping a coin. He used the mathematics of his day for price movements (Brownian motion) and for volatility (standard deviation) to derive a formula for option pricing that looks very similar to the Black Scholes option pricing model used today. Using the mathematics of probability and statistics to make assumptions about the probability of price changes has been the rule for academics ever since. Markowitz’s Modern Portfolio Theory relies on the same assumptions and the same math to give us the notion of efficient portfolios. For academics, the answer to “Why?” would be to say, “Wrong question.” Modern Portfolio Theorists assume we can’t know “why,” and so they use past data to make inferences about future returns – a process called the stochastic method in science.
For active portfolio managers and value investors of every stripe the answer to “Why?” probably falls into one of two categories. If the answer has anything to do with interest rates, fiscal and monetary policy, earnings, currency, geopolitical news, etc, then we would consider these investors to be traditional value investors who find the answer to the question “Why?” in these and many other well known metrics of economic and financial health. If the answer to “Why?” is determined by the study of market prices, then we would characterize these investors as technical investors. At Pinnacle we expend enormous effort to find both traditional and technical answers to the question of why prices move. The academic approach is misused, misunderstood, and frankly dangerous for investors who think that the answer to “Why?” can be found in past data without understanding the “because.” I agree that actually finding the one reason that prices move is an impossible objective. But ignoring the news and the behavior of investors can only make you money in a long-term bull market, a state of affairs that may not be in the cards for quite awhile.
Now, a new set of rules from the FASB is ruffling some feathers again. FASB rules 166 & 167 require financial companies to bring many of the assets held in off-balance sheet entities back onto their balance sheets by early next year, which could impede the healing in that sector by requiring additional capital to be raised by those firms.
It remains to be seen exactly what the impact of the rules will be, but the market may already be anticipating a negative outcome. After rocketing off the March low and leading the market higher for several months, financial stocks have recently been underperforming. Whether that’s directly related to the new rules or is just a temporary pause isn’t entirely clear yet. We currently have only a very modest weighting in Financials due to the many ongoing challenges in the sector, and will be paying close attention to how they act as the rules take effect.
Chart: Financial Sector ETF (red line, top panel) vs. S&P 500 ETF (blue line, top panel) with relative strength (green line, lower panel) – Financials have been underperforming since 10/14
Mr. Gundlach is widely respected as one of the leading experts of mortgage-backed securities. We purchased his fund late last year with the thought that his fund would be the best way to invest in beaten-down mortgage securities, which we believed were offering a very attractive investment opportunity at the time. Indeed, as shown on the chart below, his fund is up over 20% this year, which is a tremendous return out of a bond fund. We were certainly disappointed to learn of his departure. When we also learned that his top assistants had also stepped down, we decided we needed to take action and sell the fund, since there was clearly a material change at the top involving those managing the fund.
Bombshells like these don’t occur very often, but when they do it requires an immediate review of that holding. In today’s environment the news comes fast, and markets never sleep. This is an example of the sort of risk management that Pinnacle provides for its clients.
Pinnacle Advisory Group, like most private wealth management firms, doesn’t “sell” our portfolio performance. The broader industry doesn’t sell performance because they are strategic, buy and hold, asset allocators and investment performance is considered to be completely random depending on the whims of the investment markets. It is far better to “sell” relationships. The relationship sale is much less dependent on volatile market performance that can be good or bad in any year, and much more dependent on selling things like trust, communication skills, dependability, organization, and financial planning benefits of all kinds. We understand the difference between selling features versus selling benefits, and clearly investment returns fall under the category of features. What are the benefits that we sell? It turns out that they are pretty much the same as those sold by the rest of the industry. In addition to the benefits mentioned above, how about less stress, more confidence in the future, and the ability to be happy in your life worrying about something other than finances. And of course, we sell ourselves.
I know we don’t sell investment returns, but it’s interesting to note that Pinnacle’s investment analysts got every major turn in the market correct since the end of the bear market in 2002 when we first started to actively manage money. The net result of overweighting risk in managed accounts in early 2003, underweighting risk by the summer of the 2007, and adding risk back to the portfolios by the beginning of 2009 has been a huge BENEFIT to our clients. They have earned higher returns with less risk than an unmanaged benchmark of stocks and bonds with similar risk/reward characteristics. Our moderate growth portfolios are generally only a few percentage points away from making all-time highs. A comparison to Morningstar’s Moderate Allocation universe of funds, which are managed with a similar risk exposure to our moderate growth portfolios, would result in our being ranked among the top 5%…if we were a mutual fund. This propensity to outperform is an interesting FEATURE to keep in mind.
For consumers of Pinnacle’s investment services, they will have to evaluate exactly how we managed to outperform. Is our process systematic and repeatable? What is the likelihood that we will continue to make good decisions in volatile markets? If we make a mistake, is it likely to be a big mistake or a small mistake? Could our clients do better themselves, or can they find another firm that does it better? These are all good questions and we stand ready to provide the answers to the best of our ability. But don’t misunderstand us…we don’t sell investment performance here.
The Citigroup Economic Surprise Indicator is a quantitative measure of whether or not daily economic reports are exceeding economists’ expectations. Prior to most economic releases, dozens of economists are usually polled for their predictions. A median of those results is then calculated, which serves as the “consensus” view. If the actual result is higher, it’s considered to be a “positive” surprise, and vice versa. This indicator is designed so that it rises as positive surprises outpace negative surprises. In other words, economic momentum is building. On the other hand, when it’s declining, as it is now, economic data is falling short of expectations, indicating that economic momentum has stalled, and that the economy may soon weaken.
As shown on the chart below, the indicator bottomed last December, several months before equities, and soared higher into early June – clearly ahead of actual improvement in the economy. It then moved in a volatile, sideways fashion during the summer, but has recently rolled over and fallen back to where it was in March. This has certainly caught our attention, but since other economic measures and market-based technical indicators we follow are still holding up, we remain cautiously optimistic for now.
There are two lines of thinking when viewing this chart and job losses. The first would be the bullish case that employment is a lagging indicator, so the recent progress proves that the economy has been improving since the March lows, and very soon the report may show the economy actually gained jobs (many analysts believe that may occur by February 2010). The second line of thinking is the bear case and focuses on the other side of the labor market – hiring. From their point of view, this has been the mother of all jobless recoveries and business hiring has still not shown signs of improvement.
It will be interesting to see how the market reacts to the BLS data tomorrow. If we get a better than expected number (125,000 job losses are expected), then the bull case of improving economic conditions could finally push the S&P 500 above the 1,100 to 1,115 range it has been in for the last two weeks. If the number disappoints, however, it could serve as the catalyst to drive an overbought market lower.
Late last week, the markets hit a pocket of turbulence on news that Dubai World requested an extension on debt payments of approximately $60 billion. The knee-jerk reaction was that stock markets tanked, the dollar rose, gold, oil, and commodities fell, and risk assets were roiled, for a day. News networks heated up and talk of a possible second wave of credit losses cascading through markets like the 1997-98 Asian Contagion was the concern du jour. Personally, I don’t think it’s much of a shock that Dubai is having some problems. I mean come on, anyone that’s watched the Discovery channel has probably seen the documentary about the creation of the Palm and World islands. Not that the place is not really neat, but it doesn’t take a genius to know that indoor ski slopes, manmade islands, and spectacular office structures may seem a tad extravagant in good times, never mind while much of the world has just suffered through the worst economic crisis since the Great Depression.
Perhaps more concerning to me than Dubai is that there are a number of technical divergences that are building within the marketplace. Some examples are that neither the Dow Transportation Index nor Small Cap stocks have kept pace with the S&P 500 Index recently, previously healthy breadth (advancing vs. declining stocks) has caught a case of halitosis as the A/D line is sagging, the number of stocks making new lows is creeping higher after a long slumber, and volume is steadily falling. We aren’t the only ones noticing these divergences – some of the most bullish analysts we follow are beginning to change the tone of their bullish commentary, with the market rally beginning to look a bit weary after its torrid rise. Add a short-term extended market to the mix and you could make a good case to simply get defensive right now.
But it’s never that simple with markets, and there are a few things keeping us from getting more defensive just yet. Liquidity in the marketplace remains buoyant, momentum is still positive, the trend of most economic data is continuing to improve, and we are coming into the season of the so-called Santa Clause rally, which is the moniker Wall Street uses to describe the historical tendency for stocks to rally at the end of the year. The bottom line is that we are diligently monitoring incoming data (as always), and our strategy remains flexible, but for the time being we are cautiously keeping portfolios positioned for neutral volatility.
Chart Source: Jim Stack, InvesTech Research
