Housing Market Update

There were several economic updates on various aspects of the housing market this week. On Wednesday, data on Existing Home Sales was released by the National Association of Realtors. It’s encouraging that sales have seemingly stabilized (shown on the first chart below), but worrisome that prices continue to post big declines. On Thursday, New Home Sales data was released by the Census Bureau. The key take away from that report was that the outstanding inventory of unsold new homes continues to fall (shown on the second chart below), which should help sales and prices to stabilize going forward. While there were some positives found in those reports, on Thursday the Mortgage Bankers Association revealed that mortgage delinquencies and foreclosures rose to record highs during the first quarter. So, a mixed message from the housing market this week, which is actually an improvement from just a few months ago when the information was overwhelmingly negative.

Credit Conditions Showing Clear Improvement

In the wake of the Lehman Brothers collapse last September, and the subsequent banking and credit seizure that ensued, numerous monetary and fiscal measures have been implemented to revive the flow of credit and get the heart of the economy pumping again. These programs have brought about much cynicism, and have pundits and the media questioning the solutions that are being used to fight the current crisis. Some think the programs are turning capitalism into socialism, some are worried about how we will pay for these policies, and many are convinced that current policy is sowing the seeds for hyper-inflation in our future. However, one question that may not be garnering enough attention within the mainstream press is, how effective have the programs been in terms of restoring the flow of credit to the marketplace?

On that front I believe that the weight of the evidence is showing an unambiguous improvement in credit and liquidity conditions. One composite we have been following lately is the Bloomberg U.S. Financial Conditions Index (chart below). The index has ten components and was designed to gauge and assess the availability and cost of credit in the U.S. financial markets. Without getting complicated, as the line falls it signals that credit conditions are deteriorating, and as it rises it indicates that credit conditions are improving. As you can see it has been climbing and is now close to where it was prior to the Lehman Brothers bankruptcy. I agree with the pundits that there will be many unintended consequences resulting from recent policy actions. However, the measures taken thus far do appear to be helping to restore the flow of credit to the marketplace, and that is something that all investors should be welcoming as good news.

Not the Best Day for Financial Planners

Last week I had the privilege of speaking to the Maryland Chapter of the Financial Planning Association about my book, Buy and Hold is Dead (Again). The results were entirely consistent with my talks to other industry groups about the subject of active management. There were about 5 advisors in the audience nodding their head in agreement because they already knew what I was talking about, and another 10 advisors nodding their heads because they suspected they knew what I was talking about, and were relieved to hear a speaker say what they had been thinking to themselves. However, the other 40 or so advisors had the same “deer in the headlights” look that I am used to seeing while they learn that the most cherished assumptions about how they manage money, and how they manage their business and client relationships, are probably wrong.

I don’t envy them their discovery. To find out that there is very little science behind Modern Portfolio Theory and the Capital Asset Pricing Model is troubling, and then to find out that the Efficient Markets Hypothesis is based on a pricing theory called Rational Expectations, which in turn is based on very troubling assumptions, is bad enough. But after finding out that most of the Nobel Prize winning gospel that we have clung to for fifty years has been disproved, they next find out that there is no easy answer for how to actively manage money, even if they decided that they wanted to.

Unfortunately, as I say in the book, there is no one correct methodology for determining value, for deciding where we are in the market cycle, or to utilize technical analysis to measure how investors are moving the market. Instead, my message to the Maryland Chapter of the FPA was that they need to start over, and to learn from the ground up how to develop a forecast and then execute that forecast in a dynamic portfolio construction designed to earn excess returns above market returns. For them it must have been a terrible afternoon. After all, Certified Financial Planners are taught that you shouldn’t try to formulate a forecast because forecasts are another term for the hated and reviled act of market timing, and you shouldn’t try to earn excess returns because the markets are assumed to be efficient. Since market timing (active management) is necessary to earn excess returns, and excess returns are necessary in secular bear markets, it probably wasn’t their best day.

Municipals and Treasuries

Last year, 2008, municipal bonds had a rough year relative to U.S. Treasury bonds. With the flight to quality during the credit crunch of 2008, 10-Year Treasury bonds gained 14% more than their muncipal counterparts, on average. This performance difference was best reflected in the comparison between AAA municipal yields and U.S. Treasury yields. In late 2008, AAA municipal yields were a staggering 130% of Treasury yields on many parts of the yield curve. As an example, a 10-year Treasury yielded 2.25% and a 10-year municipal yielded 3%, and the after tax benefit was even greater especially if the municipal bond was your own state’s issue.

However, as the credit crunch has eased and the flight to U.S. Treasuries has been halted, we’ve seen a much different picture so far this year. The chart below compares the year to date performance of the 7-10 Year Treasury ETF (IEF) with the intermediate National Municipal Bond ETF (MUB). Treasury investors have a lot on their mind with supply concerns, inflationary pressures that could build in a few years, and now, dare I say, potential downgrade concerns. And while municipal investors may have their own default concerns as states battle budgetary problems, investors have clearly felt more comfortable in that space recently since munis have handily outperformed Treasuries this year.

It is generally assumed that investors will own Treasury bonds in tax deferred accounts and muncipal bonds in taxable accounts, in order to maximize after-tax returns. But the last year and a half has really shined a light upon total return investing in bonds. The huge return differentials over multi-month periods argue for a more actively managed approach to managing bond portfolios, which is our strategy here at Pinnacle.

Inflation or Deflation?

There is an intense debate among investors about whether inflation or deflation is the greater evil lurking around the corner. There’s no question that deflation has been the stronger force since the credit crisis picked up steam starting last summer, causing the global financial system to nearly implode during the second half of last year. Economic activity largely shut down, causing steep declines in nearly all asset prices. For example, the Dow Jones/AIG Commodity Index collapsed by -57% from its high last July to its low in February. More recently, the Consumer Price Index was reported to have fallen by -0.7% in April from a year ago, the lowest reading since the 1950s (see chart below).

Lately, there’s been a lot of talk of “green shoots” – tentative signs of economic recovery. Stock markets have rallied, commodities prices have perked up, and bonds yields have risen, as economic data has begun to level off from a freefall. A growing number of investors are interpreting these developments as signs that the market has begun to adjust to an inevitable wave of inflation, thanks to the massive government efforts to rescue the financial system.

We believe that the threat of deflation still exists, although perhaps to a lesser extent than a couple of months ago. Despite the endless talk of green shoots, the slightest misstep by policymakers or some unforeseen shock at this juncture could cause a major setback to the fragile recovery and would likely tip the scales definitively back towards deflation. We fully recognize that inflation may in fact lie in wait, but due to the severity of the ongoing economic problems, we think that threat lies further down the road than the inflationists believe.

Don’t Mistake The Secular For The Cyclical

Today, in the midst of the worst recession during the post-WWII period, and after a particularly horrific bear market where the S&P 500 dropped 58%, there are many compelling arguments for why the financial markets are on the precipice of a breakdown to new lows. It’s hard to dispute that the long term prognosis for the U.S. economy appears challenging due to a number of headwinds that exist, such as large debt levels that are now deflating, a savings rate that is just starting to rise (implying less consumption spending going forward), a government fist that is tightening and seeks more regulation, and the strong probability of higher taxes and inflation down the road due to the desperate measures that fiscal and monetary authorities have implemented in order to “save the system.”

While all of the aforementioned problems are real and will change the way our economy works, I think the mistake that ultra bearish investors are making right now is that they are applying problems that will occur over years and decades (“secular”) to an asset allocation that needs to be positioned for months and years (“cyclical”). Yes, this period has brought about structural change to the global financial system, and yes, it’s hard to believe that the world will return to growth rates that were partially built on a Ponzi scheme and lots of leverage. But don’t overlook the fact that credit conditions are improving, housing affordability is way up, the frantic efforts of policymakers are aimed at jump starting the consumer, and the world economy is dynamic and finds ways to adjust. Lastly, don’t forget that all of the above should now be discounted and shouldn’t catch investors by surprise. Yes, the bears are retorting that the so-called “green shoots” we keep hearing about are about to turn into dandelions, and that this bear is not done roaring yet. But the bulls know that bull markets climb a "wall of worry," and the current wall is as high as it’s been in decades. They might warn the bears not to mistake the secular for the cyclical.

The bulls believe the market is climbing a wall of worry:

Chart source: Jim Stack, InvesTech Research

Does the Latest Market Rally Validate Buy and Hold Investing?

Lately I’ve been asked if the latest market rally, a record breaking move of 38% or so over the past few months, validates the idea that investors should just buy and hold stocks. For the record, there is no market move, either up or down, that validates the idea that valuations don’t matter and investors should blindly own stocks expecting to earn historic average returns regardless of the market’s value when they buy. However, I thought I would do some “back of the napkin” math to put this rally is some perspective.

If you bought the S&P 500 in March of 1998 and reinvested your dividends you would, as of Friday’s close, have almost exactly broken even on your investment. The actual price of the index on March 16, 1998 was 1,079. If you invested in the Vanguard Total Bond Market Index Fund on the same date you would have earned an annual return of 5.57%, very close to the expected returns for bonds if you made the sensible assumption that inflation was going to be 3% for the period. However, the historic premium for stocks over bonds is about 6%, so if you purchased stocks in March of 1998 with the expectation of buying and holding and earning the historic risk premium, you would expect to earn about 11% per year.

Here’s the bad news. If the S&P actually earned the 11% that was expected in order to validate the assumptions of buying and holding, the S&P would have to trade to a price of 3,400 tomorrow, a gain of 277%. If we look at today’s 10-year normalized (average) S&P earnings of $50, the market would have to trade to an unbelievable P/E ratio of 68 at that price. Or, let’s say you are a raving optimist and think investors would reward the stock market with a multiple of 30 times earnings, a prospect that is doubtful at best. In such a case, S&P earnings would have to impossibly and immediately grow by 126% to $113. The recent 38% rally in the stock market does nothing to validate the idea of buy and hold investing, unless we are going to rally an additional 277%. Notably, the volatility of stocks was five times more than bonds for the period, raising the question of what premium return would have been considered acceptable for investors who ate 5 times more volatility to earn it.

By the way, the next time the market gets to a PE multiple of 30, I will be happy to sell my stocks to the investors who want to buy and hold.

Losing Our Natural Stimulus

Gasoline prices are on the rise so far this year, which is a concern since jobless claims have been above 600,000 for 3 ½ straight months. This is not a good development for the already hurting US consumer. Below is a chart of the AAA retail gasoline price for the past year. As you can see the price of gas remained resilient throughout the first half of 2008 but did eventually succumb to the global recession. On December 31st, the price bottomed at $1.61 per gallon at the national level after falling from a high of $4.11. This provided significant stimulus to the American people as we consume roughly 140 billion gallons of gasoline per year (using Energy Information Administration 2008 statistics). This positive effect has reversed recently as prices have steadily risen since the beginning of the year and now stand at roughly $2.29 per gallon. Using a constant demand level this price rise reflects an increase consumer cost of $93 billion, which is not what the economy needs right now as it’s attempting to stabilize.

This increase will put enormous pressure back on the consumer and prices will continue to rise until demand falls or supply rises. The refiners have efficiently shut down production to support this price increase but I would love to see more supply come back on line to support demand at a slightly lower price and return some natural stimulus to consumers.

Markowitz's Lost Message

Harry Markowitz is considered the father of modern finance by many, and his paper, Portfolio Selection, published in 1952, is the foundation of the Nobel Prize winning body of work known as Modern Portfolio Theory. It provides the mathematical foundation for strategic asset allocation, which is how professionals apply buy and hold investing to multiple asset class portfolios. To the surprise of many, here is what Markowitz has to say in the beginning of his famous paper:

“The process of selecting a portfolio may be divided into two stages. The first stage starts with observations and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performance and ends with the choice of a portfolio. This paper is concerned with the second stage.”

It is shocking how Markowitz’s work has been misapplied by the investment industry over the years. Instead of using observation and experience to make assumptions about the future performance of available securities, investors are taught to use average past performance of available securities and assume that performance is a certainty. In fact, it is the misplaced “belief” that past performance will repeat itself in the future that makes me believe that buy and hold investing is more like religion than an investment strategy. Investors who misapply Markowitz’s models in this manner must have faith that the past really is prologue to the future. Investors must choose. They can either rely on average past performance for their beliefs about future asset class performance, or they can reach their beliefs based on thorough study of absolute and relative value, market cycles, and technical analysis.

We choose the second method.

Another Failure for Standard Deviation

Carl Noble, one of our excellent Pinnacle analysts, just passed around a chart from Ned Davis Research showing the short-term standard deviation of the change in price between the Financial SPDR, (ticker XLF), an exchange-traded fund that owns a diversified basket of financial stocks, and the rest of the market as measured by the S&P 500 Index. The chart shows that for the past 44 days the relative out performance of the XLF versus the broad market has been a 13 standard deviation event. In other words, the odds of this relative price move, using the common measure of risk in the industry, is somewhere around (give or take) once per 6,117,160,000,000,000,000,000,000,000,000,000,000,000 times. That’s a little less than once per trillion trillions. To put it mildly, this price move, as measured by standard deviation, is statistically impossible. Yet here it is, just another failure for using standard deviation as a measure of risk in financial models.

There are two lessons to be learned from the chart. One is that standard deviation can severely understate the probability of events in the world of finance, and investors need to take care when using financial models that use standard deviation to measure risk. Internally, we use standard deviation when we build our risk models that predict portfolio volatility. Externally, we use standard deviation as the measure of risk in the portfolio policy statements signed by our clients, and in the scatter charts we use to demonstrate portfolio performance. In each case, the user must beware. The models communicate a level of certainty about portfolio risk and volatility that can be invalidated by the misbehavior of markets. The past year has reminded us that our caution in using this risk measure is justified.

The second lesson is that after a 13 standard deviation move to the upside, it certainly pays to think about selling. I don’t know if we will ultimately execute the transaction in our managed accounts, but it sure has our attention.

Extrapolation is a Dangerous Game

According to the Merriam-Webster Online Dictionary, to extrapolate is “to project, extend or expand (known data or experience) into an area not known or experienced so as to arrive at a usually conjectural knowledge of the unknown area.” In other words, extrapolating essentially assumes that the past and present situation will continue going forward. Investors must be on constant alert not to extrapolate present trends too far into the future, or they may get surprised when their backwardly constructed view of the future turns out to be wrong due to cyclical or structural change that occurs naturally in our world.

Before the first quarter reporting season began, analysts were extremely negative on their outlook for corporate earnings based on the fallout from the global recession and the subsequent drop-off in corporate profits in recent quarters. It turns out that analysts have been right in their assessment of poor absolute numbers, but those that bet against positive equity returns during earnings season have been wrong as the earnings surprises (the difference between actual and consensus estimates) have been positive and markets have continued their upward trajectory. The bears will see this rally as a temporary smokescreen built on a weak foundation that is bound to fail. On the other hand, the bulls may be correct in believing that some of the gloom and doom baked into future earnings is overstated. In hindsight, investors should have questioned the complacency built into earnings estimates back in mid-2007. In my opinion, right now they should be questioning whether current analyst forecasts are too pessimistic due to recent trends. Caveat permabears – those who get caught overly “extrapolating” might be prone to getting hoodwinked by the consensus view again!

S&P 500 1st Quarter Earnings (approximately 90% of the index has reported as of 5/11/09)

Approaching the 200-day Moving Average

The stock market has rallied an impressive 36% in the past two months, as measured from the intraday low of 666 on the S&P 500 on March 6 through yesterday’s (5/7) closing price of 907. The index is now just 5% below its 200-day moving average of 956.  The 200-day moving average, as its name implies, is simply the rolling average of the past 200 days of closing market prices.  It’s widely used in the investment community as an indication of the market’s intermediate term trend.  Due to the severity of the current bear market, the S&P 500 has been below its moving average for an entire year now, having last reached it in May 2008.  Even then it only briefly touched the average rolling over into a steep leg down.  The market hasn’t traded consistently above its 200-day moving average since before the market top on 10/9/07.

We believe that it will be a positive development if the market is able to rally, and stay, above its 200-day moving average.  It would be a fairly strong signal that investors really are beginning to anticipate an economic recovery later this year.  On the other hand, if the market cannot breach and hold its 200-day moving average, it would serve as a warning sign that investors remain leery of a recovery and thus are reluctant to remain in the market after the recent gains.  Either way, we’ll be watching the behavior of the market as its approaches this important threshold for possible clues as to what may lie ahead.

Junk Rally or Not?

The S&P 500 has rallied from the March lows and is now standing in positive territory for the year. But I wanted to take a look at how we arrived at this positive performance. In the chart below I have in the left column the 2009 return for the S&P 500, all 10 GICS sectors (using ETFs), and four other widely followed indexes. In the right column are the 2008 returns.

	12/31/08 - 5/4/09		Last Year - 2008
S&P 500	1.58%		-37.03%
10 GICS Sectors
Staples	-5.47%		-15.02%
Healthcare	-7%		-23.31%
Utilities	-6.20%		-28.93%
Financials	-5.32%		-54.97%
Discretionary	11.55%		-32.97%
Technology	16.10%		-41.51%
Materials	20.26%		-44.05%
Industrials	-2.03%		-38.74%
Energy	3.44%		-38.97%
Telecom	11.10%		-42.04%
Other Indexes
Russell 2000	3.11%		-34.15%
MSCI EAFE	-1.54%		-41.04%
Emerging Mkts	24.55%		-48.88%
US REITS	-4.89%		-39.88%

In red I have identified the five worse performers for 2008, and their subsequent return year to date in 2009. You will notice the five worse performers (with the exception of Financials) are now the best performers this year. The current market rally seems to be made from oversold conditions on the hardest hit areas. Bear market rally proponents agree with this point, and further point to tricky accounting that are producing better earnings in these areas as reasons to be skeptical. They are waiting for a pull back or re-test of the March lows.

But, these five areas also share two important characteristics: they are high beta sectors that are generally characterized as early cyclicals (except telecom). I am encouraged by this sign of distinct leadership by historically early market leaders. And so are the bulls.

Low Conviction Forecasts

There seems to be a misunderstanding about generating an investment forecast that presumes that active portfolio managers always have a reliable one in their back pocket. Nothing could be further from the truth. Sometimes the forecast is as simple as “I don’t have a strong opinion one way or the other.” Such a forecast actually happens more often than not, and shouldn’t be a cause for alarm for investors. After all, forecasting is all about assessing future probabilities, and sometimes the data simply doesn’t allow for making a high probability forecast.

I believe that now is one of those times. Those that believe that they “know” what the outcome of the current state of economic affairs will be are making a high conviction forecast based on an unprecedented set of economic circumstances. There is nothing new about a country debasing its currency, and there is similarly nothing new about trying to inflate assets in order to prevent a debt liquidation and deflation. But it is certainly new to do so in an economy as deep and diversified as the U.S. economy, and to do so in such a coordinated manner within the global economy. By our count we are now up to about $12 trillion of guarantees and promises to invest by the various agencies of the U.S. government, and that is in the context of a $14 trillion economy. Who can “know” where this will lead?

Low conviction forecasts are not a problem for us as a relative value manager. In this case we get more, rather than less, diversified. In addition, we manage portfolio risk to be closer to our client’s risk benchmarks, as opposed to making large bets one way or the other. Our assessment of whether or not this latest 30% rally off of the intraday low of 666 for the S&P 500 Index represents the beginning of the next cyclical bull is inconclusive. At the moment I would characterize the situation as a coin flip either way, and in that situation we will hug our benchmarks, more or less. However, there is no doubt that the entire investment team would be more comfortable if the market would back and fill a little, and give us the opportunity to add to risk positions after a meaningful retracement of recent gains.

Consumption Spending and the Second Derivative

My colleague, Carl Noble, recently wrote about the latest GDP numbers, and mentioned that we view them as mostly backward looking at Pinnacle.   Last Thursday, the March report on Personal Consumption Expenditures (PCE), which is just geek speak for consumer spending, was released.  Consumer spending data always grabs our attention since spending is such an important driver of GDP growth in the U.S. economy, and we believe it has shown to be a good leading indicator for equity markets when tracked on a rate of change basis.

The latest data point on the chart below shows a year-over-year decline in spending of -1.2% through March, which on the surface appears quite unconstructive for the economy and financial markets.  But on the bright side, there’s actually been three consecutive months of improvement since the low point of -1.5% in December.  The increase or decrease in the rate of change is commonly called the “second derivative,” and many analysts believe that the stock market is responding to the improvement in the rate of change across a variety of different indicators recently, even though most, like consumer spending, remain in decline. In other words, what we’re experiencing is a “second derivative rally.”

Breaking 3%

On March 18, 2009 the Federal Reserve announced plans to purchase $300 billion of long-term government bonds in an effort to lower rates on mortgages and other debt instruments. The ten year Treasury was trading at 3.01%, which seemed to mark the point of defense for the Fed. Yields on the ten year quickly fell to 2.5% after the big announcement (as marked by the red arrow in the chart below), and Fannie Mae mortgage commitment rates dropped to 4.25%.

But on Wednesday, following the Fed’s latest meeting, there was no announcement on future purchases – and the Treasury market did not like that news. Yields broke above the key 3% level and now stand at 3.12% and are rising. Are supply issues due to future funding of the fiscal deficit weighing on investors’ minds? Are deflationary forces subsiding, reinforced by a strong reading of the GDP Price Index? I feel there are many different contributing factors to this rise, but one thing seems certain – the Fed will have to really ramp up their efforts if they wish to keep interest rates from rising any higher.

First Quarter GDP – Very Bad, But Backward Looking

The first quarter GDP report was released yesterday, and it wasn’t very pretty.  Real GDP, which is the primary measure of overall economic activity, declined at a -6.1% annual pace in the first quarter, which was only minimally better than the -6.3% drop in the fourth quarter. Economists surveyed before the report was released estimated that the decline would be -4.7%, on average, so it was considerably worse than expected.  Within the report, private investment and trade were very weak, while personal consumption was surprisingly strong.  You have to look back to the early 1980s to find quarterly contractions in GDP of this magnitude.

Although GDP captures a lot of attention, from an investor’s standpoint, the important thing to keep in mind is that GDP is a backward-looking report.  By that I mean it reports economic activity that occurred 2-4 months ago (January – March).  While we certainly pay attention to GDP, we spend more time focusing on other data that might give an indication of what lies ahead, as opposed to what’s already happened.  Lately, a variety of indicators have given the impression that economy is attempting to stabilize, which is the first step in recovery.  We don’t expect the economy to begin growing again before the end of the year or possibly even next year, but it seems that the worst of the contraction may have passed.