Amhran na bhFiann

Yes, the PIIGS (Portugal, Italy, Ireland, Greece, & Spain) have made headlines once again. With the Greek tragedy continuing, for the hero has still not encountered misfortune, Ireland has thrust itself into the spotlight. Today, the government announced its plans to create a ‘bad bank’ to purchase bad debt from Irish banks and lending institutions. Additionally, they implemented rules that could result in more banks being nationalized. This plan is very similar to plans enacted by the United States in 1989 with the creation of the Resolution Trust Corporation and Sweden in 1992 with S&R. However, this solution has not been utilized in the developed world during the current financial crisis, as governments have chosen to use capital injections to repair the banks instead.

Looking at some of the details, the Irish government will spend 8.5 billion Euros to purchase 1,200 loans valued at 16 billion Euros. The price paid is an astonishing average discount, or price below par value, of 47%. First, the price paid should be a little concerning to U.S. financial sector investors, since many loans here are still marked close to par. Second, and as equally important, it shows how badly the European financial sector has been hit by the financial crisis and housing bubbles. And there is still much work to be done to repair the damage.

John Mauldin recently wrote a piece titled “What Does Greece Mean to You?” In it, he comes to the not so simple conclusion that “…Greece is important? Because so much of their debt is on the books of European banks. Hundreds of billions of dollars worth.” Financial institutions in the developed world are on a precipitous cliff, since a default of similar magnitude would be very bad. Now, the Greek situation has improved recently but we still need the European Central Bank and International Monetary Fund to develop a long term solution. We need to restore confidence in the market, or we will quickly see how many nations follow this tragic path.

Consumer Resilience Continues

Proponents of the “New Normal” have counted on a higher savings rate and less consumer spending as the economy slowly deleverages in the wake of elevated debt levels, structural damage to the financial system, higher taxes, and more regulatory hurdles on the way. So far the New Normal has not materialized, and consumer spending went up again this month when looked at on a year-over-year basis (see chart below).

The fact that the New Normal hasn’t materialized yet doesn’t mean that the thesis is incorrect, but as I wrote about last May on this very blog (http://echoesfromthepit.blogspot.com/2009/05/dont-mistake-secular-for-cyclical_20.html), the mistake may have been in applying a secular concept on a cyclical time horizon. If anything, over the last few quarters we’ve seen a big healing in credit conditions, a contraction in savings rates, improving confidence, and yes, even renewed spending on the part of consumers. What the economy still needs is job growth, which would improve wages, reinforce the ability to keep spending, and bolster top line earnings even further. The next clue on that front comes this Friday with the monthly employment report. We’ll be watching…

CFA Luncheon

Yesterday, I had the opportunity listen to an excellent speaker, Russell Napier, at a luncheon hosted by the Baltimore CFA (Chartered Financial Analyst) Society, of which I’m a member. Mr. Napier is a renowned financial market historian, and has done extensive analysis of all different types of historical market cycles. He is currently an author and a consultant to an Asian investment brokerage company.

I thought I would share some of his more interesting views. While not all that optimistic generally due to high debt levels and soaring budget deficits globally, he’s actually fairly positive on the U.S. for the next year or two. He believes that both the U.S. dollar and U.S. equities may do well because he’s expecting capital to begin flowing back into the country. He argued that while the U.S. certainly has plenty of problems, it’s still fairly attractive on a relative basis to Europe and Japan. Anecdotally, he pointed out that large pension funds in Europe that he works with are significantly underweight U.S. equities right now, and may begin increasing their allocations if the recovery continues. He’s more negative on U.S. bonds, but believes interest rates will rise gradually, not suddenly or abruptly.

Overall, it was very informative, and provided lots of food for thought. While we may not agree with all of Mr. Napier’s arguments, attending events like these helps us to challenge our own views and assumptions, which improves our overall decision-making process as we manage portfolios.

Health Care Overhaul

After what seems now like an eternity, health care reform legislation was finally passed by the House late this past Sunday. As the investment team at Pinnacle gathered on Monday, we were eager to watch and observe the market’s opinion of the bill. Some pundits were worried that the stealth taxes increases contained in the bill would roil markets. After all, not only is the Medicaid tax being raised (1.45% to 2.35% on households making more than $250,000), but a new Medicare tax on income will also be assessed going forward. Others were worried that health care stocks might be spooked by the reconciliation process, which will play out in the Senate this week and creates some uncertainty as to the finality of Sunday’s vote.

Well, it’s only been a couple of days, but so far the stock market, and health care companies in particular, seems to be taking the bill in stride. Yesterday, the S&P 500 broke out to a new high for this cycle (1,174). As for health care stocks, they are doing just fine. In fact, the pharmaceuticals industry appears to be really celebrating the last few days, presumably loving the fact that there is no reduction in drug patent lives, and that the mandate for coverage should increase the top line more than the fees and other concessions affect the bottom line.

We have been bullish on health care stocks for quite some time, and are overweight the sector (along with technology) within the domestic equity allocation of Pinnacle portfolios. Cheap valuations, positive pricing power, and a number of other positive micro factors embedded within health care industry groups are among the reasons for being overweight. Our stance regarding legislation and its impact on the stock market has been that it would likely be more bark than bite. Admittedly, the reconciliation piece of the bill is not passed, we are only a few days out from the passage of the bill, and some states are threatening to fight the mandate for coverage on the grounds that it’s unconstitutional. We’ll keep watching and assessing the situation, but so far, it appears the market agrees with our thesis.

Chart: iShares Pharmaceuticals ETF (Symbol: IHE)

Head and Shoulders in Gold

One of the most recognizable technical patterns is the head shoulders pattern. This is a pattern that is classified as a reversal pattern because its completion usually means a new trend has started. The pattern starts with a rise in price, followed by a sell-off period that retraces some of the gains. Then there’s a second rally that takes the price to a higher peak, and another sell-off period that falls to roughly the same level as the previous sell-off. Finally, there’s a third, weaker rally that forms a lower peak, and a sell-off that breaks below the low price of the previous two selling periods.

The chart below is a price chart of the June 2010 future contract for gold from 2/1/10 to 3/22/10. The first rise in price, or the left shoulder, peaks at $1,123/oz, as indicated by the first red arrow. The second rise in price, or the head, peaks at $1,144, as indicated by the green arrow. The last rise in price, or the right shoulder, peaks at $1,128, as indicated by the second red arrow. The white line is called the neckline, and if prices break below this line a sell signal is generated.

Furthermore, downside targets can be projected by taking the difference between the head peak and the neckline, and subtracting that number from the neckline. Specifically with gold, the peak is $1,144 and the neckline is $1,100, which would project a decline to at least $1,050, but the closely-watched level of $1,000 could also be reached.

Water Cooler Conversations

I recently engaged in some correspondence with a money manager who is a technical trader who makes “non-emotional” trend-following decisions for changing portfolio construction. I welcome any and all techniques that managers use to manage risk, but I had to smile at the thought of “unemotional” investing. I know that professional money managers are supposed to be completely dispassionate automatons who evaluate data with computer-like efficiency. But in my experience, that simply isn’t the case. In fact, while evaluating the performance of other managers we often imagine the “water cooler conversations” that must be taking place whenever a particular investment strategy isn’t working. And believe me, at one time or another, virtually every investment strategy doesn’t work for some period of time.

For trend followers, the water cooler conversations take place when the market does not exhibit a strong trend and portfolio managers are whipsawed in and out of the market. For regression to the mean managers the water cooler moment occurs when market prices continue to trend well above where they have historically mean-reverted back to their long-term moving averages. For investors who rely on market sentiment, the moment occurs when the consensus gets it right for an extended period of time and being a contrarian turns out to be a disaster….in the short-term. For value managers the moment occurs when stocks stay irrationally priced for longer than they can remain solvent. In each case, we imagine the analysts and managers of the investment firm whose strategy is on the wrong side of the market, gathered by the water cooler, and talking in hushed tones about negative portfolio results and unhappy clients.

Let me be clear. At such times professional money managers are anything but unemotional. They are human and they are all subject to the biases and heuristics that make us human. When the strategy is working I guarantee you that money managers are feeling good, and when it isn’t I guarantee you that you will find hardened professionals whispering by the water cooler about what they will do if things don’t “turn around soon.” The best professionals know and understand these emotions and deal with them in a positive way as they make investment decisions. If you are feeling fear, then the odds are that other investors are feeling the same way, and perhaps that represents a buying opportunity. I don’t believe there is such a thing as unemotional investing. The tactics may be quantitative and not qualitative, but managing emotions will always be part of the art of good money management.

New Rally High

The S&P 500 broke out and made a decisive new bull market high on Tuesday. The index is now trading at 1,165, higher than the recent peak of 1,150 reached back on January 19th. The breakout in large-caps was preceded by breakouts in mid and small-caps, as I noted last week. The pace of recent gains has been impressive, as the market has managed to close higher 19 out of the past 26 trading days since making a near-term bottom on February 8th, which is a remarkable feat. If the stock market is still to be taken as a real-time economic barometer (and some bears will argue that it shouldn’t), then its recent behavior should certainly be viewed as good news.

As we’ve been mentioning lately, most of the technical indicators that we follow are in great shape, indicating that the stock market rally continues to be well-supported. However, we’re also seeing signs that the market is overbought in the short-term, similar to the end of last year and beginning of this year just before it declined by -8%. So, we wouldn’t be surprised if another consolidation or correction occurs soon. But for now, the underlying trend of the market remains positive.

Why Aren’t We More Worried About Inflation?

Our stated view for some time has been that deflation, not inflation, is the bigger structural risk for the global economy. But, we can also find plenty of reasons that argue against getting too complacent about the benign state of inflation we currently enjoy. For example, the monetary base has exploded, the amount of borrowings by the government seems destined to crowd out the private sector, and the fiscal situation in the U.S. leaves the dollar vulnerable to future weakness.

However, a number of cyclical indicators we are watching would argue against getting too worried about inflation at this time. Capacity utilization rates are still extremely low, wages are declining and argue against the possibility of a wage-price spiral any time soon, the velocity of money is still decelerating, and the dollar has firmed on the back of weaker European growth rates and insolvency fears coming out of the Euro-zone. We are not complacent about inflation, and it may be that the current cycle will sow the seeds for a future inflation problem down the road. But as we look at the fundamental drivers of inflation, we think there are plenty of good reasons not to get too worried about it at this time.

The Unappreciated R-Squared

In the parade of Greek letters that are used to describe modern portfolio theory statistics, the most well known is beta. When William Sharp published his Nobel Prize winning Capital Asset Pricing Model (CAPM) in the 1960’s, he posited that there are two kinds of risk. One is systematic risk, or market risk which can’t be diversified away by investors. The measure of systematic risk, or non-diversifiable risk, is beta. Beta is used to measure the volatility of a managed portfolio versus the volatility of the stock market. The second well know MPT stat is alpha. Alpha measures whether risk-adjusted portfolio returns are better than you would have predicted using the CAPM model. To earn positive portfolio alpha has been the holy grail of investment managers for 40 years.

The poor sister of this collection of Greek letters and MPT science is the notion of R-Squared. R-Squared measures the strength of the relationship between the movement of the stock market and the movement of the portfolio. The higher the R-squared the more the market tells us about the likely direction of portfolio performance. Pinnacle portfolios have a high R-Squared meaning that a high percentage of the direction of our portfolio returns can be explained by the direction of the broad market returns. Having a low R-Squared is a prized commodity in bear markets where investors want portfolio performance to have a low relationship to the stock market (i.e. they don’t want their portfolio going down when the market is going down). Usually these low R-Squared investments are hedge funds, real estate funds, private equity, and market timing portfolios and they are invested in the “alternative investment” allocation of a managed portfolio. These positions are meant to “hedge” the core holdings of stocks that have a high R-Squared. At Pinnacle we call these low R-Squared strategies either hedge fund strategies or “eclectic managers.”

Pinnacle managed accounts are meant to be “core” portfolios. Our tactical strategy is meant to be implemented for the majority of our client’s invested capital. We are not offering the possibility that our portfolios will achieve investment gains in bear markets. Our version of risk management is simply to minimize losses in bear markets so that we can legitimately earn back those losses in bull markets. We do not consider our management style to be “an interesting diversification” for someone’s managed account. We provide active management as an alternative to buy and hold investing for our client’s core portfolio holdings. Our philosophy is to manage wealth somewhere between buy and hold and low R-Squared strategies. As I often say, Pinnacle clients are likely to be frustrated in bull markets when returns are compared to stocks, and bear markets when they are compared to cash. This means that clients are always likely to be frustrated with our relative returns. But over time, we will generate enough excess returns over buying and holding that our client’s are comfortable allowing us to manage the majority of their investable assets.

Are Financials Getting the Respect They Deserve?

Once upon a time the U.S. financial sector was deemed to be the most liquid and respected in the world. Financial firms in the U.S. were symbols of the strength and innovation of the U.S. capital markets, and companies like Goldman Sachs, J.P. Morgan and Citigroup were great quality names that any money manager could hold as a staple in an equity portfolio. That was before the housing market collapsed and exposed the rot in the banking system that had built on the back on a loose regulatory framework, market complacency, and of course, a good helping of pure greed.

These days, U.S. financial companies are not viewed with much respect; in fact the underlying mood in the wake of the financial crash is one of skepticism regarding anything financial-related. Combine this financial distrust with the possibility of a new and frugal U.S. consumer, and a regulatory and political environment that appears to be reversing from a long-term tailwind into a driving headwind, and it’s not hard to see why investors would question the sustainability of earnings and the appropriate market multiple for the financial sector.

At Pinnacle, we agree that structural headwinds will most likely create a difficult secular environment for financials. However, we also realize that we don’t have the luxury of investing client money over very long secular time frames, so instead our process focuses on investing over cyclical markets cycles. Some positive cyclical fundamentals for financials right now include an ultra steep yield curve that boosts profitability, and mega-consolidation within the industry that has paired payrolls to the bone and left those still standing with less competition. Yes, there are plenty of risks that still remain in the banking sector. Commercial mortgage problems still linger, a new wave of Option ARM re-sets is creating uncertainty regarding capital adequacy, and leadership in Washington appears to be turning up the heat on the regulatory front. These risks have kept us from investing more than just a small allocation to financials.

But despite these concerns, it has also been a risky proposition for managers benchmarked to the S&P 500 Index to be out of the sector entirely. Over the past year the broad financial sector ETF (XLF) has been ranked among the top three sectors (there are 10 in the S&P 500) for the year to date, trailing three months, and one year timeframes. It is the number one ranked sector on a trailing one year and three month basis, and the second leading sector on a year to date basis. I was glancing at these numbers just yesterday. As I looked at the numbers (see chart) and thought about the prevailing skepticism regarding the sector, I was forced to contemplate whether financials are currently getting the respect they deserve?

Investing in Bubbles

Ed Yardeni, the President and Chief Investment Strategist for Yardeni Research, in his March 4th Morning Briefing, quoted Fed Chairman Ben Bernanke on the subject of asset bubbles. Here is Yardeni quoting Bernanke about the role of the Fed relative to bubbles:

In his January 3 speech before the American Economic Association, Mr. Bernanke refused to accept any blame for the housing bubble. He concluded his remarks as follows: “Is there any role for monetary policy in addressing bubbles? Economists have pointed out the practical problems with using monetary policy to pop asset price bubbles, and many of these were illustrated by the recent episode. Although the house price bubble appears obvious in retrospect--all bubbles appear obvious in retrospect--in its earlier stages, economists differed considerably about whether the increase in house prices was sustainable; or, if it was a bubble, whether the bubble was national or confined to a few local markets. Monetary policy is also a blunt tool, and interest rate increases in 2003 or 2004 sufficient to constrain the bubble could have seriously weakened the economy at just the time when the recovery from the previous recession was becoming established.”

While our Fed Chairman wants to be absolved from blame for the devastating impact of asset and credit bubbles bursting all around us, I can assure you that at Pinnacle we have a crystal clear take on our mission. We attempt to identify asset bubbles, or investment manias, as early as possible and invest in them for the benefit of our clients. We then try to sell them before they burst so our clients avoid the obvious negative consequence of buying and holding an overvalued asset. In fact, by definition, the positive story for asset bubbles and investment manias are known and understood by the huge majority of investors which is why prices get to extremely high levels in the first place. Investing in bubbles is no place for a contrarian or value investor (which is a hat we also wear when appropriate). For us, bubbles represent a great opportunity to earn excess returns, but they should be treated with caution.

Some analysts believe that U.S. Government bonds with their low yields and high prices represent an asset bubble today. Others believe that emerging market stocks or gold may be the next bubble asset class. We will be diligently looking for the next bubble to emerge, as once again, the central bank has pegged interest rates at very low rates and invited speculation in risk assets of all kinds. This is an excellent habitat to be hunting bubbles.

Rally Reigniting

The S&P 500 Index is higher by almost 8% since February 8th. It’s climbed back to 1,138, just shy of the 1,150 closing price on January 19th, which was the high for this cycle (so far). Other market segments have already broken above their mid-January levels, including small-caps, mid-caps, and the Value Line Index.

In addition, internal market indicators appear to be very favorable. The market’s advance/decline line made a new cycle high on February 19th. As of Friday, there was only 1 stock that made a new 52-week low on the New York Stock Exchange, indicating that selling pressure is basically nonexistent. And while the bears continue to complain that overall volume is low, a separate measure known as On-Balance Volume continues to be strong.

The cumulative message from all of these indicators is that the market rally that began almost exactly one year ago continues to be on solid ground for now. Of course, we’ll be watching very closely for any signs of deterioration. While we believe the market can work higher from here, we’re also fully aware that the largest gains may now be behind us, meaning that we cannot allow ourselves to grow complacent.

Chart: Bloomberg NYSE Cumulative Advance-Decline Line

Say It Ain’t So, Gus

Occasionally an article will come across my desk and something in it will catch my attention. This week, William Bissett, a wealth manager here at Pinnacle, dropped me an article published in the Morningstar Advisor called, “Asset Allocation Heavyweights Square Off.” The piece, written by Ryan Leggio in the Feb/March 2010 issue, featured a conversation between John Hussman, the manager of the Hussman Strategic Growth Fund (owned by Pinnacle in our managed accounts) and Gus Sauter, the Chief Investment Officer of the Vanguard Group, the famous money management firm overseeing more than $1.4 trillion of managed assets in over 100 mutual funds. Let me just say that John Hussman, in my opinion, has to be one of the smartest people on the planet and his weekly letter about his fund is required reading for Pinnacle analysts. I most definitely would not want to be on the other side of the table debating just about anything with John Hussman.

Towards the end of an interesting interview, Leggio asked both participants how they feel about relative valuations right now. Here is what Sauter had to say:

“A lot of people have asked, what is the equity risk premium looking forward? Is it zero? Is it negative Is it small? Or is it the historic norm, with the historic norm being in the 5.5% to 6% range? I would say that, on average, the equity risk premium is at historic norms all the time. So, I think that we’re looking at average rates of return going forward, and that’s based on the concept that we’re rewarded for investing in stocks because of the inherent risk of investing in stocks. If we weren’t going to be rewarded for that, we’d sell stocks, and we’d sell them down to a price that made them attractive again. In fact, that’s what happened from the end of 2007 to the beginning of 2009.”

Mr. Sauter goes on to argue that the stock market is priced to deliver historically average returns going forward over the next decade. I don’t know how he gets there from here. Based on normalized P/E ratios the stock market is expensive. Hussman says we will basically get the earnings growth rate from stocks over the next decade, which is about 6%. Many other analysts think we will get a lot less. What is blatantly and obviously true is that the rewards for owning stocks depends on the price at which you buy them, and the average risk premium is a useless bit of information used to confuse buy and hold investors. Gus should forget the garbage about “average risk premiums at historic norms” and get in the game. Investors praying for average returns should know that there is little data to support the idea that buying and holding from these prices will be a successful strategy.

Spending and Wages

Yesterday brought the release of the personal income and spending numbers for January. The report was mixed. The good news is that personal consumption expenditures, geek speak for consumer spending, were up for the fourth month in a row, and look good when viewed on a year-over-year basis (red line in chart). The consumer continues to represent about 70% of the US economy, and is still a very large contributor to global growth, so we watch this measure closely and view the yearly rate of change in spending as a leading indicator of the equity markets.

Unfortunately, the news was not all good. Personal income came in below expectations, and inflation-adjusted wages are now clearly in a downtrend. We view real wages as a leading indicator of spending, so we don’t take the recent softness in wages as good news. Our measures of real wages are not yet negative on an absolute basis, but the rate of change is decelerating fast, so we will be watching this measure very closely in coming months. Tomorrow is Wednesday, and we will have our normally scheduled weekly investment team meeting. If you are guessing from this blog that we’ll be discussing the latest spending and wage numbers, you’d be correct!

Happy Anniversary

I hate when I forget an anniversary or a birthday, which is why my wife, Linda, took over the job of remembering family dates for birthdays, anniversaries and the like twenty years ago. But I didn’t need any help remembering that this month is the Big One for investors and financial planners. March happens to be the ten-year anniversary of the current secular bear market which has defined the entire career of young planners and investment advisors and severely altered wealth creation plans for just about everyone else.

In March of 2000 the stock market had just finished one of the best five years of annualized performance in stock market history and investors were so enthusiastic that they were paying more than 50-times 10-year normalized earnings to own broad market indexes like the S&P 500. At the time, we left traditional measures of value based on earnings behind, instead measuring the future prospects of American companies by new metrics, like how many eyeballs might view a website. Everyone was getting rich investing in “dot-coms” and the technology sector had grown to be more than 40% of the total stock market by market capitalization. Value investors were in full retreat, or were going out of business, and if you didn’t own the top 50 companies in the S&P 500 you were guaranteed another losing year relative to the broad market. Wasn’t it grand!

Ten years later the stock market is trading 30% below March 2000 prices, and adjusted for dividends stocks have lost about 1.5% per year, before adjusting for inflation. Unfortunately there is no data that I’m aware of to suggest that the stock market will deliver historical average expected returns from current elevated valuation levels. If you don’t care to look at values, perhaps the “new normal” of bloated debt levels, higher consumer saving, more regulation, and higher taxes will convince you that future stock market returns are certainly not guaranteed from here. The only answer will be active management, however you define it. Those who can scrape a few extra percent of returns above what the market will offer will truly be delivering an important service to investors who need to earn risk premiums even though the broad market is not cooperating. Buying and holding from here is truly a high-risk strategy.