Wednesday, June 30, 2010

A Time for Talk and a Time for Action

After much recent agonizing over intra-day market moves, the market finally closed below 1040, which will trigger the stop loss in our portfolios. Yes, it makes us feel like tossing our cookies to sell right here, but we believe it is an important trade from a risk management standpoint.

And as bad as selling feels now, we can feel good about reviewing and re-reviewing the disciplines we follow before making this move. Today we went over about 100 economic data points, and 15-20 technical measures. It is clear from our work that fundamental and technical conditions have continued to deteriorate. What’s not clear yet is whether growth is just slowing or on the verge of contracting. But given escalating risks of more than just a pullback, we feel it’s prudent to run the portfolios with a little less volatility. We have talked for days about our stop point, and how we were giving the market a chance, but with protection. The time for talk is over, and tomorrow we will begin to take action by downshifting some of the risk out of our portfolios.

Tuesday, June 29, 2010


I spoke with senior portfolio analyst, Carl Noble, this morning and he informed me that we are moving portfolio trader, Tim Mascari, to “Defcon 2.” Defcon is a term usually used to describe the readiness condition of the U.S. armed forces, and getting to Defcon 2 is a very rare occurrence (Defcon 2 is the highest confirmed level ever reached). For us, this morning’s news that China’s economic growth forecasts are being revised downward has moved the S&P 500 futures lower, indicating that the stock market will open lower today. As the market (once again) drifts down to our stop-loss point of 1,040 on the S&P, we are (once again) spending significant time analyzing what moves to make in order to have the portfolio properly reflect our view of market risks and possible rewards. Having Tim at Defcon 2 means we are completely ready to execute transactions across our many managed accounts if necessary.

In yesterday’s investment team meeting we noted that we have several choices in terms of how to marginally reduce portfolio risk and volatility if we hit the stop. One choice would be to significantly reduce our U.S. equity holdings but keep some very high octane industry sectors that should be the market leaders if we get a bounce off of the lows. Another choice is to significantly restructure the risk in the fixed income side of our portfolios and make a much larger bet on duration versus credit. Basically, that means that we would sell corporate bonds and buy U.S. Treasury bonds. Notably, this morning the U.S. Ten Year Treasury is trading to yield of less then 3%. This once again reinforces my belief that our ability to do this job is often constrained by our lack of imagination. It‘s pretty amazing to see the yield fall this far. Back to Monday’s conversation, we decided to reduce our equity holdings by picking and choosing targeted securities among the cyclical sectors of the portfolio without completely restructuring our U.S. positions. This seems appropriate as, at least for us, the jury is still out regarding how slow the economy will be in the second half of the year. If this is a precursor to a typical mid-cycle correction (a term you are going to be hearing a lot more about), then we shouldn’t get too far out of the market.

The last agenda item yesterday was to discuss the themes for our end of quarter market review. Surprisingly, the time has passed and we are already at the end of the calendar quarter. The guys in the Pit will do their usual excellent job pulling it together, and I don’t want to give it away, but I can say I was happy with our portfolio results for the last quarter. One of the inputs to our asset allocation decisions is how our portfolios are “working” in the current market environment. Unofficially, the numbers appear to be confirming what we already knew, which is that portfolio correlations have been very low, which means that downside volatility has been contained. I’m guessing Pinnacle Moderate portfolios only caught about 25% of the second quarter market decline. That news has an impact on the changes we will make to asset allocation if we hit our stop. I’m very comfortable that risk is being properly managed here.

Monday, June 28, 2010

Income Growth Improves

The trend in income growth carries a lot of weight in our process under normal circumstances. Recently, it’s been elevated even higher. The reason for that is that we (and others) believe that if employment picks up, and thus underlying incomes, it could be the critical piece that allows the economic recovery to continue and for stocks to resume rallying.

On that note, the latest report on personal income that was released by the Commerce Department this morning was encouraging. Until recently, that hadn’t been the case – income growth had been noticeably lacking. And bears like to point out that even the subpar income growth was largely due to government assistance in the form of “transfer payments,” as opposed to organic wage and benefit gains. So, it’s particularly encouraging that “personal income ex-transfer payments” has risen by 0.5% in each of the past two months – which hasn’t happened since late 2006, as shown on the chart below.

All in all, it was a welcome positive report amidst a slew of otherwise disappointing economic data recently. The next big hurdle is Friday’s employment report for June.

Friday, June 25, 2010

Technical Take - Head & Shoulders Top Developing?

Technical analysis can include many elements, such as trend following techniques, pattern recognition, sentiment analysis, mean reversion, etc. Technical analysis is one of the three building blocks in determining a view at Pinnacle Advisory Group, Inc. We currently view the technical conditions of the market as extremely important at this time.

One highly recognized pattern in the market place is called a head and shoulders top. It’s name comes from the shape, which is made up of a left shoulder, a head, and a right shoulder (see picture below). This pattern usually forms after an uptrend, and it’s completion typically marks a major trend reversal in the markets. Right now the S&P 500 is potentially forming a head and shoulders pattern, which has technicians buzzing. At the moment, the pattern hasn’t confirmed that a change in trend has occurred. That would occur if the SP drops below what is considered the neck (at a price below 1040-where we have our stop currently). The pattern could also be negated if the S&P 500 rises above the head, somewhere north of 1120. We still have hope that the market can grind higher after we get through this volatile period. But as some of the previously bullish evidence has deteriorated, we feel that it is important to have a protective strategy in place. Our line in the sand is at 1040 on the SP 500.

Thursday, June 24, 2010

Range Bound?

The markets have remained volatile this week. Recent economic reports have largely been disappointing, particularly the latest housing market data. While certainly concerning, we don’t think enough evidence has accumulated to join the double-dip recession crowd at this point. Overall, the market seems to be digesting some degree of slowing in the U.S. economy. It may be a rocky summer as this process continues, with the market lurching in both directions on the latest news.

We wouldn’t be surprised if the market is largely range-bound between the February/May/June low of 1,040 on the S&P 500, and the January high of 1,150 for the next several weeks. If that happens, it would reflect a level of indecision among investors as they try to determine whether there’s more in the tank for this bull market, or if it’s time to take profits. That’s not a terribly exciting scenario for investors, but it may be what’s needed after the large swings of the past couple of years.

Chart: S&P 500 Index, with possible sideways trading range

Wednesday, June 23, 2010

Another Fed Statement, No Big Surprises

The Federal Open Market Committee put out its press release today at about 2:15 EST. The committee, currently made up of 10 members, meets 8 times a year to assess financial conditions and determine monetary policy. The Federal Reserve’s primary function is to pursue a dual mandate of full employment and price stability.

Coming into today, the market consensus was that the Federal Reserve would not touch interest rates due to a recent swath of weak housing data, European risks, low inflation, and a general cooling in recent economic data. The feeling that the Fed wouldn’t move on rates could be seen in the federal funds futures markets leading up to today, where the probability of the Fed raising rates this year has been dropping like a stone lately. On that front, the Fed didn’t disappoint – they left interest rates unchanged at their current rock-bottom level of 0 – 0.25%.

Since the market was already convinced that rates weren’t moving, the intrigue surrounding today’s meeting was more about whether there would be material changes in the language of their statement. Fed statements are routinely parsed by market participants, sometimes to the point where half the battle of reading the statement is to make sure you don’t end up reading too much into any one line.

Today’s statement appeared to sum up conditions quite well. My read is that they are essentially saying that the economy is still growing, but it is challenged with many strains, most recently in financial conditions. There was nothing particularly bullish about the statement, like mentioning that they would resume monetizing (purchasing) mortgages or other debt. But on the other hand, there were no negative surprises either, like if they had hinted that a rate hike is on the way, even in the face of growth coming off the boil.

All in all I think it was in line with expectations, with no real surprises. Perhaps a more important issue regarding the Fed is that they are running out of bullets in their policy toolkit. But I’ll leave that topic for a separate blog post.

Tuesday, June 22, 2010

Confessions of a CNBC Watcher

I recently concluded my annual bout with a summer cold, which in my old age usually has me quarantined at home for a full week of misery. Last week I had the opportunity to watch a whole lot more CNBC than usual while surrounded by my tissue boxes and bottles of hand sanitizer. Here at the office the analysts in the “Pit” usually rotate from CNBC to Bloomberg, although I can’t tell why they choose one versus the other on any given day. The TV runs in the background and they seem to have developed a finely tuned ability to ignore it for most of the day, and then to pay attention if a specific analyst that we follow comes on or some other relevant news item catches their attention.

If you must know, professional analysts hate to admit to watching CNBC. Most of our independent research makes fun of the network, derisively calling it “bubblevision.” And, truth be told, there is little doubt that the female “on-air” talent is easy to look at, even if they do have Ivy League and Wall Street backgrounds. Like any network, the name of the game is ratings, and CNBC is not immune to serving the needs of their mostly male demographic. The network earned its nick-name “bubblevision” by celebrating record Dow Jones Industrial Average prices on the air, just in time to suck viewers into the excitement of buying right at the market top. If you are looking for in-depth, contrarian analysis of markets, I wouldn’t recommend CNBC as your first step towards market wisdom.

On the other hand, I just read Andrew Ross Sorkin’s book, Too Big To Fail, and in every chapter there is another story of the Secretary of the Treasury, the Director of the Federal Reserve Bank of N.Y., the Chairman of the Federal Reserve, and the heads of the largest investment banks in the country, all riveted to CNBC during the business day. I can vividly remember Charlie Gasparino breaking all kinds of stories about Merrill Lynch, Bear Stearns, Lehman Brothers, and Morgan Stanley during the financial crisis…I just didn’t realize that Hank Paulson was watching at the same time. As addicting as it may be, I firmly believe that watching financial news on TV remains hazardous to your financial health. Now that I’m back in the office I can go back to my usual routine of reading our regular daily research. My message to clients who are addicted to the network...turn it off!

Monday, June 21, 2010

“You’re a Market Timer…No I’m Not…Yes You Are”

Me: Market timing is nothing to be ashamed of. Every active manager who does something other than buy and hold securities is inevitably involved in some sort of market timing.

Them: Nonsense. Market timers try to predict the future and I would never do that.

Me: Really? What motivates you to change the securities in your portfolio?

Them: I study 75 different indicators to see what they tell us about past market behavior. Then I look for anomalies in the current data that might indicate a high probability of a certain market event. Then I use great discipline in executing changes based on high or low probability events without predicting the future at all….I just rely on my indicators to tell me what to do…and I do it.

Me: So what if your indicators tell you to sell stocks and you go ahead and sell them. Doesn’t that imply a forecast by you that stocks have a high probability of falling in value in the near future?

Them: No, I’m not making a prediction. This is just a high probability based on my scientific and systematic application of my trading system.

Me: But if you are selling and you don’t know the future, then the application of your trading system, which results in a buy or a sell, is the result of a forecast about future market direction.

Them: It most certainly is not.

Me: It is.

Them: It isn’t!

Me: The timing of your transaction, which is based on your systematic approach to developing your forecast, results in you timing the market. You can be early, late, or get it exactly right, but you can’t know the future with certainty so you are a market timer.

Them: No I’m not. Don’t call me a market timer. Instead, call me a (fill in the blank).

Me: Oh brother…look…you can be a (fill in the blank), but why won’t you admit that buying and selling securities constitutes an implied forecast of market direction and executing the transaction involves market timing? What is the big deal?

Them: The big deal is...and I’ll say this for the last time…I don’t make market forecasts and I’m not a market timer. I’m a (fill in the blank). End of story!

Me: But the result of applying your strategy can be an extreme asset allocation that represents an “all in” bet in either risk or non-risk assets. If you get the timing wrong that represents a risk to portfolio returns.

Them: So what…I’m systematically applying a strategy to manage risk and it has nothing to do with market timing.

Me: But if you are “all-in” or “all-out” that’s market timing, isn’t it?

Them: No

Me: (sigh)

Friday, June 18, 2010

Managing Fixed Income

With the advent of Exchange Traded Funds (ETFs), we have raised the question of how to best manage fixed income on multiple occasions. Since our inception, we have used individual municipal and government bonds when we felt there was value in that asset class. This is very normal in the institutional world, and has served our clients very well. However, I recently informed our Chief Investment Officer (Ken Solow) that the fixed income portfolios for many clients are drifting from our targeted duration due to the use of individual securities. As a reminder, duration is the sensitivity of a bonds price to a change in interest rates. A longer duration bond has greater price moves when interest rates change than shorter duration bonds. When an individual bond gets closer and closer to maturity its duration becomes shorter and drifts away from our intended target.

If we bought bonds to generate income, and just held them to maturity it would be a much simpler world. However, we manage bonds for total return – which is income plus changes in price. And as bonds drift from their duration targets, the total return on the bond also drifts from our expectations, and we are left with a choice. Do we sell the current bonds to purchase longer duration bonds, or do we hold on to them with the realization that our total return expectations would have to change?

Getting back to ETFs, many companies have created products that provide exposure to municipal or government bonds while managing duration. For instance, the iShares 20+ Year Treasury (TLT) invests in U.S. government bonds over 20 years in maturity, while maintaining a fairly constant duration in the vicinity of 15.5. We can purchase this product for every client and have two reassurances: the product will generate the same return for each client and iShares will manage the duration for us. So even though the use of individual securities has many merits, I feel like these two factors allow us to more effectively manage our bond allocations and therefore we may see more ETFs used in Pinnacle portfolios in the future.

Thursday, June 17, 2010

Housing Market Starting to Feel Pain of Tax Credit Expiry

The Homebuyer‘s Tax Credit officially expired on April 30th. Over the last few weeks, we’ve started to get a sense of the impact on the housing market without this government support from some of the latest housing data, and the evidence is troubling. Below is a list of some of the latest developments:

  • The National Association of Home Builders’ monthly Housing Market Index fell to 17 in June, from 22 in May. Consensus expectations were for a much milder decline to 21.

  • The Mortgage Bankers Association’s weekly index of applications for new mortgages has plunged -38% since the end of April

  • Housing Starts in May fell to a 593,000 annual rate, from a 659,000 pace in April

  • Likewise, Building Permits fell to a 574,000 annual pace, from 610,000 in April

All of this has happened in an environment of improved affordability for consumers – house prices are down significantly from their highs of a few years ago, and mortgage rates are back below 5%. We weren’t anticipating that the housing market would come roaring back, but there were increasing signs that it might be forming some sort of bottom. Instead, the latest batch of reports has created a fresh round of concern about how the housing market will fare going forward without government assistance.

Wednesday, June 16, 2010

Follow the Euro

The Euro and S&P 500 don’t have a very high correlation over a long period of time. In non-geek speak, that simply means that the movement in one does not translate to a movement in the same direction of the other all that often. For a quick lesson in correlation, statistically, a correlation of 1 between two variables is considered to be “perfect” correlation, meaning that the two move in tandem, all the time. -1 indicates an inverse correlation, meaning that two variables move in totally opposite directions all the time. A correlation of 0 simply means there is no correlation; the change in one security means very little to the change in the other. When I computed the historical correlation between the Euro and S&P 500 on Bloomberg, it is as low as 0.035, meaning there is very little long term correlation (it’s close to 0).

Lately, much market myopia has been on the evolving crises in the Euro-zone, and the correlation between the two has been increasing. Bloomberg indicates a correlation of 0.5 now, but anyone that’s been watching tick-by-tick trades knows that moves in the Euro often appear to lead the equity markets these days. If you don’t believe me, then I suggest that you start watching the daily charts of the Euro exchange traded fund (FXE) vs. the S&P 500 (SPY). Why does this seem to be the case? Well, I suppose we could blame it on hedge funds, computer linked trading devices, or the fashionable scapegoat du jour, which happens to be BP. Whatever the real reason is for the increase in correlation, we may never fully know. However, if you want a clue as to which way equity markets may be headed, just follow the Euro.

Tuesday, June 15, 2010

When Everybody Knows the Playbook

Well, it looks like we dodged the S&P 500 Index at 1,040 sell bullet. The market has bounced nicely from that level and is currently trading at 1,094. I always wonder what it means when institutional investors are all looking at the same charts showing the same resistance and support levels for the market. In this case, 1,040 was truly the last line of technical defense for the S&P to the downside and we have been writing that we would be reducing risk if the market closed below that price. Since everyone else was looking at the same chart, you wonder how much of the subsequent rally was a self-fulfilling prophesy…at least in the short-term.

Where does the playbook go from here? I believe that the same institutional investors who were playing for the rally off of the 1,040 level will now be looking for a classic summer rally. It is well known that the typical market cycle leads to the conclusion that investors should “sell in May and go away.” Perhaps a little less well known is the May sell-off is often followed by a relief rally in June and July. It is when you get to late summer that history suggests that extreme caution is appropriate. History is full of market swoons that begin in August and continue falling through September and October. So, looking at a chart it seems very clear that the current rally could take the market back to its 50-day simple moving average of 1,145, or even back to its April 23rd high of 1,217. If you get there on the rally…it’s time to sell. In a lousy year for stocks, who can afford to give up the next 10% to the upside if you can get in and get out?

So everyone will be playing chicken with everyone else, intently studying the “quality” of this rally (if it continues). In a perfect world we will see a rally in the euro, a sell-off in U.S. bonds and gold, and a return to market leadership in the late cyclicals in the U.S. market, meaning big gains for energy, materials, and industrials. If the rally plays out according to the playbook, then everyone will be looking to sell into it, hoping to catch as much of the gains as possible before we get to the late summer market doldrums and the outright fall market nightmares. The question is, if everyone knows the playbook, and institutional investors are trying to invest the same seasonal strategy while looking at the same market themes and levels of price support and resistance, doesn’t that completely invalidate the playbook? I know that we are cautiously playing for this summer rally. I also know that we won’t be surprised by a completely unexpected market move…in either direction.

Monday, June 14, 2010

A Blog-Sized Book Review: Too Big to Fail

My recent business trip to Tucson and Fresno gave me the opportunity to finish reading Andrew Ross Sorkin’s book, Too Big to Fail: The inside story of how Wall Street and Washington fought to save the financial system - and themselves. Here are a few comments about the book that you might not read in any other book review.

Sorkin’s book is written in a style that puts you in the room with all of the players in the crisis. Since he obviously wasn’t there to hear what was actually said first hand, as a reader we are relying on his research to be accurate. Is this history or fiction? This literary device is absolutely gripping for the reader, but it requires us to be a little suspicious about the details.

The financial crisis created an amazing environment of forced deal-making as the major investment banks cast around looking for merger partners. Sorkin introduces us to many of the characters in each deal, which in turn gets to be a lot of characters. By the end of this book you may wish you took notes on “who’s who.” We get a fascinating look into how quickly hundreds of bankers can assemble in New York at a moment’s notice when called, and a different appreciation for corporate jets.

Warren Buffet comes across as an unlikely hero in this tale. The bankers obviously fear him and don’t want to make a deal with him because he demands “too much value.” I was struck by an early scene where Buffett settles in for the night to personally read Lehman Brother’s annual report and decides there are too many outstanding questions for him to pursue a deal. I just love the vision of the Oracle of Omaha doing his own homework to turn down a $5 to $10 billion deal (he later invests in Goldman Sachs).

How about Treasury Secretary, Hank Paulson, so exhausted in trying to put together the TARP legislation, that he has dry heaves at the office? I thought Paulson comes across as a heroic character in the book…a view that I didn’t have prior to my read.

I particularly enjoyed the language of the deal making among the major players. CEO’s of huge investment banks calling each other to say, “It might be interesting for us to have a conversation,” which meant, “I have to do a deal with you or we will be out of business next week.” Several banks apparently came within 24 hours of joining Lehman in bankruptcy.

I remember Pinnacle’s decision to sell our financial sector equity positions in February of 2009. At the time we thought the entire sector had become nothing more than a speculation on government intervention in the market. Reading the book confirms just how correct we were in our assessment, and just how close we came to a complete economic catastrophe. Sorkin gives us an insightful look into the power of government intervention in the financial markets in 2008. I wonder if there is the political will to do anything even remotely similar in the future in the U.S. I doubt it.

Thursday, June 10, 2010

Surprising Sector Holding Up Best

Since the S&P 500 hit its recent peak of 1,217 on April 23rd, it’s fallen by 13% through yesterday’s closing price of 1,055. It violated (fell below) its longer-term term 200-day moving average on May 20th, and has traded below that important trend indicator since then. Along the way, 9 out of the 10 broad S&P sectors have also fallen through their respective 200-day moving averages (using sector ETFs), essentially “confirming” the weakness in the broad market. Can you guess the one sector that hasn’t broken down in the same fashion yet?

The obvious answer would seem to be one of the typically defensive sectors – Consumer Staples, Health Care, or Utilities. But, those would be all be wrong in this instance. The correct answer is the Consumer Discretionary sector. Consumer Discretionary has been outperforming the broad market since the first credit crisis bottom on November 20, 2008, and has been an outright market leader for much of the time since then.

The reason that the sector’s recent resilience, and its impressive performance for the past year and a half, is “surprising” is that many pundits had written off the consumer as dead, opining that a new era of frugality is upon us as a part of the fallout from the housing bubble and credit crisis. While that may turn out to be true over a longer time period, it hasn’t mattered much in the shorter-term, as the sector has clearly been exhibiting its traditional “early cycle” traits in spite of those sentiments.

Chart: Consumer Discretionary Sector ETF (Symbol: XLY) with 200-day moving average

Wednesday, June 9, 2010

Federal Reserve Beige Book

Eight times a year, the Federal Reserve formally comments on current economic conditions in a report commonly called the Beige Book (so named based on the color of its cover). It contains information gathered by each of the twelve Federal Reserve districts, and contains one national summary from the district reports. The book centers on conversations and Fed interpretations of economic data, and tries to provide a broad view of the economy. Topics typically include inflation pressures, housing, and employment data which will be used as a starting point for discussion at the next Federal Reserve meeting (usually two weeks after the Beige Book release). Investor reaction to the Beige Book is typically fairly subdued, but there are usually Fed hints present for those able to read through the lines.

Investor reaction is often quiet because of the absence of data in the report, but interest rate and Fed watchers can definitely comb through the report for hints. For instance, today’s report showed that all twelve districts reported an increase in growth. However, they were careful to say that the growth would be very “modest.” They do not want to put themselves in a place where investors perceive a hike in interest rates due to the expectation of stronger growth in the future. This was also backed by Chairman Bernanke’s congressional testimony today that policy makers would keep borrowing costs near zero for an “extended period.”

It is also worth noting that today’s report showed that labor conditions are slightly improving, consumer spending and tourism increased, and capital spending by businesses was edging up. These economic improvements are good news, especially in the capital spending area as it is one of our main investment themes in the U.S., but you can tell that the Fed does not want to cut off growth prematurely. Many businesses in the districts are still on high alert due to possible fallout from the European debt crisis, and even Bernanke himself testified that the Fed remains “highly attentive” to those risks. In fact, the implied probability is for short-term interest rates to stay at 0% until the January 2011 Fed meeting, at which point the odds of the Fed remaining on hold fall to only 47%.

Tuesday, June 8, 2010

Macro Picture Mixed and Muddled, Straddling the Line in the Sand

As I wrote in a recent entry, the bulk of our mental energy is concentrated on puzzling through whether or not fear is driving this market, or whether we are being given signals that fundamental change is occurring. Recently, we have been scouring important data points and reassessing the very core of our thesis. I’ll focus on the macro-economic front today.

There’s clearly been some deterioration in the economic backdrop, most notably in measures of stimulus that factor in currency exchange rates (a quick appreciation in the dollar takes away stimulus in the U.S. by making exports more expensive), as well as some real-time indicators of global growth (copper and other commodity prices have fallen). The recent move higher in certain inter-bank credit measures has also added to the deterioration on the macro side, although they’re still well below levels reached in the credit crises of 2008. Despite these developments, many measures of growth and manufacturing still look strong, earnings appear to be healthy, and overall credit conditions have improved considerably.

How about the all-important jobs picture? Prior to Friday, the jobs trend was improving, but Friday’s poor employment report (excluding census workers) was a big disappointment. It’s important to note that the trend of hiring is more important than any one report, and the trend had been getting better prior to Friday. We believe that employment holds the key to this cycle possibly extending further. If Friday represents a new declining trend, that is certainly not good news. But we aren’t ready to draw that conclusion yet, so stay tuned.

All in all it, the data seems to be implying that there will be a moderation in growth going forward. How much moderation may hold the key. A typical mid-cycle correction may be occurring, and a re-rating for a slower rate of growth does not necessarily mean a recession is in the cards.

European risks represent the wild card in the equation. Unfortunately it is very hard to accurately determine to what degree growth will be affected due to the strains coming from Europe. The effects of a stronger dollar in the U.S. may be offset by stronger exports coming from the larger countries in the Euro-zone. As long as a cancerous debt contagion doesn’t spread, the developments in the Euro-zone may act to keep the Fed on hold for longer, ease China’s concern of overheating, and promote a united Euro-zone effort to support fragile markets. So-called “auto stabilizers” such as oil prices and yield levels have dropped and that should act to stabilize growth going forward. But this positive view must be balanced against growing system risk mixed with a divergence in opinion of how best to combat the current problems. The European view of austerity is currently facing off against the American view that Europe needs to protect growth first and worry about debt later. Opposition in views at the G-20 meeting this past weekend do not give me the feeling that we have a unified fight on our hands, and that’s a worrisome aspect to the current situation.

In short, the macro picture is mixed and muddled – there has been some deterioration in some fundamentals, others are holding strong, and an important wild card in Europe.

Given an increasingly confusing macro picture, and some deterioration in technicals, we have drawn a line in the sand at 1,040 on the S&P 500. Sentiment and fear levels, mixed with an important support point, argue that we should be bouncing now if this is just a deep correction in the ongoing bull market. However, if the bears find a way to break the 1,040 level, than we will acknowledge that something in our thesis may be broken. With risks rising and a broken view, we will remove some volatility from portfolios as a matter of prudent risk management. We hope 1,040 holds, but we’re prepared to adjust our allocations if it does not.

Friday, June 4, 2010

This May Take Longer than I Thought

In my book, Buy and Hold is Dead (AGAIN), the Case for Active Portfolio Management in Dangerous Markets, I make some intrepid forecasts about the future of the investment industry regarding active or tactical asset allocation. One of my forecasts was that consumers would demand active management as traditional buy and hold, strategic asset allocation strategies failed to deliver expected returns in an ongoing secular bear market. I felt that consumers would demand that the industry change, and that the obvious flaws in the theoretical rationale for buy and hold investing would compel professional advisors to consider a major change in how they approached portfolio construction. Well…perhaps this is going to take a little longer than I thought.

As I was reading the Washington Post Business Section last weekend I came across an article from Kiplinger Personal Finance called, “Knowing financial advisor’s motives, expertise can pay dividends.” The writer, Bob Frick, a senior editor for Kiplinger, did a fine job of discussing the importance of knowing an advisors goals, fees, holistic approach, etc. However, one question he wants prospective clients to ask is, “Do you time the market?” He goes on to say, “By asking an advisor about her investment strategy and how it changes with developments in the markets, you’ll discover whether she’s a closet market timer. Watch out for an adviser who says, for example, that she thought foreign stocks were getting pricey so she shifted client’s money from overseas shares to commodities.”

I love Bob, and anyone else married to the same old tired assumptions about market timing. For the record, there is no more professional and risk reducing strategy that I can think of than to sell overpriced securities in favor of, presumably, more rationally valued asset classes. In this case, holding on to “pricey” foreign stocks is virtually guaranteed to generate less than expected returns for the asset class in the future. A better question for prospective clients to ask is, “how do you determine if an asset class is overvalued and what do you do about it terms of portfolio construction?” Unfortunately, in order for the question to be asked, the financial media has to stop promoting this drivel about market timing. While it’s clear to me from speaking around the country that the professional investment industry is getting very interested in how and why they should actively manage the asset classes in their client portfolios, I think the press is still stuck in the dark ages. That’s too bad for the average consumer, and too bad for financial advisors who are waiting for their clients to revolt before they make the change from passive to active asset allocation.

Thursday, June 3, 2010

That Oogy Feeling

Sometimes you just get a feeling, and it’s not easy to put into words exactly what is generating it, but your gut is telling you that something just isn’t quite right. Yesterday the investment team was discussing the “oogy” feel that the May 6th “flash crash” left behind. Beyond the actual loss on the day, which turned out to be a great opportunity to execute some trades in the short-term, the experience was somewhat surreal and had a bit of a tone not felt since 2008. That day, we witnessed ETFs gyrating way off their underlying Net Asset Value, some stocks lost almost 100% of their value in just a few minutes before quickly bouncing back, and a mini waterfall cascade of selling took place at lightning speed. Media coverage has listed a host of possible culprits for the mini-crash, such as fat finger trading errors, the compounding of high frequency and algorithmic trading, and even the complex computer driven exchanges that now govern how U.S. markets conduct their daily business. But the reality is that no one is precisely sure why the market fell so fast on May 6th, and thus the oogy feeling has lingered to this day.

John Hussman, of the Hussman funds, writes a weekly article on his website that is on our required reading list ( In his last written piece titled Oil and Red Ink, I think Dr. Hussman may have put his finger on a tangible data point that could be at the root of that oogy feeling we’ve experienced in the wake of the mini-crash. It’s what he would call “micro volatility” in the markets, but rather than awkwardly restate what Hussman writes, here’s an excerpt from that piece:

Finally, as I've noted before, I tend to get particularly concerned when the market begins to exhibit extremely large fluctuations at ten-minute intervals. This sort of increasing "micro-volatility" is troublesome, particularly when in the context of a leadership reversal coming off of overvalued, overbought, overbullish extremes. The last time we observed similar internal dispersion coupled with a leadership reversal was at the 2007 market peak.

As I noted in the July, 30 2007 comment (Market Internals Go Negative), "This is much like what happens when a substance goes through a “phase transition,” for example, from a gas to a liquid or vice versa. Portions of the material begin to act distinctly, as if the particles are choosing between the two phases, and as the transition approaches its “critical point,” you start to observe larger clusters as one phase takes precedence and the particles that have “made a choice” affect their neighbors. You also observe fast oscillations between order and disorder in the remaining particles. So a phase transition features internal dispersion followed by leadership reversal. My impression is that this analogy also extends to the market's tendency to experience increasing volatility at 5-10 minute intervals prior to major declines."

The following chart (from Dietmar Saupe in Barnsley, the Science of Fractal Images – shown below) offers a nice illustration of how the same general pattern can feature different levels of what we can call "micro-volatility." The top panels look like what we're starting to see in intraday activity.

Currently, we continue to anticipate an oversold market rally, which may be already in progress. If technical conditions are able to firm, we will continue to play to win given our base case that there is room for another leg up in this bull market. However, we have recently acknowledged risks that are building both in some fundamentals (copper, stimulus, dollar, etc.), at the same time system-wide risks are rising (Euro situation, credit canaries). Therefore, we’ve drawn a line in the sand at 1,044 on the S&P 500. If we break it, we’ll take action and get more defensive in our portfolios. It won’t feel good if we have to sell after experiencing losses. But given some deterioration in fundamentals, a building of system risks, a clean break of an important technical level, and an oogy feel to this market, it simply seems like appropriate risk management.

Wednesday, June 2, 2010

The Problems with Getting to Neutral

Pinnacle’s investment team is contemplating neutral risk…again. As we have often written, “neutral risk” or “benchmark risk”, is the level of volatility that we think is implied by owning a two asset class benchmark that we use for risk and return. Of course, actual Pinnacle portfolios own as many as twenty different asset classes and specific market sectors and industries. Fine tuning the resulting portfolio results can be frustrating. My best guess before last week was that our portfolios were slightly overweight benchmark risk, with our estimate of “equity like” exposure in our moderate portfolios at 68% versus the benchmark of 60% risk as measured by the S&P 500 Index. However, last week we beat the benchmark on every down day in the market, a result that was unexpected. The returns of our Gold ETF and The Hussman Strategic Growth Fund helped to support portfolio returns even though we were theoretically “overweight” volatility on a relative basis. For the record, we will be sellers of risk if the S&P 500 Index falls below 1,044 on a closing basis, and even though our “equity like” exposure will still be above benchmark on paper, we think we will probably be slightly underweight volatility on a relative basis.

James Montier, one of the industry’s great thinkers and a brilliant writer, who is now with GMO Investments wrote a white paper this month on the problems with benchmarks, called I Want to Break Free, or, Strategic Asset Allocation ≠ Static Asset Allocation. I have railed on about benchmarking issues in this space forever, but as always, Montier says it better. Here are a few quotes from his paper about the problems with benchmarking (I don’t have the space to quote his entire comments for fear of breaking my rule about blog length, but here are a few selected comments from Montier on the subject):

Problem 3: Benchmarking alters behavior… benchmarking tends to alter investment managers behavior along three important dimensions. First, managers motivated to compete against an index may lose sight of whether an investment is attractive or even sound in an absolute sense. They focus upon relative, not absolute, valuation.

Second, as soon as you give a manger an index, the measure of “risk” changes to tracking error: how far away from the benchmark are we? …For benchmarked investors, the risk-free asset is no longer cash, but the index that they are compared against.

Finally, benchmarked managers start to think about return in a relative sense as well. I’ve always hated the idea of sitting in front of a client having lost money, but claiming good performance because I’d just lost less than an index. That very concept sticks in my craw as an investor.

The bottom line to us is that, effectively, everything becomes relative (risk, return, and valuation) in a benchmarked world.

As always, this is great stuff from James Montier.