Tuesday, August 31, 2010

The Great Reflation: A Book Review

The Great Reflation, by Anthony (Tony) Boeckh, is a brilliantly crafted book that gives the reader a fundamental top-down understanding of how markets interact with each other. As long-time readers of BCA (Bank Credit Analyst) research, much of Boeckh’s message is a review of what we’ve learned over the years. But for most readers, who haven’t invested in BCA, Boeckh’s views will be a revelation. While Boeckh currently publishes his own investment letter, from 1968 until 2002 he was chairman and editor-in-chief of BCA publications, publisher of The Bank Credit Analyst. Many would say he is largely responsible for BCA’s stellar reputation among institutional investors for providing exceptional independent research. I suspect that anyone who reads this book will instantly see the genius in how Boeckh sees the world.

The title, The Great Reflation, says it all. The book offers a thorough overview of the market forces that led to the Great Recession, and then goes on to describe the unprecedented risks posed by policy makers’ efforts to reflate the economy and avoid a new Great Depression. Part One of the book is a primer on how credit creation is a driving force in the market cycle and how fully understanding the cycle from a “top down” perspective can lead investors to a better understanding of market risks and opportunities. Part Two of the book discusses asset allocation and the major asset classes that investors should consider when building a diversified portfolio, including U.S. stocks, interest rates and the bond market, the U.S. dollar, gold, commodities, and real estate. Part Three of the book is a somewhat gloomy and overly political view of the future. As an example, Chapter 14 is entitled, “Declining America, Will it Recover?” Fortunately Boeckh’s gloomy assessment of U.S. politics and policy makers does not in any way take away from the clear and concise lessons he shares throughout the book on how to build portfolios and assess investment opportunities.

For the curious, Boeckh generally likes stocks and dislikes bonds, gold, commodities, and real estate, although he points out that all of the above could outperform for a short period of time in the Great Reflation. The one surprise for me as a long-time BCA reader is that Boeckh subscribes to what he calls Long Wave economic theory, or what many readers may recognize as Kondratieff waves. I don’t recall BCA ever emphasizing long waves, although Boeckh goes out of his way to put the theory into the proper context and cautions us not to be overly deterministic in its use. In fact, so much of this book echoes the thoughts and philosophy of Pinnacle that I spent most of my time nodding my head and agreeing with the author. Do yourself a favor and make the time to read this book.

Monday, August 30, 2010

The Battle for 1050

The market seems to be locked in a heated battle around 1050 on the S&P 500. The index has been in a tug-of-war, crossing above or below 1050 in each of the past 5 trading days, which has been very interesting to watch. Last Friday, the bulls seemed to gain the upper hand. The market rallied for most of the day and closed at 1064. However, today, the bears fought back, pushing the market down to close at 1048. These latest gyrations, in a relatively tight range, reflect a high degree of indecision in the market, as investors try to digest the latest economic news, what the Fed might do next, the looming fall period, etc.

We’ve been viewing 1050 as an important price for most of the summer. The market briefly dipped below in late June/early July, but quickly bounced back into what we viewed as a sideways trading range that formed after the April peak. Closing decisively below 1050 in the coming days, in conjunction with the deteriorating economic backdrop, will likely compel us to take further defensive actions in Pinnacle portfolios.

Friday, August 27, 2010

GDP and Bernanke

With whisper numbers on this morning’s revision of second quarter GDP under 1%, the actual 1.6% number came to the delight of many bulls out there. Personal consumption was revised to a 2% increase from 1.6% which was a welcome surprise, although it came mainly from an increase in energy related spending. And voila, the stock market jumped on the news. It seems like a lot of negative news had been priced into the market.

Then at 10 a.m. this morning, Ben Bernanke took the stage in Jackson Hole to deliver a much anticipated speech detailing his economic outlook. Without repeating his previous assertion that the outlook is “unusually uncertain,” the speech contained the same tone and he even included a comment that economic projections are uncertain. He also noted that the economy would expand in the second half of the year at a very modest pace, although the labor market remains disappointing. And as a result, much to the chagrin of the bond market, he would keep the widely anticipated Quantitative Easing 2 (QE2) program in its holster for the time being. We feel that QE2 is one of the last remaining bullets in the Fed’s gun and, as Carl continues to argue, likely needs to be in the trillions and come after a breakdown in equity markets to matter at this point. The ten year bond found some resistance at a yield of 2.5% but this selloff may be temporary in the context of the possibility of QE2.

So now we turn to the 3rd Quarter. Economist David Rosenberg reminds us this morning that 3rd quarter GDP will most likely be close to 0%, and may even turn negative. The last three GDP reports were 5%, 3.7%, and 1.6%, so the trend is definitely clear and the recovery is on shaky grounds. There may be some optimism on the Street today, and it could extend into next week, but the historically worst month for equities is right around the corner. It is certainly setting up for an interesting fall.

Wednesday, August 25, 2010

“It’s More Than Luck”

“I read with interest the decision by Stanley Druckenmiller to close his global macro hedge fund. The guy was good—very good. He quietly went about his business of thinking about how the world works and positioning in front of capital flows—in or out—and got it right most of the time. It is easier said than done and, in his remarks describing why he was ending it, it was clear he spent much time working and not so much playing precisely because this stuff isn’t easy; and to be as good as he was for so many years ... it’s more than luck. It is hard work being open to what the market is really telling us. But a deep understanding of global capital flow from the top down seems the key to his success. We try to mimic that here as it relates to currencies.” – Jack Crooks, Black Swan Capital (http://www.blackswantrading.com)

This is the second blog this week that starts with a quote. I thought this quote, from Jack Crooks at Black Swan Capital, a currency newsletter that we subscribe to and highly recommend, was right on the mark. Crooks is giving props to Stanley Druckenmiller, a famous hedge fund manager who is perhaps best know for being a top lieutenant for George Soros for many years, who decided to close his hedge fund and retire last week. I was struck by Crooks’ comments about “doing the work,” which is one of the guiding principles at Pinnacle. When you “do the work,” it’s hard to ascribe success to luck.

It isn’t healthy to spend too much time working and not enough time playing, as apparently Druckenmiller did for much of his career. We all know that balancing family, community, and work, isn’t an easy thing to do. But we also recognize that good value investing implies that you can better understand the valuation of the market…than the market. And as I’ve written before, the preceding statement is dripping in conceit. While experience tells me that we have been able to identify value opportunities for our clients over the past eight years, it also tells me that we should continue to be cautious in our approach to active management, because markets can and do make a mockery of you.

Over the years we have written about how we do it. We insist on diversifying our decision making within our investment team. We “cheat” by employing a variety of methods to identify value, including traditional value, global macro, and studying market psychology. We utilize quantitative methods for evaluating markets, but perhaps our secret sauce is our belief in incorporating wisdom (if we have any to add), common sense, and experience to our investment process. If we have gained wisdom, common sense, and constructive experience over the years it has been through hard work. My objective assessment is that no one here is a genius. We are not “smarter” than our competition (although we still compete on an uneven playing field where many smart investors don’t believe in active management). However, I believe we outwork our competition. Our analysts are immersed in their jobs and passionate about what they do. We try to have “a deep understanding of top down capital flows,” as did Druckenmiller, and as does Crooks. It isn’t the sexiest methodology for outperforming, but I believe it is an important, and underappreciated, part of our process.

Tuesday, August 24, 2010

Why Didn’t I Say That?

The next book on my summer reading list is The Great Reflation, by Tony Boeckh. Boeckh is the president of Boeckh Investments, Inc., and was the chairman and editor-in-chief of BCA Publications, publisher of the Bank Credit Analyst, from 1968 until 2002. Boeckh was largely responsible for building BCA into the globally respected independent research company it is today. We are long-time subscribers. My Baltimore to LA to Fresno to Visalia and back travel schedule last week gave me a good head start on reading Boeckh’s book and I expect to be writing my review of it for you by next week or so. However, there is one paragraph in the introduction that is so brilliant that I had to share it now. Here is what Boeckh has to say about the investment process:

“A framework of analysis for understanding markets is not the same as building a model or set of indicators fitted to back data. I can assure you, from a lot of experience, that they always break down. An eclectic approach that is based on common sense, strong logic, and objective data, balanced by right-brain intuition and lots of curiosity, is what works best. The investment world will never be deterministic, never amenable to scientific models, at least for any period of time. Some approaches work well in some periods, other approaches in other periods. Successful investors not only know how to think outside the box but, from experience, know what to pay attention to in each market environment.”

I’ve read this paragraph four or five different times and I suggest you do the same. I’ve typed it twice (because I didn’t properly save this blog post the first time I wrote it). I intend to have it set to music. I’m hiring a rap artist to “rap” it for younger financial professionals. I’m going to find an artist to sculpt this quote in metal and in stone, and I’m having it burned into wood. There are times when writing a blog post is difficult, and there are times when they seem to write themselves. But this time Boeckh wrote it for me. I can’t imagine a clearer statement of our philosophy of money management at Pinnacle than this one. We try to remember that “successful investors not only know how to think outside the box but, from experience, know what to pay attention to in each market environment.” This is a particularly difficult market environment and we continue to invest our managed accounts using “an eclectic approach based on common sense and right brained intuition.” It’s unfortunate that it is impossible for the rest of Boeckh’s book to be as perfect as this paragraph. I wish that I had said it myself.

Monday, August 23, 2010

On the Hunt for Attractive Defensives

As the global economy continues to show signs of slowing, and risk of an economic contraction grows, we have been slowly rotating down the risk spectrum in Pinnacle portfolios. This has taken the form of reducing the overall amount of equity in portfolios, as well as some transitioning between cyclical and defensive equity sectors. Recently we’ve reduced industrials, energy, financials, materials and semiconductor sector ETFs, and replaced the exposure with utilities and consumer staples, which are considered to be countercyclical, or defensive, sectors.

As the chart below illustrates, the traditional defensive sectors are health care, consumer staples, utilities and telecom services. We currently have an overweight in health care, have been building into utilities and staples, and are taking a close look at the telecom services sector to see if it might be an attractive investment candidate. In coming days we will also be closely monitoring industries within our sectors, and possibly reducing some of the more cyclical exposure there as well. The world is constantly changing and we will continue to change with it. Right now we are on the hunt for attractive defensives in our portfolios.

Friday, August 20, 2010

Initial Jobless Claims

Yesterday, we got a one-two punch to help send stocks lower on the session. The first economic data point to hit the street was initial jobless claims. Initial jobless claims measure the actual number of people who have filed for unemployment benefits for the first time (if they have met the five criteria for inclusion). The number came in unexpectedly high at 500,000, which is also a significant psychological number. Below is a chart of the series which comes out weekly. This is the largest number in almost a year and is causing some serious angst among investors as double dip fears rise. Without job creation the largest part of our economy, consumption, is likely to suffer as a result.

Then the second punch came with the release of the Philadelphia Federal Reserve economic index which came in at -7.7%. A positive 7% was expected. This index gauges manufacturing activity in the Tri-State area of Philadelphia and for the first time in over a year the index showed a slowdown. This is not good news if the manufacturing sector, which helped raise the economy from the depths of the recession, is now starting to roll over.

These are only two data points, on one day during the summer doldrums, but it is not a good picture. We were worried about the possibility of continued fundamental deterioration in the economy, and started to position our portfolios accordingly. We will certainly be on the watch for improvements in these numbers but for right now it seems risk is elevated, and we must manage to that.

Wednesday, August 18, 2010

When Active Management Matters

This blog may be a little geeky, but bear with me here. In the March/April Financial Analysts Journal, Roger Ibbotson, along with James Xiong, Thomas Idzorek, and Peng Chen, published an article called, “The Equal Importance of Asset Allocation and Active Management.” For those who don’t know, Roger Ibbotson is a giant in the field of finance. His study evaluated thousands of mutual funds and concluded that the market was responsible for about 80% of fund returns and the rest of the return was equally attributed to portfolio policy or active management. Portfolio policy is the same as the portfolio’s benchmark asset allocation. So yours truly, ever on the lookout for studies that minimize the importance of active management, marches into the office of Michael Kitces, our Director of Research at Pinnacle, and says, “Michael, we have to respond to this.” So Michael agrees, and we pen an article that is published in the prestigious Advisor Perspectives online letter that takes issue with Ibbotson’s paper. Kitces and Solow claim that Ibbotson’s study is flawed, that the universe of managers in the study are not active, and that the technique used to determine portfolio returns, called Style Analysis, has the impact of minimizing the benefits of active management.

Our letter created something of a stir. I personally received a number of congratulatory emails describing how we brilliantly enhanced the case for active management. However, Bob Huebscher, the excellent editor of Advisor Perspectives, forwarded several emails to me that took issue with our article. Some were quite reasonable and well thought out, and some were penned by enraged wackos who felt we had no right to breathe the same air as Roger Ibbotson (I should note that Kitces decided to get married and go on his honeymoon while all of this is going on…it was a great wedding!). Anyway, a few of the letters and my replies were published yesterday in this week’s issue of Advisor Perspectives. For one of the letters, as yet unpublished, Huebscher sends the correspondence to a “referee” who is supposed to figure out if there is any merit to any of this squabbling. The referee, who remains anonymous, is actually quite kind to our point of view and says so in his comments. But he ends with the following thought for Huebscher: “My main problem with their article (Solow/Kitces) is that they keep saying ‘excess returns over and above the market’s returns' (attributable to policy allocation and active management), when of course they mean 'over and above, or under and below.’ It’s a typical example of using language to imply that we can expect managers to add value over a market index, when we know that virtually all studies show that on average they don’t, and that there’s no statistical basis for an expectation that they will.”

So, here it is. Kitces and I obviously failed to make our point since the referee restates the same old tired point of view. He correctly states that there is no statistical evidence to suggest that active managers can outperform a market index. The point of our article is, there is no statistical evidence that they can’t! We believe the best active managers can and do outperform, but investors will always have a difficult time figuring out how to assess the performance results of active managers. I’ll be writing more about this, but it comes under the same old category of me complaining about Pinnacle’s performance benchmarks…again.

Monday, August 16, 2010

Navigating the Range

Back on June 24th, I wrote that we wouldn’t be surprised if stocks remained mostly range-bound between 1,040 and 1,150 on the S&P 500 through the summer (http://echoesfromthepit.blogspot.com/2010/06/range-bound.html). Except for a brief dip below 1,040 in late June/early July, that’s how things have played out up to this point. Of course, the overall sideways trend in the market has been accompanied by an unsettling amount of volatility in both directions. Investors still seem to be going back and forth over whether another recession is a foregone conclusion, or if the decline from late April to late June largely discounted those concerns.

For our part, we’re trying our best not to rush to any conclusions, and to remain open-minded and flexible here. We’re concerned enough that we made a few adjustments in the past week to modestly lower volatility in client portfolios by reducing some highly cyclical equity sectors in favor of more defensive sectors, largely due to increasing signs that the economy is slowing. But at the same time, we haven’t decided to fully batten down the hatches yet. With the occasionally treacherous fall period looming, we’re making sure to stay on our toes.

S&P 500 Index: Still Range Bound

Friday, August 13, 2010

The Three Hundred Pound Gorilla in the Room

…Or is it the elephant in the room? No matter. The investment team spent the day last Friday pouring over economic data and a host of other security related issues, only to decide that the outlook remains either “mixed” or “muddled.” Senior Analyst Carl Noble is writing our monthly market review and as of this writing I don’t know which description he will choose. For me the biggest problem is not to decipher what the “weight of the evidence” is telling us about global economic conditions at the moment. It seems clear to me that while we can find a number of positive bullet points in the data, the general conclusion is that the global economy is still weak and that the risks are tilted in the direction of slower rather than faster economic growth. Heck, all we have to do is listen to the gloomy comments from our Fed Chair, Ben Bernanke, to know that we are not yet experiencing the robust economic recovery we all hoped for based on the amount of economic stimulus that has been thrown at the economy. The risk of the U.S. experiencing actual deflation is palpable. Inflation rates are less than 1% and the fear is that any kind of economic slowdown will put us on a path of generally falling prices, an economic condition not seen in the U.S. since the Great Depression. And, the consensus wisdom is that there is little policy makers can do about it since interest rates are already at zero and there is little political appetite for further fiscal stimulus programs.

As an investor, if you believe in the recession/deflation scenario, the best values in world are found right here in good-ole U.S. Treasury securities. Ten-year yields which are hovering around 3% would fall dramatically to new lows. There is no reason to think that “fair” yields wouldn’t be 2% or perhaps much lower on the bonds. You would sell equities on any bounce from here as the “fear trade” would be on and risk assets would get sold in a flight to safety. But the wild-card here is monetary policy. What would Ben Bernanke do if prices were to actually begin falling? He has written several famous papers on the subject of what the Fed could do at the “zero bound,” or zero interest rates. At the moment those investors who are “short” risk assets are terrified that the Fed would come in with a massive Quantitative Easing (QE) program to induce inflation. In the most talked about scenario, the Fed would buy about $1 trillion in bonds to significantly lower the dollar and subsequently create asset inflation in risk assets of all kinds. Those investors who bought bonds in advance of such a QE program would get slaughtered, as would investors who have underweighted risk assets. If the Fed were to come in with a QE program, when would they do it? Could you buy the bonds, wait for the markets to riot, and then safely sell them as the Fed rides to the rescue later in the year?

The Fed is now the “Three Hundred Pound Gorilla” with the power to distort the markets in any number of ways. John Mauldin just mentioned in his e-letter this weekend (JohnMauldin@Investorsinsight.com) a rumor that the Obama administration is thinking of proposing a new strategy for Fannie and Freddie to forgive the amount of consumer mortgages that are currently under water. And of course, the debate on tax policy is heating up and will have a huge impact on the direction of financial markets heading into the fourth quarter. Oh, and did I mention it is election season again? I’m afraid that lately we are spending a lot more time trying to decipher what Washington will do to us than I would care to admit.

Wednesday, August 11, 2010

The Paradox of Thrift

There was good news buried in the GDP report released last week. Based on large revisions to previous data, the U.S. savings rate is now above 6%. This level of savings makes sense in a world where U.S. consumers are presumably engaged in repairing their balance sheets by paying down debts and increasing their savings. While most economists will agree that increased savings is a positive for economic growth over the long-term, over the near-term it has the unfortunate impact of reducing consumer spending. Hence…the paradox. While it makes financial sense for any one of us to live within our means, spend less, and save more, if all of us decide to save more at the same time, it is a strong headwind to economic growth. After all, consumer spending represents about 70% of U.S. GDP. It would make sense that a dramatic increase in savings should be correlated with a decrease in consumer spending. Of course, consumer spending has its share of other issues to contend with, including high unemployment, low consumer confidence, record high mortgage foreclosures, record high amounts of income from government transfer payments, etc.

However, it seems to me that the bullish argument here is clear. You would have expected that higher rates of saving would have an impact on the top line growth of corporate earnings, but so far that hasn’t been the case. While retail sales haven’t torn the cover off the ball, they seem to be at least hanging in there for the time being. A recent Bloomberg/BusinessWeek cover story talks about consumers making choices about their spending, but the bottom line is no one seems to be giving up the most recent upgrade of their iPhone just yet. If the stock market can continue to rally in the face of increased savings rates, then the bullish take would be that when the virtuous cycle for the economic recovery takes hold and the employment statistics begin to improve, then there is a lot of room for spending to improve even as savings rates remain at elevated levels from their bubble lows and closer to historical norms.

For those of the bearish persuasion, the revision to the savings number is just another nail in the case for the downturn that is right around the corner. They see too many headwinds to economic growth as it is, and increases in the savings rate might be the proverbial straw that breaks the camel’s back. We continue to closely watch all of the relevant stats on consumer spending. With earnings season largely behind us, our thesis of market weakness in the fall is about to get tested.

Tuesday, August 10, 2010

Fed Day

Today brought the long awaited meeting of the Federal Reserve’s Open Market Committee. Investors were watching very intently, as for weeks there have been rumors that the Fed might institute a new round of quantitative easing. Many have postulated that any new stimulus from the Fed was already discounted in the market, and some were concerned that if they didn’t do anything, then the market would sell off in violent fashion. Others were concerned that the market might interpret more stimulus as a warning that growth must be in very poor shape, particularly in an election year.

2:15 came and went, and the Fed took what seems be very moderate action. They added language to their statement that said they will attempt to support the economic recovery by rolling over their current holdings of treasury, agency, and mortgage-backed securities as they mature. Below is a link to the FOMC statement that was released today. The market seemed to perk up as it surged off the day’s lows immediately after the statement was released. But by the end of the day the market gave back some of optimism, and it closed down, though still well off the intraday bottom. The message of the market was somewhat muted for now, but it will be interesting to see how the market trades in coming days as participants have a little more time to digest the latest move by the Federal Reserve.


Monday, August 9, 2010


I have a quiz question for you. If you are an investor using the trend-following technique, you believe the trend is your friend. One of many methods used to identify a trend is to add up the past twenty, fifty, and two hundred days of prices, and then average them out in order to see if the moving average of price is trending either up or down. You then use this information to make a forecast about the future direction of the market, which you expect to continue in the direction of the trend. On the other hand, what if you use the mean reversion technique? Practitioners using mean reversion add up enough past price data to establish the average, or mean, price and then watch to see if the market is drastically diverting from the norm. If the price gets to two or three standard deviations from the average, you could be either a buyer or seller depending on whether current prices are above or below the average. If you practice mean reversion, the trend is definitely not your friend since you are betting that the trend will reverse to the mean or average of the past. Once again, mean reverters use past data to formulate a forecast of future market direction. So…which of these strategies is more “forward looking?” I’m guessing the answer is mean reversion, if only because the strategy requires the investor to execute transactions in anticipation of a market reversal, instead of waiting for the actual market reversal required by trend followers. Both strategies have obvious risks. For trend followers the risk is that the trend reverses and you are whipsawed in or out of the market in a trendless market. For mean reverters the risk is that the trend continues long past the point that standard deviation says it should. Or, there is a structural change in the market that changes the mean going forward.

How about traditional value investing? Traditional estimates of market value depend on forecasts of future cash flows, dividends, and earnings and discounting them at current interest rates to determine a “fair value” for a market or a security. I suppose you can’t get more forward looking than that. On the other hand, Pinnacle also studies measures of market value based on the average of five and ten years of past earnings. This method still requires investors to execute transactions in advance of a market move, but the data used to make the forecast certainly isn’t forward looking. Another important aspect of Pinnacle’s investment process is to analyze the global economic environment. One part of that decision making process is to analyze the Conference Board’s leading economic indicator, as well as the ECRI (Economic Cycle Research Institute) leading indicators, the OECD leading indicators, and a variety of market leading indicators including copper, commodity, and shipping prices. However we also look at numerous coincident indicators and all of the above are often compared to the data points of the past.

All of which is to say that Pinnacle is often forward looking in our investment process…which has its own set of risks and rewards. We recognize these risks by making small changes to our portfolios as the data is evaluated in real time. The natural result of the process is to avoid large asset allocation bets because we are often working in advance of actual changes in market trends. Investors are well-served because we have no philosophical problem marrying trend-following and mean-reversion in our decision-making process. Perhaps our biggest problem is trying to explain all of this in a simple way to Pinnacle prospects.

Wednesday, August 4, 2010

Assessing, and Constantly Reassessing

We currently have investments aimed at the Managed Health Care industry in several of our model portfolios. The position has not been performing up to expectations as of late, and as is the routine here, that meant a complete review of the industry and holding to reassess our conviction in it. A security review in this case consisted of reviewing valuation metrics, technical conditions, micro-fundamentals (like wages and costs effecting the industry), business cycle analysis, ratings from the independent analysts we follow, earnings, seasonality, and pretty much anything else that we believe relevant to the industry and/or specific holding (e.g., politics in this case).

After reassessing all of the above, we concluded that it’s prudent to hold our positions at this time. There is no crystal ball to go to when rotating among equity sectors and industries, however we believe it is critical to have a system that covers all of the bases and provides us with an informed opinion to help us execute our strategy. Once the work is completed and we make a decision, we generally give the position some time for our view to unfold. But we are not dogmatic about sector holdings any more than we are about our overall market view. Since the market is constantly moving, either for us or against us on a position by position basis, it requires that we constantly reassess where portfolio holdings stand in our investment models. Assessing and constantly reassessing positions is just a routine part of the investment process at Pinnacle Advisory Group.

Tuesday, August 3, 2010

Ahead of the Press…Again

In the July 26th issue of Businessweek, the feature article titled “Amber Waves of Pain” attacks the commodity Exchange Traded Fund (ETF) market. They note that investors were “angry” about certain ETF investments that did not perform as expected including the U.S. Oil Fund (symbol: USO). This was mostly due to a condition in commodity futures markets known as “contango,” where longer dated futures contracts are more expensive than near term contracts for the same commodity. USO and other commodity ETFs are constructed to buy contracts that are closest to maturity, and continuously purchase new near term contracts when they are about to expire. This process effectively reduces profits when contango exists, since the ETF is forced to purchase the more expensive future contracts that lose money when they are about to expire, resulting in something called “negative roll yield.”

Additionally, many commodity index funds reinvest their contracts between the fifth and ninth business days of the month. Because this rebalancing is well known by other traders, who are not bound by specific roll dates, they game the system and make it more expensive to conduct these rolls. These traders buy and sell before the expected ETF roll which drives up the price of the next futures contract while driving down the price of the expiring contract. In the end, the purchasers of certain ETFs lose.

However, here at Pinnacle, this is old news. In March, we recognized the inherent problem in many commodity ETF products and pro-actively searched for alternative products. This search led us to the E-TRACS UBS/Bloomberg CMCI Index Exchange Traded Note (symbol: UCI) which we believe is the most attractive commodity index option available at this time. UCI is constructed in a fashion that staggers the purchase of futures contracts at different maturities ranging from 3 months to 5 years, rather than just buying the closest contract to maturity. This helps to reduce the negative roll yield effect when contango exists. Additionally, UCI is constructed to slowly rebalance small percentages of future contracts every day. This helps prevent other traders from manipulating the price of the futures contracts. UCI has outperformed our previous holding by 150 basis points (1.5%) since we purchased it. We expect the marketplace to continue to develop new approaches to manage negative roll yields. This is another instance in which Pinnacle was ahead of the press…again.

For a more in depth look at UCI, please see the following Article of Interest on our website.


Monday, August 2, 2010

This Time Is Different

I just returned from Las Vegas where I attended a four day investment conference. The eight hours of flying time (round trip) offered a great opportunity to get caught up on my reading list. This Time is Different, Eight Centuries of Financial Folly, is an immensely important book written by Carmen Reinhart and Kenneth Rogoff. If you haven’t heard of it, don’t worry. It’s not the sort of book that is going to challenge Suzy Orman on the financial best seller lists. But if you are an informed institutional investor you would find it impossible to miss the many references to this book this year by the best and brightest analysts. So, having read about it all year, it was time to plow through it myself.

Reinhart and Rogoff’s book is a titanic work of scholarship where they create a database that contains the data on eight centuries of financial crises. They categorize financial crises as inflation, currency crashes, currency debasement, banking crisis, and internal and external debt defaults. The author’s empirical research is based on a comprehensive database on global financial crises that they created from a number of sources. The data comes from sixty-six countries in Africa, Asia, Europe, Latin America, North America, and Oceania. Readers will find that much of the book discusses the methodology the authors used to analyze data and present it, which I suppose is wonderfully exciting to economic historians who are thrilled with this important addition to the literature, but for the rest of us it makes for some very dry reading. If you can stick with it, it is easy to see why the book has been such a sensation among institutional investors. The book provides us with historical benchmarks to measure the economy and financial markets before and after financial crises. It’s hard to imagine a more relevant discussion.

The conclusions reached by the authors are rather depressing. Economic crises that are caused by financial crises take much longer to resolve than other financial downturns caused by normal changes in the market cycle. In addition, few countries are immune from crisis and, interestingly, in many cases developed countries are not as dissimilar from emerging markets as you may think when it comes to financial crisis. Investors hoping for a V-shaped economic recovery will not find much solace in the historical record. The authors spend several chapters exploring the causes and impact of our current financial crisis, what they call, the “Second Great Contraction,” which is the only global financial crisis to occur during the post WW-II period. They conclude that the warning signs of the current crisis were easy to see but were ignored by policy makers who suffered from the misplaced idea that “this time is different.” The economic implications of this book are clearly troubling for those fearing a double-dip recession. However, the research presented on historical stock prices before and after financial crises seems to show a V-shaped bottom in equity prices after the crisis. If the global composite holds, it would be good news for bullish investors. Of course that begs the question of whether this crisis has been resolved or if it is still evolving. This is a great book for serious investors – but you’ve been warned – it isn’t the most entertaining book you will read this year.