Thursday, September 30, 2010

Market Discounting Change in Seasonal Tendencies?

We’ve been cautious in our asset allocation since the middle of the summer, mostly due to the mix of poor business cycle dynamics and technical conditions that led us to put on some risk control measures. One of the many risks we faced during the summer was the prospect that markets were approaching the traditionally tough seasonal period that occurs between September and October. Many think of October as the worst month of the year, probably scarred by the 1987 stock market crash that took place during that month. After reading some very intensive studies on the subject, it turns out September is historically the worst month of the year, and October is not even historically the second worst.

On that front, there is some potentially good news for investors when looking at the seasonal environment. First off, we are effectively through September. Secondly, there has been a flood of data running through research services that indicate that the stock market typically does very well coming out of the midterm elections, and has generated particularly robust gains in pre-election years (2011).

The markets have been surging lately, and we can’t help but wonder whether the market is front running the positive seasonal tendencies around the corner. We aren’t ignoring this shift, and view this as an on the margin headwind becoming a tailwind. However, we also acknowledge that seasonals can be fickle and tell us nothing about the fundamentals of the global economy. Seasonal statistics look great on paper, but they don’t always work as advertised. One only has to look to the 10% S&P gain that just occurred during the worst seasonal month of the year to keep from putting too much stock in simple seasonal tendencies.

Wednesday, September 29, 2010

An Interesting Discussion About Quant

I sometimes have the privilege of hearing from my colleagues in the money management community about the views expressed in my book, Buy and Hold is Dead (Again), as well as other articles that have been published in a variety of professional magazines and journals. The most recent correspondence I’ve enjoyed is with Brian Schreiner, Vice President of Schreiner Capital Management, Inc. Brian and I have exchanged views about the state of the money management industry in general, and more specifically the need for the industry to fully embrace the idea of active money management. Brian recently reread my book, and took issue with some of my ideas about quantitative decision making. For example, he correctly points out that in my book I call Modern Portfolio Theory the “father” (or something like it) of all quant models, when in fact, hardly anyone today thinks of MPT as being an example of quant. I feel that any technique for portfolio construction that doesn’t require reason, judgment, or informed intuition, but instead simply requires numbers to be plugged into a mathematical algorithm in order to asset allocate a portfolio, deserves the quant title. Here is what Brian had to say about quantitative portfolio management techniques:

"You get to my main point-- that investing is about making fewer mistakes. And, when it comes to mistake avoidance, computers are generally superior to human beings. Quant is the answer to the root problems of behavioral finance. The investor has to understand what they are-- an animal that has evolved into a mistake prone homo sapien, full of misperceptions, misunderstandings, bias, emotion, fears, greed, ego and so on… Working from there, you can start to develop an investment strategy. And, inevitably, you will arrive at a solution that relies not on the mistake prone human, but on a rule-based system that has one primary objective: to avoid mistakes.”

I thought Brian hit this one almost out of the park, and asked him for permission to share his thoughts with you in this blog. I agree with almost everything, except the part about quant leading you to a rules based system that avoids mistakes. It turns out that quant models are built by humans who suffer from all of the biases and heuristics that make qualitative decision making so difficult. The problem with a rules based system is that the rules change, and when they do someone has to recognize the changes and update the model. The process is excruciating. The model worked in the past but it hasn’t been working lately. Why? Maybe it’s the rise of high frequency trading, or hedge fund activity, or unanticipated or unprecedented government market intervention. Should we change the model? If so we are in new territory with no track record….and on and on. I still believe its best not to rely too heavily on quant as a matter of good risk management, the same way you need to defend against poor judgment calls. I believe that all investment models work…until they don’t. That’s why we use both quant models and informed intuition at Pinnacle. Thanks for letting me share your thoughts Brian. I always appreciate the comments of intelligent and passionate investors anxious to improve our industry and advance the cause of active portfolio management.

Tuesday, September 28, 2010

Confidence Not Cooperating

Improving confidence is typically seen as an important ingredient for a lasting economic expansion. This morning, the Conference Board released their monthly survey of consumer confidence, and it showed a decline to 48.5, the worst reading in seven months. Both of the main sub-components of the index fell to their lowest levels since February.

Focusing on the two sub-components reveals some interesting information. Typically, the “expectations” component bottoms and starts to recover earlier than the “present situation” component following recessions. As you can see on the chart below, that’s exactly what happened this time around (although expectations are also down now by almost 20 points since reaching a recent high in May). However, the present situation component is completely moribund, still scraping along the lows first reached in March 2009 and showing no sign of following the lead of the expectations component. You certainly wouldn’t guess that the recession ended in June 2009 by looking at this indicator.

The fact that confidence is faltering at present when we’re only about 15 months into this recovery is worrisome. As you might expect, the dour mood is likely very closely linked to the stagnant labor market. It’s hard for consumers to feel especially good with unemployment as high as it currently is. No wonder there has been a lot of speculation recently that the Fed is seriously considering additional measures to support the economy.

Chart: Consumer Confidence – Expectations (blue line) vs. Present Situation (black)

Monday, September 27, 2010

Investing or Gambling?

I just returned from a weekend in Atlantic City where I was the guest of a fellow Rotarian, David. David would scoff at the notion that he is a “high roller,” but he does have Seven Star status at Harrah’s casino in AC and without knowing the details, you have to spend a lot of time gambling to get to seven stars. David earns boatloads of “comp points” for his gambling activities, and so he treated me and two other Rotarian friends to a weekend of fine dining, golf at Atlantic City CC, unlimited time in the “Seven Star Lounge,” limo rides, $1,000 suites…and…well…you get the idea. For someone like me who manages portfolio risk for a living, and who doesn’t like to gamble, the scene in AC was fascinating and worthy of comment.

To begin with, every gambler there knows that the odds are stacked in favor of the “house.” I was, somewhat amazingly, treated to a lecture on the subject by a professional poker player I met in the Seven Star Lounge informing me that he plays poker because he doesn’t have to beat the house, just the other players at the table. I sat there and received a somewhat stern lecture on risk management from a 35 year-old guy who has made his living playing poker for the past six years! As an aside, this professional player dressed his young daughter up in a “hoodie” and sunglasses when her elementary school had a “dress like your dad at work” day. Our host, David, knows the odds favor the house, but he consistently makes money playing the slots in the casino. He won $9,000 last weekend, including $1,500 while the rest of us were watching the Ravens-Cleveland football game. David “knows” when the machines are about to start paying, or more accurately, he knows when they are likely to keep paying, a skill that is obviously quite useful at a casino. And while I may have been a skeptic before last weekend, I’m now the last person to tell him his system won’t work. He believes in his system and that’s good enough for me.

What about the investment game? Buy and hold investors argue that the odds also favor the house, with players having to pay transaction charges, taxes, and investment advisory fees. They say you should just buy a low cost index and hold for the long-term. In addition, I would add that high frequency trading and proprietary trading desks further stack the odds in favor of the house. Yet active managers, like Pinnacle, persist in playing the game. Why? I believe that in a secular bear market where cash yields are nil investors have little choice. You either develop rules to try and even the odds of winning through actively managing your portfolio or you will fail to meet your financial objectives. That’s why we believe that all investors make mistakes and the successful investors make fewer mistakes than the “house,” or in our case, the consensus. For us the “house” returns are our benchmark returns. If we can’t beat the house then we shouldn’t play. At the moment we have eight years of returns that say we can do it. Thanks for a great weekend, David. I’ll see you at the Flop Poker table!

Friday, September 24, 2010

Currency Reform – Let’s Be Careful What We Ask For

Risk assets are flying, and it’s a feel good autumn Friday. One of the headlines that may quietly pass by on this feel good day is that the House Ways and Means committee approved legislation aimed at putting pressure on China to raise the value of its currency. One of the things this legislation would do is allow companies to petition for higher duties on imports. While China currency bashing seems very pro-American on the surface, especially at a time of such high structural unemployment and a decline in our manufacturing base, I have to wonder who is really going to win if a trade war heats up between the U.S. and China.

Yes, I love America and think we should pressure China to more freely open up their markets and accept more U.S. imports. But duties on Chinese imports? Let’s be careful here. Job losses are still high, incomes are still suffering, and consumer confidence is still quite low. If things aren’t tough enough now, what’s the mood going to be like when Wal-Mart is forced to pass on the increasing prices of Chinese goods to consumers who are already feeling strapped as it is?

I’m not saying that some global rebalancing of growth doesn’t need to occur, but starting a trade war doesn’t sound too attractive to me from a U.S. consumer perspective. They say history doesn’t repeat, but often rhymes. Let’s hope this legislation doesn’t end up rhyming with a previous tariff bill known as Smoot-Hawley, which was passed in the 1930s. I don’t believe that worked out too well…

Thursday, September 23, 2010

What’s So Scary About Deflation?

A few days ago Carl Noble wrote a blog about the latest Federal Reserve (Fed) meeting and some new language regarding deflation. The question some might have is why is deflation such a worrisome prospect?

First off, there is a psychological component to deflation. If consumers perceive that prices will be cheaper tomorrow than today, then why buy today? Seems logical and innocent, but if less consumer spending leads to softer profits, then employment falls, and eventually income goes with it. With less income, who’s going to feel confident to spend, especially if prices are assumed to keep going down? Yep, it can lead to a vicious downward spirals that is very hard to reverse once it gets some momentum.

Deflationary danger levels rise even further when starting debt levels are high (like they are today). In environments where income and assets are low or declining, but debt levels stay the same, debt to income and asset levels get worse by default. This can lead to forced selling, and it can lead to using income to reduce debt (deleveraging) rather than spending or investing it. Reducing debt for an individual is healthy, but when everyone does it at once it exacerbates a weak or falling growth environment (aka the Paradox of Thrift).

The good news is that Helicopter Ben Bernanke appears to be willing to wage war against a budding debt deflation, and new attempts to reflate assets and income may be on the horizon. The bad news is that there is no way the Fed or any other monetary or fiscal authority can guarantee policy tools will be strong enough to combat deflationary impulses that were unleashed during the financial crisis. Hopefully, easy money and rising asset prices can lead to confidence, renewed spending, new jobs, better income, and a reversal of deflationary tendencies. But anyone feeling too confident about the efficacy of monetary policy in thwarting debt deflations should force themselves to examine the Japanese economy over the last several decades. That is truly scary…

Wednesday, September 22, 2010

Rise of the Machines

In our monthly Investment Committee meeting this week, Ken brought up High Frequency Trading (HFT) as a topic of discussion (using the very witty title I have borrowed for this post). For those of you who do not know about HFT, it is a combination of trading strategies using computer algorithms to make profits on small but very quick trades which usually last for mere seconds. They have become so dominant in the trading game today that it is estimated that they are responsible for over 70% of trading volume on any given day. Is this a good thing? Well, that is the question currently being debated.

HFT firms will argue that they provide three major benefits to the marketplace. They provide added liquidity to the market, they narrow the bid-ask spread (price difference between selling and buying a security), and improve market efficiency by reducing price inconsistencies. However, critics are quick to point out that these trading strategies are essentially front-running trades as they can see large orders and execute faster, while in the process trimming profits from individual investors. Additionally, the firms are engaging in questionable activity including multiple order cancellations which might be viewed as market manipulation.

Whatever side of the argument you fall on, I think we need to concentrate on one important area. These trading strategies are implicated, rightly or wrongly, in the flash crash that occurred in May. Every week since the flash crash we have seen equity outflows by retail investors as they are increasingly concerned with volatility. This creates instability and a lack of confidence in the marketplace which is very worrisome since our recovery is standing on a very thin edge. It might be time to restore that confidence and encourage capital investment as the exchanges were built to do.

Tuesday, September 21, 2010

No QE 2 for Now

This afternoon brought the latest statement from the Federal Reserve, and the big news is that they’ve decided not to implement any additional quantitative easing (QE) measures for the time being. The 9% stock market rally so far this month has been partly attributed to investors anticipating the possibility that the Fed would unveil a new program of large-scale asset purchases to support the economic recovery, possibly on the order of another $1 trillion or so. We didn’t believe that was very likely at this particular meeting for several reasons, including the proximity to the November elections and still positive economic data. Of course, they left open the possibility that QE might be necessary going forward if the economic recovery falters.

While the QE 2.0 arrow was kept in the quiver, the market did latch onto some new language regarding inflation. Remember, the Fed pursues a dual mandate to maximize economic growth while maintaining price stability. In the past, the price stability part of the equation was usually focused on containing inflation. Now, policy makers are concerned about trying to avoid deflation. They seemed to indicate that inflation is currently running too low (core CPI is less than 1%) for their tastes, with the implication that they may need to take some sort of action in response.

Investors immediately reacted to those comments - stocks, gold, and foreign currencies all surged, while the dollar tanked. However, many times there are knee-jerk reactions to events like these that end up completely reversing in a short period of time. It will be interesting to see how things play out in the coming days – will the market remain buoyed by the inflation comments, or will some degree of disappointment set in due to the lack of additional QE?

Monday, September 20, 2010

Good Thing We Don’t Wait for the NBER

Today, we finally received official word from the National Bureau of Economic Research (NBER) that the recession ended in June 2009. And while that’s good news, informed investors are probably wondering, “Where have they been?” One of the reasons that the NBER is notoriously late in classifying expansions and contractions is that they use coincident measures of economic activity to mark these important events. More specifically, they focus on industrial production, employment, real manufacturing and trade sales, and personal income less transfer payments. These data points are relevant and important, but they gauge activity that is happening now, not activity that should occur in the future.

Since markets anticipate and discount future events, trying to position off of what is happening now is fruitless since it’s effectively like looking through the rearview mirror. This is why we focus on leading indicators in attempting to forecast future economic and financial market direction. Many of these leading indicators were foreshadowing an economic turning point as early as the second quarter of 2009 and we thought they clearly pointed to the recession being over during the summer of 2009 (you can read our second and third quarter 2009 Market Reviews here).

What’s really ironic is that that it’s taken the NBER so long to determine the end of the recession that leading concerns are now pointing toward a slowdown in our future. Our job is to determine whether the slowdown will be a benign mid-cycle correction or the start of another contraction. The data is still somewhat ambiguous on that front, and we’ve taken a defensive posture until the message is more uniform. Whether or not we get more bullish or bearish is still in question, but one thing is for sure, we can’t wait for the NBER to help us with calling a cycle change. The only thing you can count on from this group is that their call will be really late!

Friday, September 17, 2010

Buckets of Risk

A substantial part of my job is to try to explain Pinnacle’s investment process to folks who are interested in active and tactical management. Although I spend my days in the trenches with Pinnacle analysts trying to implement our strategy, it is no small challenge to try and simplify our process into an explanation that investors can understand. My latest attempt at explaining what we do around here is to ask investors to visualize several different “buckets of risk.” Let me explain.

In prior posts I’ve discussed Pinnacle’s investment process as a different kind of core holding where our portfolios meet the requirement of attempting to systematically deliver returns within a well defined range of risk or volatility. Traditionally, core holdings are strategic buy and hold portfolios because both advisors and clients can point to historical back-tested performance of asset classes in order to agree on rational parameters for risk and reward. Instead of buying and holding where we are constrained to own asset classes in fixed percentages, we instead are constrained by the historical risk and volatility of the buy and hold portfolio, but with no constraints in terms of what we actually own. Think of it this way…each Pinnacle investment strategy has its own separate “bucket” of risk that is a different sized bucket from the other Pinnacle strategies. We offer clients five different risk buckets to choose from: Dynamic Conservative, Dynamic Conservative Growth, Dynamic Moderate Growth, Dynamic Appreciation, and Dynamic Ultra Appreciation. As you might imagine, as you move from conservative to ultra appreciation each bucket is allowed to own more risk and volatility. This in turn implies higher future returns. How our clients actually choose which bucket is right for them is (hopefully) the result of working with our wealth managers in the financial planning process.

The cool part of this, the part that differentiates us from most other advisors, is that we are free to fill each risk bucket with whatever asset classes we want to own as long as we don’t overfill the bucket. To reiterate, we are not constrained to buy and hold a fixed mix of pre-defined asset classes for each bucket. Instead, our analysts are free to find value opportunities wherever changing market circumstances cause them to appear, and we are free to change them as our experience, judgment, informed intuition, and quantitative assessments may dictate. The risk bucket is defined by historical market returns, but the assets we own at any point in time are only limited by our best evaluation of what constitutes good value. We pledge to honor what we consider to be the two unbreakable rules of investing: 1) We will fill the risk buckets with a diversified portfolio of asset classes, and 2) We will try not to fill the bucket with overvalued assets. At the end of the day Pinnacle clients have different levels of interest in the details of how we fill their risk bucket, but in my experience they all are vested in the idea that we systematically manage risk…and that’s exactly what we do. To offer clients an actively managed core holding is an oxymoron in the investment business. Those that understand this will find great value in our investment process.

Thursday, September 16, 2010

Competitive Devaluation in Progress

Manipulation of a country’s currency is one mechanism that can be utilized to try to reflate economic growth. This is especially true when a country has a heavy reliance on exports. A cheaper currency lowers the cost of the country’s products abroad, thereby boosting the ability to export goods. When many countries are trying to weaken their currencies at once it is called competitive devaluation. This typically occurs in environments that have a deflationary tone; when there is too much supply and not enough aggregate demand in the global economy. That appears to be the backdrop in the world today, so it’s not surprising that a weaker currency is being pursued by many countries.

Yesterday, Japan’s currency intervention was a hot topic, and the yen weakened appreciably on the day. However, many believe it won’t work, primarily because it’s a unilateral move right now, and it’s hard to believe that other countries will have much tolerance for an appreciating currency versus the yen.

The U.S. is also part of this game, and today Treasury Secretary Timothy Geithner is again voicing concerns about the Chinese currency being artificially low. He’s done this before, and so far the Chinese seem to only get more adamant that they won’t be forced into a stronger currency. Listening to Geither rail against the Chinese currency policy, I wonder if the U.S. isn’t getting a dose of its own medicine from years past. In 1971, then-Treasury Secretary John Connolly told Europe that “the dollar is our currency but your problem.” China hasn’t been as blunt yet, but their actions and rhetoric so far seem to reflect a similar sentiment. Let’s hope this currency devaluation environment doesn’t lead to broader trade wars and tariffs. Competitive currency devaluations need to be monitored closely in today’s investing environment.

Tuesday, September 14, 2010

Slightly Overcooked?

This is not the first time I have written about (whined about?) managing the volatility of Pinnacle portfolios when we insist on owning a diversified group of asset classes. We don’t have a dial to turn to adjust portfolio volatility, which is heavily dependent on the day-to-day correlations of the various asset classes we own. I just reviewed our performance for the first week of September, where the S&P 500 Index is already up about 5%, and the Pinnacle Moderate Growth portfolio captured about 40% of the move to the upside. The term used to describe relative performance to a benchmark is “beta,” so in this case the DMG portfolio had a beta of about 0.40 for the week. On down days the portfolio beta appears to be considerably less where we have observed downside capture of only 20% - 30% (beta of 0.20 – 0.30) of the broad market. The good news is risk to principal is clearly being managed in this market environment. The bad news is that we may have “overcooked” the amount of risk that we took out of the portfolios over the past few months.

We use several models to determine what portfolio volatility is likely to be based on the current mix of asset classes in our portfolio. One model that is intuitively obvious is a “beta” model that simply looks at the weighted beta of all of the securities in order to estimate the total portfolio beta. The problem is, of course, trying to estimate correlations. Two asset classes can have a the exact same beta relative to the market, but if the are zigging and zagging differently, then the total portfolio beta can be significantly less than a simple beta model might predict. We also use our “equity-like” models where we look at the risk attribution of each asset class in order to come up with our total equity or “risk” exposure. Because we own several asset classes that presumably have low correlations to the broad market, the equity-like models must be continually adjusted to reflect the current performance of the asset class and our subjective view of what correlations may be like in the future. The DMG portfolio current equity-like total is 61% of the portfolio, which implies that portfolio volatility could be substantially higher than we’ve been seeing if we get peak correlations going forward.

The spread between our “equity-like” calculation of 61% for DMG and downside beta of only 0.20 – 0.30 observed in down markets is troubling. I am certain that this will be one of the major areas of concentration for the investment team this week. At the moment the actual observed volatility in Pinnacle accounts implies a severely bearish view that is not consistent with our actual forecast. However, if correlations peak we may see an entirely different level of volatility in managed accounts. It should make for some interesting discussions.

Friday, September 10, 2010

Financial Markets Trading off of Economic Expectations

The start of September has been kind to the equity markets. And if it seems like the last few data economic points have been better than expectations, we’d agree. Housing data has been kinder lately, with the Case Shiller index (8/31) and pending home sales (9/2) breaking a string of very nasty reports during August. The ISM manufacturing numbers were better than expected on (09/01), and the labor market reports have surprised to the upside with the latest non farm payroll (09/03) and initial jobless claims (09/09) beating expectations. This is all good news, though too early to call a definitive end to the slowdown in growth we are experiencing.

Given that the market volatility in August was heavily driven by worries of a double dip, it’s not surprising that the financial markets appear to be breathing a sigh of relief during this bounce off the August lows. The graph below shows how linked financial markets have been this year to changes in economic expectations. The black line on the graph is he SP500 index, and the blue is the Citigroup Economic Surprise Index for the United States. A positive number on the index means economic data points have been beating the consensus expectations and a negative number means they have been come in less than expectations. Currently the line is rising, but it is still in negative territory. The good news is that despite the negative reading, the positive rate of change in the index appears to be driving investors risk appetite at the moment. The risk is that the latest batch data is simply a headfake, and that equity markets are again vulnerable to any weakening in the data from here.

Thursday, September 9, 2010

Sovereign Yields Rising Again

So here we are again. Sovereign yields of the problem children in the European Union are on the rise again. The chart above shows the yields on the Greece Generic 10 Yr Bond in Orange and the yield on the Irish Generic 10 Yr Bond in white. As you can see on the chart, the Irish 10 yr yield has risen to a new high of 6% (before backing off a little bit today) and the Greek 10 yr is approaching the high water mark. As a reminder, bond prices are falling as the yields rise. This fall in bond prices and rise in yields not only hurts investors who own these bonds, but more importantly it increases borrowing costs for these nations, and makes it harder for them to service their bulging debt loads.

This recent wave of yield pressure is due to skepticism surrounding whether Ireland can reign in the ballooning deficit and support the local banks. In the short term the recent announcement to split the Anglo Irish Bank into a ‘good bank’, which will deal with deposits only, and a ‘bad bank,’ which will deal with the bank’s loan assets, was well received by the market. The markets also started the morning celebrating that a Norwegian Sovereign Wealth Fund had purchased government debt of these struggling nations. Of course, whether or not this was a prudent decision over a slightly longer time frame than one day is still to be determined.

At the beginning of April, I last wrote on the sovereign default fear that was present in the system. At the time, the equity markets had not yet responded to the turmoil brewing in the bond markets, but within the next few weeks the equities started to decline, on their way to a 20% fall in the MSCI EAFE (broad index of international stocks concentrated in Europe). And now once again we have to ask ourselves, ‘are equities the last ones to get it?’

Wednesday, September 8, 2010

Fixed Income: Flattening & Steepening Trades

Govt. bonds have had an outstanding year, and the longer maturity bonds with the most interest rates sensitivity have fared the best. Though there are a good number of pundits that would call bonds the new “bubble”, there are some good fundamental reasons for why bonds have rallied recently. Concern about the state of the global economy, a realization that the trend in inflation is currently down, and a Federal Reserve that will be forced into keeping short rates low for the foreseeable future are all good fundamental reasons bonds have performed so well year to date.

Despite the recent returns, one has to be skeptical and wary about how much more return can be squeezed out of government bonds if the economy doesn’t contract from here, especially when considering how much money has flowed into the bond market recently. One way to invest in fixed income without buying the bonds themselves is to enter into yield curve flattening and steepening trades. The steepness or flatness is simply the difference in yield between two different maturities on the yield curve. Currently the 3 year minus 2 year spread is quite flat, at .26 percentage points of spread between the two maturities. The 30 year minus 2 year spread is still very wide, with a difference of about 3.3 %. This may represent an opportunity for investors that want to bet that the long end of the curve will flatten, presumably driven by long rates dropping closer to short term yields that are being anchored by the Fed. Like all trades, there will be bets on both side of the equation, and that’s what makes a market. With new ETN’s available to invest in a flattening or a steepening yield curve, we now have another tool in the arsenal to invest in fixed income markets without buying the bonds themselves. With yields at these levels, another option is good news for fixed income investors!

Tuesday, September 7, 2010

Don't "Over Think" It

During one of our investment team meetings last week, we made the point that it is often important to look for the “easy” trade. It reminds me a lot of watching youth soccer teams where the athletes try to thread a pass through several defenders in order to set up the Striker with a breathtaking play, when a simple pass towards the sidelines would advance the ball and create a situation that is ultimately harder to defend. In our case, I believe we were discussing dividend paying stocks in the context of market valuation, where the earnings yield of high quality S&P companies is more than twice the yield of US Treasury bonds. The “easy" trade would be to buy a high dividend ETF and hold it as long as the dividend growth is supported by the economic and earnings cycle.

Our discussion prompted some emails among team members trying to explain our current investment stance into a few short declarative sentences. And here is what Yours Truly had to say:

“The economy is very slow but the evidence is murky as to whether it is still slowing. The stock market is secularly expensive but on many measures it is now cyclically cheap. With the Fed and the President (but maybe not Congress) standing by to apply fiscal and monetary stimulus, there is real risk in getting too far out of the market. Considering that the portfolios are running very cool already with a beta for DMG at about .35, it would appear that no more selling is warranted, and that we should wait until we break the bottom of the range for any further changes.”

Like many other things in life, trying to simplify can be a good thing. We don’t want to “over think” this market. If we can find an easy trade to fit our theme it is definitely worth our strong consideration for inclusion in our managed accounts.

Friday, September 3, 2010

Schizophrenia and Relative Value Investing

The stock market began the month of September with a gain of close to 3% and I’m not happy this morning. The month of August was terrible and I’m pleased. What’s wrong with this picture? The answer is simple. When we have positioned our portfolios to defend against market declines then any market rally is a cause for concern and market sell-offs are something to look forward to. It is difficult to describe the mixed emotions that result from positioning portfolios to be defensive in bear markets, and then being correct in your forecast. On the one hand, Pinnacle strategies have a high r-squared to general market direction which means that a market decline on any given day will typically result in lower portfolio values for our clients. This is bad. It is bad for them because their financial plans usually require that they accumulate wealth to fund their retirement and other objectives, and losing money…any amount of money…does not help to achieve their financial goals. Blessedly, Pinnacle clients are highly educated consumers of investment advice and they seem to understand that there is, in our opinion, no fundamentally sound investment methodology to completely avoid portfolio declines. Time diversification allows us the flexibility to manage accounts without making dangerous asset allocation bets that require us to completely abandon risk assets in bear markets. Of course, there is a difference between asking our clients to be patient (buy and hold and pray) and asking them to be patient (give us the time to allow our active strategies to work). Since there is no barrier to exit a relationship with Pinnacle, I am thankful for our clients’ forbearance every single day.

On the other hand, if we get our forecast right in bull markets or bear markets our relative performance can soar versus both the broad market and our blended benchmarks. In declining markets, assuming we are defensively positioned, the pros would say we earn positive alpha, and our clients would say thanks because they have friends that lost a whole lot more than they did. It is admittedly rather confusing to find yourself rooting for a market decline in such situations. Yesterday’s relative portfolio performance is going to look awful. Yet, it looks like Pinnacle portfolios performed beautifully during the month of August and the numbers are going to be excellent on a relative basis. The S&P 500 Index lost 4.57% during the month with dividends reinvested and Pinnacle portfolios lost a small percentage of that total. However, as always happens in conditions of falling markets and portfolio values, my enthusiasm is measured. The bottom line is that yesterday our client made money and after the month of August our clients are that much further from retirement and we (the partners at Pinnacle) took a cut in pay. However, by minimizing the negative compounding of the portfolio, we are laying the groundwork for being able to help our clients systematically accumulate wealth over time. There must be some medication for this…

Thursday, September 2, 2010

Will the Jobs Show Up?

Yesterday was a great day for risk assets, as markets celebrated better than expected manufacturing numbers out of both the U.S. and China. On the back of an excruciating August for equity markets, it’s hard to tell whether the magnitude of the bounce had more to do with short-term oversold conditions, or if the market is telling us that it has overly discounted the slowdown in global growth that appears to be taking place.

One of the indicators less talked about during the rally yesterday was the ADP employment survey, which declined by 10,000 instead of increasing by the 15,000 that economists expected. We’ve continually written that jobs are very important at this point in the cycle, and that we need to start seeing more robust job creation if the expansion is to extend. Tomorrow we get the monthly payroll report for August. Like last month, the decline in employment of temporary census workers is expected to produce a negative headline number. But the data will be scrutinized excluding census workers, and the current estimate is for an increase of about 40,000 in private payrolls.

Should payrolls surprise to the upside, it would make sense that the markets might rally further. On the other hand, if it is another disappointing report, it wouldn’t be surprising if markets take some of yesterday’s gains right back off the table. But often times market moves have a way of defying commons sense. If it turns out to be a poor number, it will be really interesting to see if the market can shake it off and find a way to rally anyway. If so, we might just be in for a bigger rally. No sense in making any big guesses here, but we’ll be watching closely.