Thursday, December 15, 2011

A New Blog Home

Last week, we unveiled our brand new, completely redesigned Pinnacle Advisory Group website. When we started the Echoes from the Pit blog in 2009, we kept it separate from the company site, since there was really no place to host it there. However, with our new online home, we're now bringing our investment blog over. Echoes from the Pit will continue -- make no mistake -- but it will do so over at the main Pinnacle website. If you've been receiving Echoes from the Pit updates by email, you'll continue to get them without interruption.

Here's the new Pinnacle website.

And here's a shortcut directly to Echoes from the Pit. We'll be adding some recognizable "Echoes" imagery to it in the next week, but all the content is right there now. (Be sure to bookmark it.)

This is a great opportunity to explore Pinnacle's new site. There's a lot to see: In addition to our investment posts, we'll also be carrying helpful articles on money management, and regular video profiles, interviews and mini-documentaries.

We're going to keep this page up for a month so readers see the announcement. Then in mid-January, we'll put an autoforward on this address so that visitors are taken automatically to the new site.

We'll see you over there!

Friday, December 2, 2011

Chinese and U.S. Relative Strength

China may be sporting a 9.1% Year over Year Real GDP, but the stock market certainly does not reflect that strength. The chart below displays the S&P 500, which is the green line in the top chart, and the Chinese Stock market measured through FXI ETF, which is the red line in the top chart. It also shows the relative strength of the S&P 500 measured against China. When the line is falling, the Chinese stock market is performing worse than the U.S. stock market.

There are a few things to point out on this chart. First, the Chinese stock market has been underperforming the U.S. stock market since July 2009 (as marked by the light blue lines). Second, the Chinese stock market has created a new downtrend channel, which means it is underperforming by an even larger margin since the beginning of the year. I have marked this with the red lines.

Finally, the red, downtrend channel has provided traders with nice buy and sell signals. I have focused on the sell signals which I marked with the vertical black lines in the chart. When the relative strength line hits the upper red line, it has marked a good selling opportunity for traders. With the recent policy intervention by the global central banks, we are once again seeing the relative strength line rising to that red line. I will be watching this over the next few days to see if it once again portends a good selling opportunity.

Wednesday, November 30, 2011

Central Banks to the Rescue

Markets exploded higher today on the news of a couple big actions from global central banks. First was the report that China had lowered its reserve ratio by a half percentage point, indicating that it has now shifted to policy easing and boosting economic growth, rather than continuing to battle inflation through policy tightening (as they’ve been doing for the past two years). Then came the announcement that six major central banks -- including the Fed, ECB, and BOE -- were unveiling a new arrangement that lowers the interest rate on dollar currency swaps in an attempt to end the worsening bank funding crunch in Europe.

It seems like we’ve been down this road several times since the European debt crisis began to intensify earlier this year. Some grand plan or solution is floated, and the markets rejoice, only to fall back again when investors realize that the core problem -- the ultimate solvency of over-indebted nations -- has not been resolved. However, we’re also aware that the central banks are powerful enough to spark sustained market advances even in the face of suspect fundamentals, as the Fed has done in the past couple of years with QE1, QE2, etc. So today’s actions can't simply be ignored.

Once again we’re left to ponder whether “this is it” -- the game changer that signals all is well and investors can safely swim in the risk pool again. While today’s rally is certainly impressive, we don’t think we can make that determination just yet. For our part, we’ll be looking for signs of confirmation in coming days – key technical levels being taken out on the upside, a credible plan out of Europe, etc.

Tuesday, November 29, 2011

Credit Not Confirming the Equity Rally

Yesterday was a big day for equity markets, and today I did a quick check to see how some of the European credit metrics were behaving. From what I've seen, the credit markets have not confirmed the equity bounce. Below are a few charts we're watching, along with our interpretation. 

ECB Eurozone Liquidity Recourse to the Deposit Facility is rising fast again. This implies that banks are afraid to lend, and would rather just park funds at ECB. 

Euribor OIS is elevated. This chart is watched as a barometer for interbank lending in Europe, and high and rising levels say that bank lending to other banks remains in a stressed state. This metric confirms the message coming from the prior chart. 

Credit Default Swap (CDS) pricing on European Sovereign debt is still surging. This suggests that the cost to insure against European Government default is rising rapidly.

CDS for European Banks are surging up in price. Unicredit SpA(Blue line) is one of Italy’s largest banks. This chart shows that the markets are pricing default risk into European banks at an alarming rate, and many now cost more to insure than they did during the great credit crises of 2008/2009.

The Ted spread is used as a measure of confidence in the financial and banking system, and it is moving up in tandem with the other measures I mentioned. This is not a good sign for the health of the banking system.

There are more charts, but you get the point. Equities had a big day yesterday, but credit markets have not confirmed the latest equity market rally.

Monday, November 28, 2011

The Brutal Realities of Calendar Year Reporting

The year is rapidly coming to a close, and 2011 will be remembered by Pinnacle’s investment team as one of the more difficult in recent memory. The financial markets have faced a variety of challenges, including those caused by natural disasters (the tsunami, earthquake, and nuclear meltdown in Japan), political upheavals (the Arab Spring, U.S. debt downgrades, and ongoing political gridlock), and financial turmoil (the European crisis). The investment team has responded to changing market conditions with a series of transactions that, for the most part, have reduced the risk in our managed accounts in anticipation of volatile markets. By my count we have executed more than thirty trades since June of this year, and more than one hundred transactions since January, each of which has been the subject of intense debate within the team. I hope to never again sit in on a meeting where the topic of discussion is the implications of a cloud of radioactivity drifting over a major industrial city.

Yet for all the hard work, we come to the last month of the year with Pinnacle portfolios basically breaking even versus our various benchmarks for both year-to-date absolute performance and year-to-date relative performance. For those investors who tend to think in terms of “How much did I make?” the year is going to be disappointing. Even a big December rally won’t rescue what is likely to be small single digit returns for the year. Of course, investors who think in relative terms are still in the game. If the markets continue to sell-off as they have over the last couple of weeks, we have an opportunity to beat our benchmarks by several hundred basis points. In a year or two no one will remember all of the work that went into earning our returns in 2011 -- all they will see is the calendar year number buried along with all of our other calendar year numbers.

It is precisely this state of affairs that causes so much mischief in the world of professional investors. The fact that four weeks of performance will dictate how others judge your entire year doesn’t seem fair…but there it is. Unlike the hedge funds that will most certainly ‘game’ whatever is to come in the next month in the hope of making their year, there is nothing in Pinnacle’s playbook that would allow us to do the same. While we’re certainly not passive investors with no tools to take advantage of market opportunities, we simply don’t operate with a four week time horizon, and we won’t change the portfolio positioning from defensive to aggressive in order to try to catch a flash market rally that could reverse at any time. It is possible that the markets will continue to sell-off during the month of December, in which case we will be big relative winners due to the defensive character of our current portfolio asset allocation. On the other hand, the market could easily rally if the market becomes too oversold in the short-term... or if we have a typical “Santa Claus” rally... or if the Fed announces QE3... or if the ECB announces its own quantitative easing program...

It’s going to be an interesting four weeks. Stay tuned.

Wednesday, November 23, 2011

Triangle Measure and 61.8% Retracement

Last week, Carl wrote a blog post on the triangle pattern that formed after the large October rally. As he mentioned, this is usually a continuation pattern. However, traders would have been wise to wait for the upside breakout, because the pattern broke to the downside. I marked the triangle with the red and white lines in the chart below, and you can see the price breaking the white line to the downside last week. This has led to a vicious decline over the last few trading days and we now stand at a key inflection point.

When the triangle breaks, an estimated price move can be obtained by subtracting the low from the high of the triangle, and then subtracting the result from the break level. For this triangle that would be 1235-(1290-1220). This gives us an initial price target of 1165, which is the low for today (although the day is not over). Additionally, this level is the 61.8% retracement of the October rally, which I circled in green. So the S&P 500 is testing a good support level right now, and if this does not hold, it's very likely the 1100-1120 lows for the year will not be far behind.

Tuesday, November 22, 2011

Hanging on a Headline

Today brought a revision to 3rd quarter GDP, which while disappointing, is at least in our rearview mirror. It also brought the Richmond Fed Manufacturing Survey, which was better than anticipated, but still pretty anemic (zero versus the expected negative two). At this point, we’re looking at low volume markets that are whipping all over the place, and appear to be hanging on the next headline.

Thus far, the two high impact stories of the day are the revamping of a credit line by the International Monetary Fund (IMF) and the (apparently early) release of the Fed minutes. Markets caught a bid on the IMF line, but quickly sold back off as the details look somewhat lackluster. The minutes were just released and markets have surged again on hopes that the Federal Reserve might jump to the rescue. Whether that will hold is another story.

As we approach the Thanksgiving holiday, I give thanks for my family, my co-workers, and our clients, who trust us to manage their precious assets. I’d also like to give thanks that Thursday I can eat some turkey in peace without worrying that the next headline might produce another round of high powered volatility.

Monday, November 21, 2011

How to Make a lot of Money Right Now

You know, it’s not that hard to make a lot of money in the financial markets, no matter what you might have heard. For example, I can tell you exactly how to make a fortune in the next couple of months. Here is what you do:

First, assume that Germany will capitulate to the fervent pleas of just about every other country in Europe and agree to allow the ECB to print about a trillion euros, give or take. Never mind that the ECB and Germany have both been firmly on the record stating that this shouldn’t happen because this would be against the law (along with several other better reasons). They seem to take the position that if the central bank prints the money, then the countries with the most debt will probably spend it. Imagine that. As of last week, it appears that without a massive quantitative easing program (the central bankers' term for printing money) the whole euro experiment might go up in smoke. So go ahead and bet that policy makers will suck it up and not allow the Eurozone to fall apart. Once Mario Draghi, president of the ECB, and Angela Merkel, Chancellor of Germany, get serious about debasing the euro currency, prices for credit default swaps on bank debt and sovereign debt will plummet, yield spreads between Germany and all of the other Eurozone countries will crash, liquidity will wash over market participants like a cool breeze and equity markets around the world are going to go vertical.

But that’s not all. This week the world will turn its attention, once again, to the ongoing tragi-comedy that is the U.S. Congress, or more specifically, the Super Committee tasked with coming up with $1.3 trillion in savings in order to avoid $1.2 trillion in automatic, across-the-board spending cuts (starting in 2013, and evenly divided between defense and non-defense spending). By the time you read this post, the committee will have had to announce its verdict, so we may be a little late to get in at the absolute bottom. To make the big money you have to believe that the committee is going to shock the world and go big... really big. If the committee comes up with $3 - $4 trillion in savings based on revenue increases, entitlement spending cuts, savings from pulling out of Afghanistan, and other savings that will kick in far in the future, the market is going to love it, if for no other reason than that we will avoid another embarrassing downgrade from the rating agencies on U.S. debt. Considering the terrible year thus far, a big deal could be the perfect excuse for hedge funds to work their way into a buying panic.

So let’s review. Back up the truck, borrow money from mom, mortgage the house, leverage the portfolio, bust out the derivatives, and empty your pockets, because this is one of those times when risk takers can make a whole lot of money…. as long as the players follow the script I’ve carefully laid out for them. Of course, it’s possible that Germany and the ECB mean what they say about quantitative easing, and the Super Committee won’t get a deal done, in which case, risk takers are going to get slaughtered. U.S. economic data is looking, on average, a little better to me over the past several weeks, and the earnings season has been stronger than expected, but I just can’t get excited about being much of a buyer right now. Europe is going into recession, and I think that will put a substantial damper on the U.S. economy, which at best is going to slow along with it.

I'll let others make the big money if they have the stomach to buy in front of all of this headline risk. If they get it right, they'll be considered brilliant observers of global economic policy and shrewd and calculating risk takers. If they get it wrong, well...

Friday, November 18, 2011

Can Santa Ride Through Frozen Credit?

Right now the equity bulls have a case for another leg higher, resting largely on technical conditions. We’re now into the best seasonal period of the year for stocks, and headed towards the end of a tough performance period that might encourage large financial institutions and hedge funds to try to juice some returns out of this lackluster market. Meanwhile sentiment has been gloomy for months, and a lot of cash likely sits on the sidelines that could potentially fuel a short term run. Given this backdrop, it’s not inconceivable that that we could see a Santa Claus Melt Up that heads for the old highs of about 1360 on the S&P 500.

But anyone following the credit markets lately could also come to the conclusion that the bulls have drunk too much egg nog. Recently the yield levels on European peripheral debt have risen to worrisome levels, the cost to protect European banks have been surging, and there are indications that the plumbing of the European banking system is clogging up in a hurry. Essentially the credit markets are showing some signs of a deep freeze in Europe, which ratchets up system wide risk and threatens to derail global growth over the next few quarters.

Yesterday the S&P 500 broke through the triangle pattern that Carl mentioned a few days ago, which would imply that the next stop for the market should be somewhere in the low 1160 range, if the patterns holds. Investors must decide what this correction means to their portfolio positioning. Those who believe Santa will ride to the rescue will likely use this correction as an opportunity to add risk, and those who believe the Credit Grinch will cancel the Christmas festivities have no reason to abandon their defensive posture. At Pinnacle we are positioned defensively, but have been eyeing up a way to get slightly less defensive, given that evidence we follow is less uniformly bearish than it was a few months ago. I’m not sure if this is time to buy or not, but you can bet there will be some interesting discussions on this topic as we approach the kick off of the holiday season next week.

Wednesday, November 16, 2011

Watching the Triangle

While the latest news on the economy, Europe’s ongoing debt crisis, and the progress (or lack thereof) of the debt “supercommittee” continues to cause plenty of day-to-day volatility in the market, in reality, stocks have been going sideways for nearly three weeks. The bulls are encouraged, viewing this as a healthy pause after strong gains in October. But the bears are also heartened, noting that the market is still struggling to clear its 200-day moving average or surpass the late October high.

Several market technicians have pointed out that the sideways action has produced a triangle formation (shown below using the S&P 500). The pattern basically represents increasing indecision on the part of investors. Typically, the direction stocks take in breaking out of the triangle is a good signal of the next significant move for the market. More often than not, it will continue in the same direction as the prior move, which in this case would be higher, based on the October rally. But that is far from certain, given the current environment. In any case, with the triangle narrowing rapidly, we shouldn’t have to wait long to find out.

Monday, November 14, 2011

Which Commodity is Wrong? Part II

In the previous blog post, Rick Vollaro brought to your attention an important divergence currently happening in the market -- the one between crude oil prices on one side and the CRB RIND (raw industrials) and copper on the other. These three indicators are typically regarded both as important global growth barometers and as highly correlated with the stock market. Figure 1 highlights the relative price action of these three series since 10/3/2011, when the S&P 500 formed a short term bottom. Since then, crude oil prices have risen more than 25% while the CRB RIND stayed flat and copper bounced around to end about 7% higher (though it seems to be in the process of rolling over). Meanwhile, the S&P 500 has been stuck in the middle, looking like it's not sure which commodity to follow.

We performed a historical analysis (weekly data available since 1988) to determine historically which, if any, of the above commodity series was most relevant for the stock market. In addition to coincident correlations (relation between movements in two variables at the same time) we also looked at leading correlations (relation between movements in one variable and movements in another variable at some point in the future) up to 8 weeks. Table 1 reports the results. Thanks to the heat map, we can clearly see that both copper and CRB RIND have historically been much more correlated to the S&P 500 than crude oil prices in coincident terms. Moreover, even when a lead is applied, the correlation of copper and CRB RIND to the S&P 500 remains elevated. Table 2 reports the T-statistics of the correlations in Table 1. In other words we are testing whether the results from Table 1 are statistically significant, using a 99% confidence level. When it comes to the T-stat, the higher the better -- specifically, we want it to be higher than a given threshold (the right-most column in Table 2) in order to achieve the desired level of statistical significance. While the T-stats on copper and the CRB RIND are very large and passed the test by an ample margin, only a few of the T-stats on crude oil passed the test and only by a tight margin. Based on these results, copper and the CRB RIND appear to be more reliable barometers of global growth and to correlate better with the stock market than crude oil prices.

Figure 1: Relative Price Action Since 10/3/2011

Table 1: Leading the S&P 500 weekly returns (correlations since 1988)

Table 2: Leading the S&P 500 weekly returns (T-stats since 1988)

Friday, November 11, 2011

Which Commodity is Wrong?

Right now we're watching some interesting divergences within the commodity complex. Sean wrote a recent post about oil's rise, and he mentioned that many analysts see this as a sign that the U.S. might avoid recession. What’s puzzling is that oil is currently diverging from other commodities that are typically seen as barometers of global growth, like the CRB Raw Industrial Spot Index (RIND), which tracks a basket of 15 economically sensitive commodities, excluding oil (see the chart below).

Some of the technicians we follow are screaming that the strong correlation between oil and equity markets indicates that oil will likely lead the markets higher. They may be correct, but we're currently investigating the potential correlations and lead times between oil, copper and the CRB RIND. Stay tuned for the results of Sauro Locatelli’s research on which commodity is more likely to be wrong... coming soon to a blog near you.

Thursday, November 10, 2011

Will Europe Drag the U.S. into Recession?

With signs that Europe is likely in the grips of recession due to their inability to adequately address their debt crisis, we’ve been trying to get a handle on how that will impact the U.S. economy. The reality that economies are more globally connected than ever hasn’t prevented some analysts from predicting that the U.S. will be fine, even if growth in Europe is contracting. We weren’t believers in the idea of “decoupling” when it was popular back in 2007-08, and we find ourselves skeptical again today.

A recent research report from Citigroup illustrates how tightly linked economies are these days. The chart below (from the report) shows the correlation in GDP growth rates between major European economies and the U.S. over the past two decades. In the 1990s, the correlation was only 18.5%, and it was much easier to buy into the idea that the U.S. could decouple from Europe (and vice versa). In the past decade, however, the correlation has jumped up to 72%, clearly indicating that the economies move together more often than not.

If the U.S. economy was firing on all cylinders, we might be more open to the idea that a European recession would be a non-event. But with the current recovery lackluster in many respects and with risks still unusually elevated, we're following economic developments in Europe with significant concern.

Wednesday, November 9, 2011

The Euro is on an Island

For months now I’ve been watching two charts very closely on my ticker screen -- the Euro exchange traded fund (FXE) and the S&P 500 (SPY). It’s been amazing to see how movements in the FXE have correlated to SPY (approximately 84% since September). This may be not be much of a surprise since the market has been taken hostage by the European debt crises, to the point where every rumor coming from Europe seems to create a short term market move.

Today I want to point out a technical pattern currently found in the FXE. At the moment the FXE is in the middle of an island reversal pattern (see chart below). Island reversals get their name from the appearance of the chart, where there's a price gap up, and then a gap back down, forming what looks like an island. The key here is that when the pattern forms and the gap is not quickly filled, it's usually a bearish omen for that asset. If the FXE declines and current correlations hold, this won’t bode well for the S&P 500, unless the U.S. is about to decouple from problems in Europe. While I don’t have room to get into my views on decoupling right now, I will say that the last time we heard about it was when people believed that the emerging markets could decouple versus developed markets. That was in 2008, and the theory didn’t work out so well. Those who believe it will work this time may get caught on an island with the FXE.

Tuesday, November 8, 2011

A Sign of U.S. Expansion

The chart below is the price of West Texas Crude, and you can see that the price has been climbing since the beginning of October. In fact, crude prices are up an amazing 28% in just over 1 month. Many analysts believe this is evidence that the United States has avoided a recession, and that the economies in China and Germany will be much stronger than expected from this point forth.

It is hard to deny the strength in oil right now. The price has risen above its 200 day moving average ($94.87) today after breaking the downtrend line from May to September. The price found little resistance at the 50% retracement level, which was also the same level as the 200 day moving average, and is now moving to the 61.8% level at $100 per barrel.

While this is definitely a good looking chart, I'll still be watching the U.S. equity market for further signs of strength. The S&P 500 and crude oil has been extremely correlated recently with a 95% correlation since July. The S&P 500 is now testing its 200 day moving average as I write and if the stock market fails at this technical level again, I don’t think there's much hope for oil to rise further. And that will help quiet the Avoided Recession camp.

Thursday, November 3, 2011

Our Latest Assessment...

Yesterday the Investment Team met to discuss the state of the markets. The agenda was ambitious: We needed to assess Europe’s Grand Plan, recent economic data, technical conditions, and what smoke was coming from the independent analysts we follow. Ultimately we had to decide whether or not our allocation was consistent with the weight of the evidence.

Here is a summary of the meeting and our thoughts.

The European Grand Plan

Is the latest European bailout plan a game changer? No. Most of us felt the plan was an improvement over earlier efforts, but all of us agreed that it lacks details and doesn’t appear to be enough to stem the European problems in the long term. Though equity markets have celebrated, we have not seen credit markets confirm, particularly on the European periphery. Whether it can stabilize things in the short term is more questionable, and the surprise referendum was proof of how fragile the situation is. In short, the plan is an improvement over previous offerings, but is not enough to shift our view.

[In the time since our meeting, we’ve seen rumors that the Prime Minister of Greece will be resigning... and then another that he’ll be staying... and still another that the referendum will be scrapped. Stay tuned. There should be two or three more rumors before the day is over.]

Business Cycle Data

The discussion covered three regions of the globe...

United States
We acknowledged that 3rd quarter data was quite a bit stronger than we expected. However, equity markets appear to have already recalibrated expectations of growth back to moderate levels, and the team was uneasy that many leading indicators still point to slower growth ahead, and that the trend of much of the data we follow is still down. We also noted that other parts of the globe are slowing, which will impact the U.S. In our judgment, it’s still worth defending against the risk of anemic growth, or even oncoming recession. However, if the data continues to surprise us on the upside, we may be forced to change our view on the U.S. economy and admit that we missed it on this front.

From a monetary perspective, the team thinks the Federal Reserve is likely to pursue further options if the situation deteriorates. However, after the recent firming in the data and the equity rally, it’s unlikely that the Fed will start a new program in the imminent future. Fiscally, it doesn’t appear that the government will come up with a material program before the election, and the super committee is unlikely to make the kinds of budget cuts necessary to fix long term problems before November 23rd.

[Since our meeting the Fed left rates unchanged and has not started a new quantitative easing program.]

Europe’s economic situation continues to get worse, and the Euro-zone might even be recessing. The economic weakness in Europe will likely flow through the globe and press against the U.S. and Emerging Markets, due to the interconnected nature of the world economy. From a monetary perspective, there’s a good chance that new ECB President, Mario Draghi, will start cutting rates to combat the deteriorating economic situation. While that’s good news, the rate cuts will be reactive, not proactive, and it’s questionable whether cutting from a 1.5% starting point will be enough to keep the European barge from turning in a negative direction.

[Draghi cut rates by 25 bp this morning.]

Chinese data continues to slow, and its prior tightening policy will likely continue to move through the system and inhibit growth. China has shown interbank lending stress and is at risk of a property market slowdown, which creates a layer of system risk in the entire region. The good news is that China has recently stopped tightening and some of the emerging market countries have begun cutting rates, but the effects will take time to work through the system. Part of Asia’s challenge is dealing with a very slow developed world, which will put pressure on exports out of the region.

Technical Conditions

Intermediate technical conditions don’t appear to have turned, but there are definite improvements in the shorter term technical outlook. Given how depressed sentiment got during the latest downturn -- along with the fact that we’re entering a more positive seasonal environment -- most of the Investment Team believes the rally will continue to drift up, perhaps toward the old highs of 1360. Without intermediate measures turning, we have to decide what to do about a short term rally of this nature. The risk to our current outlook is that the money that had been kept on the sidelines is now pouring back into the market, which engenders confidence and brings more investors back into the game. The market is at a crucial point right now: A confirmation or failure could determine the direction the market will take into the year’s end.

Independent Analysis

A number of our independent analysts have gotten more bullish, and while some stay bearish, there are no new bears emerging to confirm our stated view. We don’t rely on any single analyst or view, but the overall tone is getting more positive and we can’t ignore that.

Is the Allocation Consistent with the Current Weight of the Evidence?

None of us are bullish on fundamentals right now, but there has been enough change in technical conditions and analyst opinion to consider whether the allocation is still consistent with the overall weight of the evidence.

Ultimately, the combination of some better-than-expected U.S. data, improving short term technicals, and a change in tone from the independent analysts we follow give us less certainty that the markets will make their way back to levels of 950-1050. Therefore , the allocation needs to reflect this by getting slightly less defensive. In no way are we turning bullish at this time, but we are going to play a bit less defense to acknowledge some of the evidence against our current view.

Magnitude and Tactics

In terms of magnitude, removing our last stop-loss amount (roughly 5% equity) is a reasonable response to the changes. We are currently working out the details of how best to execute our strategy. Stay tuned for details.

Wednesday, November 2, 2011

In the Recession Camp

In our blog posts we often mention the ISM Manufacturing Report on Business PMI and the ECRI Weekly Leading Index, which are usually at the front line of the many barometers of economic activity we watch regularly. While the ISM PMI is built so that a reading below 50 signals economic contraction, its historical track record in calling recessions is far from perfect. On the other hand, while the ECRI team has a stellar historical track record in calling recessions, their weekly growth index doesn’t feature an absolute threshold below which a recession signal is triggered, and its interpretation is not as straightforward, at least for outsiders.

John P. Hussman, a Ph.D. in economics and one of our favorite reads, recently suggested a way of combining these two indicators to obtain a single recession signal that is more reliable than the sum of its parts. Following his idea (but doing our own math, as always), we found that over the last 44 years, whenever the ISM PMI was below 54 and simultaneously the ECRI Weekly Leading Index Growth was below -5, the U.S. was already in a recession (as defined by the National Bureau of Economic Research) 86.80% of the time. Moreover, if the U.S. was not already in a recession, there was a 92.59% chance of entering one within three months and a 95.06% chance of doing so within six months. The accuracy of this combination is easily explained: Our research indicates that the ECRI Index leads the ISM PMI by about four months (see chart below). Therefore this set of conditions can be interpreted as economic growth being near stall speed (low ISM PMI) and headed lower (negative ECRI Index). Adding a third condition (negative S&P 500 trailing-six-month return) and lowering the thresholds to 52 for the ISM PMI and to -7 for the ECRI Index worked even better; whenever these three conditions occurred simultaneously, the U.S. was already in a recession 94.19% of the time and was going to be in a recession within the following three months 100% of the time. That means always. Incidentally, this latter combination is the one we observe today (ISM PMI 50.8, ECRI Index -10, S&P 500 trailing six-month return -10.66% as of 10/31/2011).

Just another (heavy) piece to add to the weight of the evidence.

Tuesday, November 1, 2011

The Euro Mess is the Dollar's Gain

It was just four days ago when the world celebrated the European rescue. Now that has all changed. Carl initially pointed out that the European bond market was not happy with the bailout, and now everyone has joined the party. Not only are 10-year Italian bond yields surging to a worrisome 6.25%, but the Euro is selling off heavily and European financial stocks are well below pre-bailout levels. This is all possible due to Greek Prime Minister George Papandreou. He has called a referendum on the new EU aid deal, which could backfire if his coalition loses the vote.

Due to the increasingly hilarious (in an uncomfortable sort of way) situation in Europe, our Rising Dollar position has rebounded very nicely. The chart below shows the Dollar Index. We were very excited in September when the price level broke above the green line, but became nervous when the green line broke in October. However, after an amazing 4% rally, the index is now once again trading above the green line, the 50 Day Moving Average and the 200 Day Moving Average. We're glad to have our safe-haven hedge in a Rising Dollar Fund.

Friday, October 28, 2011

The Wrong Tail of the Curve

Let me be clear: Pinnacle’s investment mandate is to outperform over a complete market cycle, and that definitely includes outperforming in bull markets. Lately, however, the bull markets have been built on the back of extreme monetary and fiscal policy. It was just about this time last year that Pinnacle’s investment team found themselves on the wrong side of a rampaging bull market. The summer’s headlines about Greece and the frightening after-shock of the “flash crash” were receding in everyone’s memory and investors were beginning to anticipate a massive policy response. We were suspicious of the fundamentals of the market at the time, but our process forces us back into the market when technical considerations become overwhelmingly bullish, and so we looked for a place to enter. The market finally cracked in November to the tune of a 3% “correction” and we began adding risk back into the portfolio. The best I could say is that we were, at best, cautiously bullish. Well… it feels to me like history is repeating itself this year, with the same kind of rally coming off of a similar summer selloff, with the same type of hype regarding policy response that just doesn’t feel right. Once again we are trying to guide our clients through incredibly volatile markets that feel more like casinos than rational markets where participants try to allocate capital to profitable ventures in order to grow their wealth.

The problem is that we live in a world of asynchronous risks, meaning that the systematic risks in the world’s economy are so great that if the wheels come off the cart, the result will be catastrophic to our clients' financial plans. We have seen two frightening bear markets in the past decade when investment bubbles that were, in large part, the creation of policy makers, burst. I have often said that in the current environment, our job is to buy into bubbles and then sell them before they burst. (Actually I’m not so greedy that I wouldn’t be happy with selling just after they burst.) The problem with the “buy the bubble” plan is that if you know the bubble is a bubble, then buying into it becomes an act of pure speculation. And we are not in the business of speculating with our clients' money.

So here we go again. The market is running away on the strength of what, at first glance, seems to be a poorly-defined agreement in Europe about what to do with a solvency crisis that can’t be resolved by leveraging up rescue capital to the tune of 5:1. In addition, recent U.S. economic data includes some prints that contain the somewhat lukewarm good news that we are not currently in a recession, even though the real economy still seems extraordinarily fragile. At some point additional evidence of improvement may compel us (Pinnacle) to buy, because at the end of the day you have to respect the market, and sometimes it does irrational things for very long periods of time. When systematic risk is as high as it is today, investment professionals mutter about “tail risks,” or the risks that are measured at the far left of a normal probability distribution. At the moment, it seems to me that if things don’t go exactly right there are large potential losses to be defended against. We are bound to respect these risks for our clients, but lately it feels like we are worried about the wrong tail of the curve.

Thursday, October 27, 2011

The European News: A Game-Changer or Bull Trap?

In the after hours yesterday, news leaked out about an apparent impasse between the banks and European leaders, and markets seemed poised to sell off again on another European snafu. By 9pm details emerged that a deal had been cut with the banks regarding haircuts on Greek bonds, and the mood in Asian markets quickly turned around. By the time I woke this morning, a plan had been hatched in Europe that put the markets into celebration mode. Risk assets love the fact that a tangible plan has finally emerged, and today markets are partying like it’s 1999.

Some of the key parts of the plan are:

  • Private investors have agreed to realize 50% haircuts on Greek Bonds.
  • Banks are required to recapitalize using a 9% threshold of the highest quality capital.
  • EFSF will provide bond insurance for some amount of bonds from Euro issuers, and could potentially lever the EFSF to just over 1.4 trillion USD.
  • Greece will get slightly more bailout money than what was agreed upon in July.
  • The ECB will keep buying Sovereign Bonds as needed.

As always, the devil is in the details, and looking under the hood there are already some relevant questions being asked about the plan. For instance, why is the International Swaps and Derivatives Association (ISDA) not going to consider the 50% haircut a credit event on Credit Default Swaps (CDS) insuring Greek bonds? If ISDA refuses to recognize this effective default, will there be unintended consequences coming from holders of defunct insurance that take a loss with no insurance? If banks are forced to raise capital, will they do so by curtailing loans which could spill into the European economy? For that matter, is the 9% capital a sufficient amount in an economy that appears to be decelerating rapidly? Etc., etc.

We will spend the next few days parsing the language of the plan, monitoring credit market relationships for signs of divergences or confirmation, reviewing key technical measures, and assessing a variety of respected analyst opinions. Now that that European news has finally hit, it is time for Pinnacle to assess whether this plan is a game-changing event or a bull trap for investors who are late to the party.

Tuesday, October 25, 2011

Credit Markets Are Still Not Buying It

Risk assets have been enjoying one heck of a rally the past few weeks. Stock markets around the world have been surging, with the S&P 500 up nearly 15% from its October 3rd low. The Russell 2000 Index of small cap stocks has exploded higher by more than 20%. Commodities have joined the party in recent days, with oil jumping by $18/barrel, to climb back above $93. The recent action in the stock and commodity markets seems to be giving the 'all clear' signal that a U.S. recession will be avoided and Europe is on the verge of solving their debt crisis.

Lost amid the recent euphoria, however, is the fact that the market most sensitive to a resolution of the European crisis – the European sovereign debt market – doesn’t seem to be following suit. In fact, some measures are actually worsening. For example, the Italian 5-year bond yield (shown below) recently reached a new high. If an agreement was really imminent, we would expect European bond yields to be plummeting, not creeping higher.

Here's the bottom line: While it is excruciating to be positioned defensively as stocks scream higher as they have recently, we don’t believe that anything has been resolved yet. Our best guess is that stocks are enjoying an overdue rally from deeply oversold conditions. We continue to keep an open mind and look for more definitive signs that it is becoming safer to accept more risk, but we don’t think we’ve reached that point yet.

Thursday, October 20, 2011

Managing Money in a Manic Market

Right now the market is being jerked around by headlines that change by the hour. At 3pm on Tuesday, a story broke about a deal between Germany and France, and the market soared in the last hour of trading. Then about 5 minutes before the close, the story was refuted and the market quickly turned, with selling continuing into the next trading day. The yoyo swings are probably attributable to heightened macro tensions combined with computer-based high frequency trading that seems to exacerbate every move.

This note off pretty much sums up the way things are working right now. (My highlight in yellow).
Mis)managing Expectations: No EFSF Leverage Decision To Be Reached This Weekend
Submitted by Tyler Durden on 10/20/2011 - 10:41
Headline time:
  • German ruling coalition sources say EU summit will not reach a decision on EFSF leveraging
  • And since the catering has already been paid for, "German ruling coalition sources says EU summit to go ahead on Sunday" even though no decision will come out of it.
Now... spin? Or another headline in 10 minutes refuting this one. Stay tuned and don't touch that dial while we break for commercial.
At Pinnacle we don’t get hung up on any one piece of news that hits the market. Instead we rely on a process that weighs evidence that builds over time. While markets are whipping back and forth, we realize that the business cycle doesn’t turn with one data point, technical conditions are a complex set of many different indicators, and valuation is a slower moving measure which matters most at the extremes. Our process weighs all the news and data, but keeps us from becoming day traders who obsess over the latest rumor to hit this manic market.

ISM Manufacturing Index

The Manufacturing ISM Report On Business, issued monthly by the Institute for Supply Management, compiles a survey of the nation’s supply executives to gauge economic activity in the manufacturing sector. The report is typically considered one of the growth barometers the market watches most closely. The results of the survey are ultimately condensed into a single percentage number, called PMI, which is scaled so that a reading greater than 50% indicates expansion while a reading below 50% indicates contraction. The September 2011 PMI came in at 51.6%, which is 1% higher than the August PMI of 50.6%. Is this enough to conclude that we've avoided a recession (at least, for now)?

To answer the question we looked at the track record of this indicator versus real GDP growth since 1949. Overall, the ISM manufacturing was 'right' (being above 50% when real GDP growth was positive and below 50% when real GDP growth was negative) about 77% of the time, and 'wrong' (being above 50% when real GDP growth was negative and below 50% when real GDP growth was positive) about 23% of time. Moreover, we found that the probability of the indicator being right or wrong was consistent across periods of positive and negative real GDP growth; this means that the ISM Manufacturing was above 50% 23% of the time when real GDP growth was actually negative. In fact, we found that historically the index was as high as 63.5 during periods of negative real GDP growth. This is certainly a less than impressive track record. Especially given that the September 2011 reading cleared the 50% mark by a margin as slim as 1.6%, we do not regard this as sufficient evidence to conclude that the risks of a recession have decreased.

Wednesday, October 19, 2011

Does Europe Have a Bazooka in its Pocket?

``If you have a bazooka in your pocket and people know it, you probably won't have to use it,'' U.S. Treasury Secretary Hank Paulson said at a July 15 Senate Banking Committee hearing.

Lately I’ve been thinking about Mr. Paulson’s quote as investors somewhat squeamishly face down this weekend’s European Union summit in Brussels. The headlines are whipping around almost as fast as market prices as policy makers try to manage investor expectations on a daily basis. Lately it has been German policy makers who are trying to keep a lid on expectations, for the very understandable reason that when all of the sovereign debt guarantees go up in smoke, it will probably be German tax payers who are most on the hook to pay. The latest rumor occurred yesterday when the Guardian newspaper leaked a report saying that France and Germany had agreed on a €2 trillion package to rescue the Eurozone. The deal was to include additional guarantees for either public or private bondholders, and an agreement that European banks should be recapitalized to meet the 9% capital ratio that the European Bank Authority is demanding following its re-examination of the exposure levels of about 70 “systemic” banks. The markets rocketed higher until the rumor was squashed just before the market closed.

Pinnacle analysts now find themselves in the curious position of doubting the long-term efficacy of any policy remedy suggested by the troika -- including the EU, the ECB, and the IMF -- but fearing a massive bull market surge as investors commence panic buying to save their year. Clearly European policy makers have picked up the bazooka, but it seems like they might need something bigger, like a tank, or dare I say, a nuclear option? The leaked plan levers up the current EFSF by five times, turning it into the equivalent of AIG. If done, the EFSF will inevitably lose its AAA credit rating, and if that occurs there will be knock on consequences for the entire plan. The point being debated by the team is how the market will view the new plan. It seems as though the easy trade is to err on the long side as the market might believe that a couple trillion euros is bound to find its way into risk assets in the same way that the U.S. Quantitative Easing funds found their way into stocks and commodities. Our current view is that investors will see through the initial headlines and ‘sell the news.’ If so, it’s very possible that the current earnings season, which so far has been respectable, will be pushed from the headlines and Europe will once again take center stage.

It used to be that the weekends were for rest and relaxation and a chance to power down from the onslaught of news that impacts our investment outlook. Lately the weekends are a preferred time for policy makers to manipulate the news cycle, and so Pinnacle analysts have to follow events at the same time they root for their favorite football teams. By next Monday we may know whether or not investors have been rewarded with a bazooka blast, or whether policy makers have once again misfired and disappointed the market.

Stay tuned…

Monday, October 17, 2011

The Battle Continues

For two months, the bulls and bears fought a battle between 1230 and 1120 on the S&P 500 before briefly breaking to new lows on October 4th. After an amazing short covering rally that has taken the price level back to 1230, resistance is being met once again. The chart below is the price chart of the S&P 500 Year to Date, and the resistance line I mentioned is marked off by the red line. Now, the most likely path of least resistance is down and could easily fall back to 1120.

The selling comes as no surprise to the Pinnacle Investment team. Greece will still default, the U.S. is looking as though a recession is inevitable, and the Chinese economy is running out of steam. These factors led us to reduce risk in the portfolios. We sold the break below 1100, and much to our chagrin, we were punished in the short term. And at the end of last week, we sold again at the much more favorable price of 1220.

After these trades, our portfolios are now running at 50% of benchmark risk. If the market continues to rise through year end, we will not be able to keep up with the benchmark returns. It is therefore vitally important to watch the technical levels, as a break above 1230 would be considered very bullish. To the downside, first up is 1200 (buyers and sellers love whole numbers), and then the 1120 level I mentioned previously. Let the battle continue.

Friday, October 14, 2011

The Most Important Characteristic

I recently saw a research piece from Wolfe Trahan where the well-known and highly respected analyst, Francois Trahan, referenced the book, Good to Great, in discussing the “best” portfolio strategies. It got me thinking about Pinnacle’s investment methodology and how we continually attempt to improve how we do what we do. I’m not sure how anyone in the investment business characterizes themselves as “great,” since active money managers know that the market makes a mockery of us on a routine basis. However, I was thinking about our investment team, and specifically our investment analysts, and wondering what characteristic is most needed to be great. They certainly need to be intelligent, persistent, tireless, and able to fit complicated ideas into a simple narrative.

But I think far and away the most important characteristic for an investment analyst -- at least here at Pinnacle -- is courage. Perhaps not physical courage (although there have been times when shoes were thrown in my direction during investment team meetings), but having the courage of your convictions. In the real world of working on an investment team, there are many team dynamics that come into play that can sway the decision-making ability of the group. For example, there is first and foremost a natural desire to conform to the same opinions as the rest of the group. It is a very uncomfortable feeling to sit in a meeting with your peers where they all say black and you say white. Yet the analyst who makes an impassioned case for “white” often adds the most value to the conversation, if for no other reason than it makes the rest of the team reconsider “black” as the best answer. The willingness to resist compromise, especially on a team where everyone actually likes and respects each other, takes courage. It is terribly human to want to fit in and behavioral finance tells us that herd behavior is one of the heuristics that lead investors to poor investment decisions. It takes courage to exhibit what society considers 'bad manners.'

Along the same lines, it takes courage to oppose the opinion of the Chief Investment Officer, and the opinion of the Chief Investment Strategist. It ain’t easy to go toe-to-toe with the boss, especially when you will be sitting at the table with him discussing next year’s compensation at the end of the year. Yet it turns out that informed, considered, and well-articulated dissent is a requirement for investment analysts who want to succeed in a career at Pinnacle. As one of the architects of our investment process, perhaps the thing I am most proud of is the group of analysts on our investment team. Our investment process depends on the conviction of the team in our forecast, which is forged in serious debate about the market evidence. For our analysts, that's just another day at the office -- and that takes guts.

Thursday, October 13, 2011

Unemployment Insurance Claims and Challenger Layoffs

One of the indicators that the financial press uses to gauge the U.S. job market is unemployment insurance claims. The data, compiled weekly by the U.S. Department of Labor, tracks how many new people have filed for unemployment benefits in the previous week. Since the weekly data can be quite volatile, the 4-week moving average is typically monitored.

Today’s report showed that jobless claims inched down by 1,000 last week to 404,000, while the 4-week average fell by 7,000 to stand at 408,000, marking the lowest level since mid-August. Initial unemployment claims saw a sharp decline after reaching the 650,000 mark in March 2009; however, since late 2010, they have been stubbornly stuck in the 400,000-450,000 range. Claims usually fall near the 300,000 level in periods of rapid economic growth, while it is commonly said that a level near 375,000 is necessary just to keep up with population growth without increasing the unemployment rate.

Our research indicates that the Challenger layoff survey may be a good leading indicator for unemployment insurance claims. The data, compiled monthly by the consulting firm Challenger, Gray & Christmas, provides information on the number of announced layoffs by U.S. corporations. Commonsensically, once the announced layoffs are executed, the laid-off workers will need to apply for unemployment benefits. Our study indicates that the pass-through time is around 8 weeks. In this context, the recent spike in the Challenger layoff survey is certainly worrisome. According to the survey, the number of planned layoffs in September amounted to 115,730, the highest in more than two years and more than double August’s total of 51,114. If the correlation we estimated between the Challenger survey and unemployment claims since 1999 holds, then we may see a spike in unemployment claims over the next few weeks. Lastly, it is worth noting Challenger’s comment that September’s increase in planned layoffs was not “directly related to recent softness in the economy.”

If they say so…

Friday, October 7, 2011

A Bullish Divergence in Financials

Now that we are positioned for things to go wrong, what could go right? I have noticed that momentum divergences seem to be forming. A momentum divergence is a technical condition where momentum does not confirm price movement. The chart below shows this divergence by using the Financial Sector SPDR price chart in the top panel and the Relative Strength Indicator in the bottom panel.

The two white lines mark the bullish divergence in the XLF. The price of XLF made a new low on October 3rd; however, the RSI failed to make a new low. This is a sign to traders that a trend change may take place.

However, this is only one small piece of the indicator and a weight of the evidence approach must be utilized. The RSI and price chart are still in clear downtrends from January and the RSI has failed at 50 on every move higher. This suggests to me that the weight of the evidence is still bearish, but that we must continue watching closely. Off the bottom of 2009, financials rose an amazing 140% in 5 months. We don’t want to miss that!

Thursday, October 6, 2011

Short Squeeze or Sustainable Rally?

After reversing on the dime from what seemed like a market free-fall on Tuesday, risk markets have been on a tear the last few days. What a move, from the intraday low of 1074, the S&P 500 index has rallied roughly 8.5%, off the Tuesday lows. Any investors that used the psychological level of 1100 as a stop loss trigger have been smarting for the last two days. Unfortunately we are among that group of investors, and it currently stings to watch the market seemingly laugh in our faces for selling days ago. To help us avoid the myopia of a few days trading activity, we make sure to take a step back and focus on our process and what we believe the bigger picture to be.

Despite the torrid rally of the last few days, we don’t think the world has changed materially. Yes, a few data points have come in less-than-horrific recently, and Europe is talking a big game again. But overall we still believe the evidence for the business cycle is skewed to the downside, the problems in Europe have not gone away, technical conditions are still broken, and valuation is not low enough to provide a healthy margin of safety. Therefore our current thesis is that the market is unwinding severely oversold conditions and short positions that had built up during this bear run. We don’t feel great about the latest whipsaw at 1100, but we are staying defensive at this juncture.

Wednesday, October 5, 2011

My Vocational Moment

Last Friday I was given the opportunity to do the “vocational moment” at my Rotary Club. The purpose of the vocational moment is to briefly inform or educate the rest of the club about an issue related to your employment. I decided to fully explain the European sovereign debt crisis in under three minutes. I stood up and said, “They spent too much,” and sat back down to much laughter and applause.

When that died down, I returned to my feet and offered a more detailed explanation:

“You can think of the crisis in Europe in much the same terms that we think of the financial crisis in the U.S. over the past several years. In this context, instead of sub-prime debt being owned by banks, think of sovereign debt of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) being owned by banks. Instead of Lehman Brothers going bankrupt, think Greece. Instead of the TARP, think the European Financial Stability Facility. The EFSF is funded to the tune of 440 billion euros by various countries in the European Union and it can issue loans to “bail out” sovereign countries, which in turn bail out banks around the world that own European sovereign debt.

“The EFSF has 440 billion euros and the European Financial Security Mechanism (EFSM) has 60 billion euros, for a total of 500 billion euros. The International Monetary Fund has agreed to kick in ½ of the EFSF/EFSM total, to the tune of 250 billion euros. So the total bailout package is 750 billion euros, or roughly $1 trillion dollars. Sound familiar? The ESFS has already lent money to Portugal (twice) and Ireland (once) where the loans were ranked AAA by all of the rating agencies. Would it surprise you to know that all of the member EFSF countries guarantee this debt, yet few of them actually have a AAA rating as individual countries? In addition, Portugal helped to guarantee the debt that was issued to bail out Portugal, and Ireland helped to guarantee the debt that was issued to bail out Ireland. Does that sound familiar? (In this context think of rating agencies as… uh… rating agencies.) Finally, consider that all of this sovereign debt is insured by banks in Europe and the U.S. who also own the sovereign debt. To be clear, U.S. banks own little of the sovereign debt itself, but do own their fair share of the insurance (called credit default swaps, or CDS). So here think AIG.

“The good news is that 750 billion euros is getting approved to backstop the debt of European countries that spent too much. The vote you may have read about last week (my talk was last Friday) involved Germany agreeing to expand the EFSF to 440 billion. The bad news is that the market never expected to have problems with the liquidity of Italy and Spain. Even though the EFSF is big enough to deal with the smaller PIIGS countries, it’s not nearly big enough if Italy is in danger of default. They are short to the tune of about $2 trillion. Even if Italy makes it through, European banks have stopped trusting each other enough to lend to each other, so they’re relying on the European Central Bank for overnight lending.

“Oh… the further bad news is that the last number I saw showed a 70% correlation between the performance of European stocks and U.S. stocks. Therefore, I recommend bottled water, canned goods, and a shotgun as a preferred asset allocation. Thank you.”

Tuesday, October 4, 2011

Crossing a Line in the Sand

The S&P 500 Index has flirted with crossing below 1100 three times since early August. The market has been bouncing around since August 9th, when it first traded to an intraday low of 1101. It rallied to a high price of 1230 on August 31 and exhibited a record breaking amount of volatility over the past month. Yesterday the S&P 500 made a new closing low of 1099 and invalidated many of the arguments for bullish investors who hoped that the 1100 number would be the low from which the market could rally through the remainder of the year. After all, at today’s prices the stock market has declined by 19.4% from its 2011 high of 1363, set this past April. Since 20% is the unofficial decline needed to declare a bear market, the bullish case held that the market must have fully discounted the chances that the U.S. and global economy would fall into recession. As Pinnacle clients know, we have been systematically reducing risk in our managed accounts for months as the weight of the evidence continues to indicate that the risks of recession are growing.

In our view, yesterday’s market action suggests that prices will decline further. Since 1946 the average bear market decline has been 27%. When the bear market occurs during a secular bear market like the one we are currently experiencing, the average decline is more like 35%. Considering the number of analysts now willing to make a call that the U.S. is either currently in a recession, or will imminently enter recession, we believe it is prudent to continue to lower portfolio volatility. As of last Friday, we have been adding 1% to our current position in the U.S. Dollar ETF, selling 2% from our energy ETF position, and selling the remainder of our Equal Weighted Industrial ETF in our Appreciation and Ultra Appreciation models. In addition we are selling our entire position in the Merger Fund and trimming 1% from our High Yield Bond Fund positions. We are also completing a number of rotational trades within the Healthcare, Financial, and Consumer Discretionary sectors. The result of these transactions is that our portfolio strategies will be more defensively positioned with the majority of our equity allocations invested in low volatility sectors like Health Care, Consumer Staples, and Utilities.

With these latest trades, we believe that our portfolio construction properly reflects the risks of further market declines. There are still risks to our bearish outlook, notably the possibility of massive intervention by central banks and governments to provide excess liquidity to markets through programs like quantitative easing. A multi-trillion dollar bailout of European banks, along with central bank intervention in currency and bond markets (as well as other risk asset markets), could propel stock markets higher around the world. In addition, economic data is still somewhat mixed. However, considering the latest market action and negative changes in the economic forecast, we believe it is prudent to put aside fears of missing higher returns and concentrate on defending portfolio principal.

We will be explaining these transactions and our latest market outlook in great detail in our upcoming Quarterly Market Review, which should be released within the next two weeks.

Friday, September 30, 2011

The Answer to the Question...

A couple weeks ago, I posed a question in my blog post, “Asking the Wrong Question?” Investors typically choose between two different philosophies of portfolio construction. One method is the traditional method of investing in markets, where you have years of data to rationalize investment decisions. By owning markets, you are saying that you are willing to live with whatever returns and volatility they deliver, with the expectation that over the long-term, they will perform as expected. Of course, the problem is that markets can misbehave and investors can panic. During secular bear periods, markets can underperform expectations for decades.

As a solution, Wall Street suggests we invest in managers who implement strategies designed to deliver returns independent of markets. That is why the investment universe includes private equity, hedge funds, managed futures, and other low correlation strategies. The problem here is that managers make mistakes, and go 'hot' and 'cold' in delivering returns on a systematic basis. Strategies work until the market arbitrages the excess returns to… well… market returns. In the worst case, managers can 'blow up,' creating havoc with an investor’s portfolio.

The question remains, which approach is better? The answer is neither. Both approaches offer investors rewards along with a clear set of risks. Pinnacle has addressed this problem by creating a portfolio construction process that utilizes the best of both philosophies. Our portfolio asset allocation must stay within well-defined limits of volatility that are based on the past performance of markets. We respect the idea that past performance, while not a guarantee of future results, does give us a rational basis to begin to forecast future returns. We believe that individual markets, or asset classes, are efficient enough so that we don’t try to pick winning stocks or bonds within an asset class, and are content to own industries, sectors, and countries using ETFs and mutual funds. However, we also recognize that the performance of markets depends on the market cycle, the psychology of investors, and the valuation of markets. Therefore, we think it’s important to be active managers.

We defend against the problems with active management in a variety of ways.

  1. We have an investment team instead of one stellar senior manager who can have hot and cold streaks. 
  2. We trade incrementally based on changes in the data so that we can avoid large market timing errors. 
  3. We are non-dogmatic in our approach to discovering value, so we look at value in three different ways. 
  4. We use both qualitative and quantitative methods to make investment decisions. 
  5. We use a relative value approach that encourages us to stay within striking distance of our benchmark allocations. 
  6. We try to hit 'singles and doubles' rather than making large bets that are win/lose propositions. 

Our assumption is that all active managers will make investment mistakes. We try to make fewer mistakes than the consensus, which has been a great recipe for earning positive risk adjusted returns.

Thursday, September 29, 2011

Commodity Rout Should Provide Relief for Consumers

As bad as it’s been in the equity markets lately, it’s been just brutal in the commodity pits. The Dow Jones/UBS Commodity Index is off -14% this month, while the S&P 500 is down -5%. Certain individual commodities like copper, gold, silver, etc. have been bludgeoned in recent days. Earlier this year, commodity prices were soaring -- gas prices touched $4/gallon back in May. That spike is still filtering through official inflation numbers, with the CPI reaching a post-recession high of 3.8% in August.

It seems that the Fed’s QE2 program launched late last year was successful only in squeezing consumers by bringing back some inflation. Gains in asset markets have largely vanished, and economic growth was hugely disappointing in the first half of this year. But the inflationary side effects linger. Now, with QE2 out of the way and investors unimpressed with the Fed’s latest scheme to extend the maturity of its portfolio, commodities are undergoing a major re-adjustment lower. The bad news is that we view the commodity rout as reflective of a weakening global economic backdrop, and we don’t think it’s fully run its course. But the silver lining is that it should help sow the seeds for an eventual turnaround by providing some relief for consumers.

Chart: iPath DJ/UBS Commodity Index ETN

Tuesday, September 27, 2011

Gold is not a Religion

Based on copious amounts of anecdotal evidence, gold investors tend to be highly sensitive to criticism. The gold bugs would have you believe -- and proclaim zealously -- that the precious metal must be held in all portfolios to protect against everything wrong in the world... and how dare you say otherwise! There is too much money printing and currency debasement, with massive inflation on the horizon and geopolitical risk on the rise.

Of course, there may be some truth to that, which is why we hold a small gold position in our portfolios. But we prefer to view gold as any other asset, and we have done very well managing the position.

Below is a chart of gold from 9/30/2009 to present. At four different times over the last two years, we changed our position weight in gold. In early 2010, we increased our gold position to 5% in all portfolios. Gold then had a massive rally for the entire year and we decided to take our position down to 3%. Very quickly -- in one month -- gold worked off excessive optimism, become oversold on momentum indicators and came back to the longer trend. At that point, we felt it was time to add back to our position by increasing it to 4%. Gold proceeded to have an even bigger rally from $1330 to $1800, as optimism surged. We felt this was too far, too fast and the price looked stretched, so we once again reduced our position to 3%.

Treating gold as a tradable asset has served us very well, and we will continue to manage the position in this way. At some point, we may not even own any gold. Blasphemy!

Monday, September 26, 2011

How to Jump Start the System: See Newton's First Law

Newton’s First Law Of Motion: Every object in a state of uniform motion tends to remain in that state of motion unless an external force is applied to it.

Some of the best analysts we follow have described the economy as a barge that is very slow to turn once it has a direction and some momentum behind it. Lately that barge appears to be headed in a negative direction, and picking up speed. We’ve seen this in a variety of leading indicators of growth, employment trends, and confidence -- the latter of which has all but vanished. Add in political dysfunction in the U.S and Europe, questions regarding the effectiveness of monetary policy, and liquidity tightening in the emerging world, and the momentum for a negative economic feedback loop to develop is building.

Currently the question policy makers are struggling with is how to reverse engines and get the barge to turn back in a positive direction. As Newton said best, we are currently in need of a strong external force, and preferably one that is turbo charged for this environment! One possible solution would be a globally coordinated intervention of sufficient magnitude. Back in 2008, such a coordinated effort helped to stabilize credit markets and jump start growth, and it might do the trick again.

As the expression goes, this is easier said than done. In 2008, there was arguably more gas left in the monetary and fiscal tank than there is now, and there was also much less political baggage to contend with. Over the weekend, there were some positive signs that global monetary and fiscal authorities are waking up to the gravity of the current situation, and I sincerely hope a credible plan of sufficient magnitude arrives soon. But with rumors running rampant, and rhetoric still cheap, we will remain skeptical and defensive until we see action that we believe is worthy of being a game changer for the current cycle.

Friday, September 23, 2011

Our Increasing Conviction

Changing the asset allocation of Pinnacle portfolios is often the result of a change in our forecast for various market segments. Even saying the word, “forecast,” raises the specter of foolishly staring into a crystal ball, trying to predict the future. Because we are in the business of making accurate forecasts, we readily admit that we will make forecasting mistakes, because, regardless of what you may have heard, we really can’t predict the future with complete accuracy. However, we can assign probabilities to future events and try to identify good investment values based on what we call “the weight of the evidence.” At any point in time the investment team has a view of where we are in the market cycle, market valuation, and investor enthusiasm for taking risk. The results of our view can be seen in our current portfolio asset allocation, where we compare the changing risk in our managed portfolios to the fixed risk in our benchmarks. One of the most important elements in our work is to assess the level of conviction we have as a team about our forecast. When the team has low conviction, our portfolios tend to hover close to benchmark levels of risk. When the team has high conviction in our forecast, then the portfolios can be structured to have dramatic differences in risk than the benchmark.

Lately the weight of the evidence has not been kind to investors who are predisposed to a bullish point of view, and our conviction in a bearish forecast continues to grow. One of the “big guns” in the bullish case was to stay out of the way of fiscal and monetary policy conjured up by central banks and governments to reflate assets in an attempt to mitigate the problems in Europe and the U.S. This week the U.S. stock market has effectively voted “no” on the $400 billion proposed jobs bill and the Federal Reserve’s much anticipated Operation Twist. We are beginning to suspect that bearish investors are less fearful of a strong and coordinated policy response to slow growth and too much debt. If you are bearish, there is always the concern about what policy actions remain in store for us as we slog through the “bogey man” months of September and October. However, at the moment it seems as though the Federal Reserve isn’t overly interested in QE3, and even if they did more quantitative easing, it’s uncertain to us whether the market would respond favorably. In other parts of the globe, Europe’s problems continue unabated by any effective policy action. And, yesterday China printed a disappointing industrial production number signaling more weakness ahead in their GDP growth. Financial markets are rioting.

All of the above has created a greater level of conviction among Pinnacle investment team members that the market is headed lower, perhaps significantly lower. Our current conversation is about reducing risk positions even further if the S&P 500 Index falls below the important support level of 1100. At that point the market will have invalidated much of the bullish thinking that the market was forming an important base through the summer and setting the stage for a significant rally through year-end. We may still get a rally later this year, but our conviction is growing, based on the weight of the evidence, that more price declines are just ahead. 1100 on the S&P represents a 20% decline from the market top. Unfortunately, the median bear market, with secular bear cycles, is a 34% decline. The bearish case seems to be getting stronger.

Thursday, September 22, 2011

Re-Testing 1100

The stock market hasn’t responded very well to the Fed’s latest stimulus attempt, to put it mildly. In case you hadn’t heard, the Fed announced the widely anticipated “Operation Twist” yesterday. The program involves selling $400 billion of shorter-term Treasuries that are currently in their portfolio, and using the proceeds to buy longer-dated bonds. The idea behind it is similar to the last two quantitative easing programs -- the Fed is attempting to drive down longer-term interest rates even further than the record lows they were already at prior to the announcement, in an attempt to spur the economy. However, this latest attempt differs from the earlier ones in that they won’t be expanding the size of their balance sheet. They’re simply swapping shorter-dated securities for longer-dated securities.

The past two days’ rout on the heels of the Fed’s announcement has wiped out the 5% gain that occurred last week. As I write this Thursday afternoon, the S&P is trading at 1121. The closing low on August 8th was 1119, and the intraday low on August 9th was 1101. So despite several weeks of stocks bouncing around and holding above this low, a re-test of that low is upon us. Often times, a re-test can be a healthy development and serve as a launching pad for the next rally. The reason we aren’t optimistic that is going to happen this time is that several other markets we’re watching have already broken their August lows, including the Russell 2000 (small-caps), the Dow Transportation Index, the EAFE index (international stocks), emerging markets, China, etc. These are all clues that the S&P is likely to follow suit, perhaps in the very near future if the downside volatility of the past few days is any indication of what lies ahead.

Chart: S&P 500 Index with 200-day moving average

Monday, September 19, 2011

Apple as the New Safe Haven? Please.

The markets were down again today on European concerns, but they did manage to pare very large intraday losses and make a run for positive territory on some indices late in the trading day. One of the interesting things that seemed to fuel the run was a surge in Apple stock, which is now almost 15% of the Nasdaq 100. The stock ended the day up almost three percent, and at a new 52 week high, closing at $411.63. Puzzled at why Apple was moving up on this mostly glum Monday, I checked our Bloomberg to see if something earnings- or guidance-specific had hit. That wasn’t the case, but there were some notes about Steve Jobs delivering a future speech, and the possibility of the company joining the cloud computing revolution, which may justify the move. Sean also mentioned that the chatter he was hearing and reading was that Apple was being bought as the new safe haven.

Gold has gone parabolic, and treasuries are arguably priced for a recession/deflation. Corporate earnings have been healthy and U.S. balance sheets have a lot of cash. But a large cap tech stock as a safe haven? Goodness gracious, I believe Mr. Market has been watching too much Cramer lately.

Right now tech stocks are staging a pretty good rally, and that is a developing technical positive that needs to be balanced against the many negatives in the backdrop. That being said, I think any investors considering buying Apple stock as a safe haven ought to think not twice, but maybe three, four and five times about what they’re doing. Attractive hedges are in demand these days, but despite the temptation to buy into this story, we’ll stick with boring old treasury bonds, gold, and the dollar as decent hedges in this environment. Apple is hot, trendy, and has been a very nice investment since 2009. But Apple as the new safe haven? Please.

Friday, September 16, 2011

Dr. Copper

It is bounce or bust time for Dr. Copper. We have written in the past that copper should be followed as a barometer of global growth. Therefore it is worrisome that the metal has underperformed this week as the equity market recorded five straight days of gains.

Only time will tell, but there are a few warning signs in inter-market relationships. Not only has copper failed to move higher, but financial stocks continue to underperform the equity benchmarks and emerging market stocks continue to underperform domestic equity. There are a few good signs like the Nasdaq Q’s leading higher and semiconductors rallying, but I still feel the weight is negative.

Thursday, September 15, 2011

Coordinated Policy Action

Today brought news that five central banks – the Federal Reserve, European Central Bank, Bank of England, Bank of Japan, and Swiss National Bank – have teamed up to provide unlimited short-term U.S. dollar funding to troubled European banks. It was a coordinated policy response designed to calm increasing market concerns about another credit freeze, this time centered in the European banking system. The market reacted positively to the news, with stocks sharply higher globally, the euro rallied, and bonds were down.

While it remains to be seen how much of an impact this program will ultimately have, a strong, globally coordinated policy response is high on the list of “risks” to our current defensive investment stance.  For the past year, instead of global coordination, we’ve mostly seen ad hoc, unilateral attempts to combat structural economic problems from various countries and central banks. There has been little in the way of coordination, and somewhat predictably, most of the programs have enjoyed at best only fleeting success.

Today’s policy action is notable for its coordination, but seems designed mostly to address the growing liquidity crisis among European banks. It does nothing about solvency, which is the crux of the problem over there. However, if political leaders in Europe are ever able to put together something meaningful to tackle the solvency issue, while at the same time offering a globally coordinated monetary response, that could be a force powerful enough to spark another big rally in asset prices, and would likely cause us to abandon our current defensive positioning in order to participate. This particular program, while well received today, doesn't seem to be enough to do that on its own.

Wednesday, September 14, 2011

Where Could We Be Wrong?

As Pinnacle investors know, we are investing defensively right now due to our feeling that the business cycle is under severe pressure and that technical conditions have broken down. Taking a negative view of the current situation is not a bad thing -- it is actually what we are paid to do when we feel it is necessary. However, given that we have a mission of beating our benchmarks over time, it is nerve racking to stay materially off the benchmark, because there's always a chance we are incorrect.

Here are a few examples regarding where we could be wrong in our forecast:

Technical Patterns: Some market patterns are tracing out higher lows and highs after the waterfall decline we have experienced. These are typically positive patterns.

Sentiment: Sentiment has gotten pretty bearish, which is typically a contrary sign.

Economic data: While we think the weight of the evidence we follow on the business cycle is negative, there are some data points that give us pause. As an example, the last ISM series was better than expected.

Analysts: There are some analysts we read who are warming up to the markets right here.

Europe: Now that folks are questioning a breakup of the Euro, perhaps it's time to bet on its survival? Maybe prior dysfunction in Europe is a catalyst for a major proposal that markets discount as a positive.

Emerging Markets: They are slowing, but perhaps they're poised to cut rates and increase stimulus.

High Impact Events: Maybe the Fed has another round of juice that moves markets, much like it did last time.

At the moment, we continue to give the downtrend the benefit of the doubt, and the weight of the evidence regarding the business cycle is still heavily skewed in that direction. Therefore we will stay defensive until evidence builds that better days are ahead. But the reality of forecasting is that there's always room for error, so in all environments we must question where we could be wrong in our thesis.