Comments on the Md. State Retirement Pension Plan

I recently took a quick look at the Md. State Pension Plan year-end numbers. As a student of portfolio construction, here are a few comments. First, the numbers are presented in a way to suggest that the Plan utilizes a “tactical overlay” from its “target” or fixed asset allocation. Note that the targets for U.S. and international equity are equal and that the plan considers “global equity” a separate target in the plan. The total U.S. equity target is only 12.3% which is surprisingly low. But the current allocation to total equity is 51.2% of the plan which is a big bet on equities versus the target. My guess is that “credit/debt strategies” represent some kind of hedge-fund-like fixed income strategies, and combined with the fixed income allocation of 17.3% means 22.8% of the fund is fixed income oriented. Considering the fund only has 2% in cash and the total fixed income target is 25%, I would characterize this portfolio as a growth-oriented portfolio comparable to Pinnacle’s Dynamic Appreciation portfolio.

Of particular interest is the 37% target of the portfolio for alternative investments. The current 23.7% actual allocation sounds about right all things considered. Still, I can’t help but wonder if the 37% alternative target is expressing too much faith in Wall Street engineered financial products like hedge funds and private equity that promise better than market returns based on 1) a return premium due to their lack of liquidity, or 2) better management due to high fees. While the risk in the real estate allocation can be attributed to the asset class, the risk of the remaining alternatives can probably be attributed to the ability of the hedge fund managers to execute their strategies. Let’s hope the plan administrators don’t buy too much Wall Street BS about these strategies.

Pinnacle’s DA portfolio outperformed this portfolio for the trailing 3-yr and 5-yr period. To be fair, this looks like a typical institutional portfolio construction to me. Pinnacle assets under management: $870 million. State of Md. Pension assets: $35.9 billion.

Sell the News?

Today brought the release of 4th quarter GDP, which came in at 3.2%. The headline number was below expectations for 3.5% growth, but let’s not get crazy here, as this number was pretty close, and will be revised two more times before it becomes official. Within the report, personal consumption was a notable positive, and it exceeded expectations with a 4.4% gain versus the estimate of 4%. I don’t think anyone around these parts will take issue with GDP in the 3% range, since that should be strong enough to help the labor market marginally improve, while not so strong that it would cause the Federal Reserve to consider tightening monetary policy.

But what is Mr. Market doing on this number? Well, it’s selling off handily at the moment. One thing to remember when assessing these GDP reports is that the data is clearly looking in the rearview mirror. We have been encouraged with the state of the U.S. economy in recent months, and we’re not expecting a sudden change for the worse over the next few quarters. But we have also been worried about the complacency building in markets. Lately the U.S. stock market has continued to rally, but we’re noticing potential warning signs coming in the form of technical divergences and the recent poor relative performance of a number of risk assets versus the broad market (small caps vs. large caps, emerging markets vs. U.S., silver/gold ratio, etc).

The monetary policy differences in China (raising rates) also create the potential for slower exports (which happens to be a big positive contributor in today’s GDP) on the back of slower international growth. Often times markets buy the rumor and sell the news. I wonder if this GDP number doesn’t represent a typical “sell the news” event. If so, a healthy correction in stocks would not only clear some of the weak hands in the market, but could set up a healthier environment to reposition for the possibility of another move higher in this bull market.

The New Guy on the Block

A few weeks ago the members of Pinnacle’s Executive Team decided to do their part in lowering the U.S. unemployment rate with a new hire, and they chose me. Needless to say, I feel very fortunate having the opportunity to join this amazing team. My journey with Pinnacle began in the spring of 2010, when our Chief Investment Officer Ken Solow spoke to the Quantitative Equity Investment Strategy class I was taking as a graduate student at the University of Maryland. The class was composed of three students (I guess equities were not so popular back then), which gave me the opportunity to introduce myself. After the presentation I expressed my interest in Pinnacle to Ken, and I guess Pinnacle did not mind having some cheap labor around, because supply and demand met and turned into a part-time summer internship.

For me, the internship was a very positive and instructive experience. Most of my time was spent working on Pinnacle’s quantitative models and observing Pinnacle’s investment process. I guess the investment team members liked my work and were not yet sick of my Italian accent by the end of the summer, because the internship turned into a full time offer. I accepted with much enthusiasm – I could not believe that someone was willing to pay me to do some of the things that I love most, which are investing and playing with numbers. After graduating in December 2010 and enduring the lengthy process of obtaining a work visa, I was finally able to join the firm at the beginning of the New Year. As I am now into my fourth week as a Junior Investment Analyst, I have to say so far my experience has been great – no one has asked me to get them coffee or to make copies.

All jokes aside, everyone at Pinnacle has been very supportive and as enthusiastic for my presence as I am for being here. The past four weeks have been a confirmation of last summer’s experience, which taught me that Pinnacle isn’t just another advisory firm. It is a firm where clients’ needs truly come first, and where the comfortable tenets of Modern Portfolio Theory are questioned every day to the benefit of an investment model that can actually work in the real world. In addition, I discovered that the organizational culture really encourages open dialogue and the sharing of ideas. Although, as the new guy, my policy has generally been to keep my mouth shut and my ears wide open (I believe at this point I have much more to learn from than to teach to my colleagues), I feel like my input is already highly valued. To conclude, I cannot overemphasize how fortunate I feel for being part of this great team, and I am looking forward to paying back the trust that was given me, and to becoming another contributor to this blog.

4th Quarter Market Review

Although this space is normally reserved for fairly brief comments on the financial markets, we also write more in depth articles on a monthly and quarterly basis that get posted to our main website. So, for those who haven't seen those pieces before, we thought it would be a good idea to direct them to the Pinnacle website from time to time in order to access them if they would like. Therefore, you can find our recently published 4th Quarter Market Review (as well as older articles) by clicking here.

A Sick Sense of Humor

For more than a decade I have run the investment operations at Pinnacle. As the Chief Investment Officer of the firm I’ve been responsible for, among other things, crafting the firm’s overall investment strategy and process, communicating our process to our clients through written materials, the web site, speaking engagements, publishing books, etc., and integrating active and tactical money management into the culture of our firm along with my partners. But my most rewarding job as CIO is to nurture the professional growth of the investment analysts who work at Pinnacle. Because we are active managers who change the asset allocation of our portfolios as we identify investment opportunities, and because we utilize a qualitative decision making process (along with our quantitative work), our success is to a large degree based on the judgment, experience, and right-brained intuition of the investment analysts on our investment team. Regular readers of this blog know that Rick, Carl, and Sean have been making it difficult for me to make a big mistake in running our portfolios for a very long time.

It would be nice to say that everything is sweetness and light when our team meets to discuss investment issues. As it turns out, our analysts often disagree about the investment decisions before the group. As CIO my role has been to nurture differing opinions, encourage informed dissent, make certain no one’s feelings are being hurt, keep everyone on track, and then (after the smoke has cleared) make good decisions for our clients. The decisions are nuanced and difficult. There is rarely an overwhelming amount of conviction about any one decision before the team. As the team leader and CIO for the past decade I’ve had the final word on all investment decisions and consequently, I’ve had the final responsibility for the decisions we make as a team. Let me tell you, the job is…well…tough.

While I retain all of my other duties as CIO, as of January 1 of this year, Rick Vollaro, in his role as Chief Investment Strategist, has taken over the role of investment team leader. It is now his job to manage the team and I represent, for the first time in many years at Pinnacle, just another opinion to be weighed on our investment team. I am pleased to report that Rick has stepped into the role with ease and the investment team is running as good, or better, than it ever has. I am also pleased (I’m only pleased because I have a sick sense of humor) to report that there have already been several split decisions among the analysts that Rick has had to resolve as we address the challenging market environment we face this year. On a personal level, I get to be more argumentative, less accommodating, less of a manager, and more of a general pain in the neck in dealing with my teammates…and my team leader. Most of all, I no longer have the final call and get to watch Rick step in and do the job that he has trained for over the past ten years. It is truly a pleasure to see him step up and manage the group. Our clients will be well served.

Was That It?

We’ve been anticipating a correction in the stock market for a couple of weeks, mostly due to signs that the market is overbought and investors have become too bullish in the short-term. Over the past two days, it seemed like maybe a correction was materializing, as the S&P 500 dropped by -1.1%, and the Russell 2000 Index fell by -3.5%. However, today the market is a little higher, so that leaves us wondering, was that it?

We don’t think so. Although the last market selloff was very shallow (the -4% S&P decline in November), we felt coming into this year that the market was probably overdue for a bit of a steeper decline that could carry the S&P down to around its 200-day moving average (blue line in chart below), which would be about -10%. Again, this was largely due to the fact that some signs of optimism are higher than they were last April, just before the market plunged by -17%. We don’t expect that there’s going to be a replay of last spring, but we don’t think a minimal, 2-day pullback is enough to clear the current overbought, over-bullish conditions.

Which Indicator is Wrong?

At Pinnacle, we look at multiple indicators that we consider good leading indicators of global growth. Some of them are packaged indices that have multiple economic components, and some of them are market based barometers. Currently there is an interesting and eye-popping divergence developing between two market based barometers.

The chart below shows the Baltic Dry Index (blue line), which monitors global shipping rates, and the CRB Raw Industrial Spot index (black line), which is made up of 22 economically sensitive commodities. As you can see, typically the lines of the chart are somewhat in sync, but right now they are giving very divergent messages. So the question is, which indicator is wrong about the future direction of growth? We’ll be mulling this one over.

Hi-Low, Silver!

The price of silver has broken below its 50-day moving average today. From August 23, 2010 until now, the price of SLV (a silver ETF) has gone from $17.61 to $27.61, which is a 57% gain. That annualizes out to roughly 215%. That’s an amazing ride in 5 months. But now that the 50-day MA has been broken is this the time to add to the position or is there more selling to come?

Everyone by now is aware of the bullish argument for precious metals including gold and silver. They’re in a secular bull market that has lasted for 10 years and fiat currency concerns may take them to bubble levels. But technically speaking, they may be overdue for a breather that appears to be occurring, and many indicators are showing this deterioration. The Relative Strength Index (black line in lower part of chart below), which is a momentum oscillator created by J. Welles Wilder, is confirming the price drop as it has fallen to new lows.

Several independent research services, including Ned Davis Research and the folks at the Bank Credit Analyst, have warned us of precious metal weakness in the short term. With their warnings and the emerging technical deterioration, we recently reduced our GLD (gold ETF) position from 5% to 3% in client accounts. We still believe in the secular story for precious metals which is why we maintained a small position, and we may add back to our positions as this correction unfolds. But at the moment, we’re anticipating a little more selling and will wait for oversold levels to start that discussion.

What’s Consensus?

One of the things we are always trying to assess is what the current “consensus” market opinions are. Contrarian investors typically look to steer away from the herd, since the market presumably has discounted most of the news by the time the most investors have gravitated to a particular idea. This is especially important at market tops and bottoms, but perhaps less relevant somewhere in between – but I digress. Here are a few thoughts I think are somewhat consensus right now:

Equity Markets – Many investors seem to be bullish on equity markets for the next six months, beyond that it seems most believe a bear market may be in the offing. The masses also seem to be looking for a pullback sometime soon as bullish sentiment has picked up to levels not seen in some time. But even those looking for a pullback don’t seem to be anticipating anything worse than a benign adjustment to clear the froth, and then it’s clear sailing until the second half of the year. We are more or less in this camp right now. But it does make me a little nervous that this seems to be a commonly shared view right now.

Bond Markets – Everyone seems to figure that an improving economy ought to lead to higher bond yields over the course of this year. There also seems to be a consensus of somewhere between 4.25% and 5% on the 10-year Treasury as an approximate area where yields could start to cause serious problems for the economy. Most analysts seem to view higher yields in a negative light, and aren't open to the idea that higher yields might actually be good for stock investors if it creates a widespread bond-to-stock move. And beyond a shorter-term pullback, not many other than the perma-bear crowd are looking for a major decline in yields right here. Again, beyond a temporary pullback that we think is likely, we generally agree that yields are likely to rise over the course of the year. But we also think that yields will ultimately be capped from going too high due to low inflation, the Fed anchoring short rates, and structural economic problems. So again, I think we generally favor the consensus.

That’s my view of consensus calls, and I’ve already covered that I’m a bit nervous that we appear to dead on the consensus with our view. Of course, it’s important to note that the research we read is usually independent and consists of very smart analysts that get paid to make such calls. One must also acknowledge that sometimes the consensus is correct. That being said, it still makes me a bit nervous to be aligned with the herd.

Relative Strength

Relative Strength is the study of the price movement of a security relative to the price movement of another security. In more simplistic terms, it is a line graph that shows which security is outperforming. If the line is rising, the numerator is outperforming. If the line is falling, the denominator is outperforming. Analysts frequently use this simple concept to ensure they are invested in the right areas (i.e., the areas that are outperforming) relatively. Therefore, it becomes a great tool to assist with asset allocation and equity sector rotation, but there are other useful applications.

Below is a chart of two securities: the MSCI Emerging Markets ETF (EEM) in red and the S&P 500 Dividend Adjusted Index (SP-DA) in green. The line in orange at the bottom of the chart is the relative strength line of EEM/SP-DA. When EEM is outperforming the orange line rises, and when EEM is underperforming the orange line falls. The start date for this chart is 1/23/2009 (to help illustrate my point), and it shows strong outperformance of EEM versus the S&P 500 through yesterday. But the chart can also be used to identify divergences, or differences between the S&P 500 and the relative strength line.

There are a few divergences that I can point out on this chart, which will hopefully highlight the leading characteristics of Emerging Market stocks. At the very far left of the chart, the S&P 500 fell into March 2009 while the orange line was rising. The market bottomed shortly after this positive divergence as the emerging market stocks led US stocks higher. Another positive divergence occurred in June/July 2009 as the relative strength line started moving higher while the S&P 500 made its bottom in July. There are also negative divergences, like when the relative strength line started to head lower before the S&P 500 top in April, and most recently the relative strength line has moved lower from the October peak as the S&P 500 continues higher. Does this negative divergence foretell of another correction in the S&P 500?

Risk-Adjusted Returns

Here is a trick question for you. Would you rather earn a 10% return with 10 units of volatility (don’t worry about how to measure the volatility units, I’m trying to make a point here), or would you rather earn an 8% return with 4 units of volatility? Clearly the second choice is the more efficient portfolio earning higher returns for each unit of volatility (two percent return per unit of volatility in the second choice versus one percent return per unit of volatility in the first choice). The correct answer is to choose the inefficient portfolio with the highest returns. Why? Because we know the return! In hindsight, volatility shouldn’t matter, even to the most risk adverse investors. If you know that portfolio A will earn 10% versus 8% for portfolio B, then you would cheerfully choose portfolio A even though it is 150% more volatile that Portfolio B. Volatility, as a measure of risk, is only meaningful in the context of uncertain returns. However, if you don’t know, with certainty, the future returns of Portfolio A or B, a condition that reflects the reality that investors face every day, then volatility as a measure of risk becomes very relevant. Perhaps Portfolio A is on the way to losing 10% instead of earning a positive return of 10%?

In bull markets it makes perfect sense that risk and volatility are undervalued. Why would anyone complain about too much upside volatility in their portfolio? It’s fun to imagine that phone call – “Ken. I’m calling you because my portfolio is making a lot more money than you said it would. You will be hearing from my attorney in the morning.” Hindsight is an amazing tool for diminishing the value of risk management of any kind in bull markets. Any strategy that reduces returns, or potentially reduces returns, has no value. Perhaps that’s why they coined the phrase, “you can’t eat risk-adjusted returns.” In bull markets, all that matters is the magnitude of the gains.

Professional investors have several tools to measure whether or not the amount of volatility in a portfolio is “worth it” considering the amount of portfolio return that is earned. Portfolio Alpha is a well known metric that measures the excess returns of a managed portfolio to a benchmark portfolio, and then divides the excess returns by the amount of beta of the portfolio (beta is the volatility of the portfolio compared to the volatility of the benchmark). A positive alpha means that the portfolio is earning more than you should expect for the amount of risk that you are taking. So, let’s go back to our first question. Portfolio A earns 10% with a negative alpha (very bad) and Portfolio B earns 8% with a positive alpha of 4.6 (very good). Which portfolio should you invest in? I already told you…Portfolio A. It made more money than portfolio B. Alpha only matters when you are trying to figure out what will happen in the future. If you get to make the decision with 20-20 hindsight (you never get this choice), then choose the highest return every time.

What is a Fair Multiple?

According to Yardeni Research, the 3rd quarter of 2010 saw corporate America reach near record profit margins of 8.6%. One obvious way of growing corporate profits is to grow profit margins, but to plan on outsized margin growth from today’s record levels seems a little too optimistic. In fact, profit margins are mean reverting so while margins could still expand from here it seems more likely that investors should plan on flat to lower margins in the future. Another way to grow profits is to increase corporate top line sales growth. U.S. consumers continue to confound bearish analysts (I include myself in this group) who thought that consumption might be curtailed by stubbornly high unemployment statistics. The dismal number, including part-time workers who want to work full-time as well as discouraged workers who have recently dropped out of searching for a job, remains at about 17% of the workforce. You might also think that consumers would be less than enthusiastic if their home values continued to fall, which according to Case-Shiller- they have for the past four months. Nonetheless, year over year growth of retail sales was 7% by the end of November and real personal consumer expenditures grew by 2.5%. Not bad for an economy that is supposed to be saddled with consumers who are anxious to cut their spending and repair their balance sheets.

Historically investors would, quite sensibly, discount the amount that they are willing to pay for future earnings when profit margins are at record highs. In that light, paying 13 times next year’s projected operating earnings makes sense. To be exact, at today’s S&P 500 price of 1276 and current consensus 2011 operating earnings estimates of $95, the market is trading at 13.4 times estimated 2011 earnings. The question is, is 13 times earnings too low in the midst of an economic expansion? Over the past thirty years the median forward operating earnings multiple is 14 times earnings. Of course, for most of the past 30 years interest rates haven’t been at 0 and the Federal Reserve didn’t more than double the size of its balance sheet. Is it possible that investors should give this economic recovery a little more benefit of the doubt?

To get to this year’s (2010) estimated per share earnings of $83.75 companies grew operating earnings at an amazing 38% year over year rate from 2009. To get to the 2011 forecast of $95 we need a more reasonable 13% growth rate for operating earnings. If investors simply give the market its median multiple of 14 times 2011 earnings we could see the S&P 500 trade to a price of 1330 without any growth in earnings estimates for 2011. A multiple of 15x, which in my mind is unwarranted, gets us to 1,425. For the market to advance without an expansion in the multiple, something good needs to happen with consumer spending or corporate profitability. I’ve seen bullish forecasts of 4% GDP growth for 2011 fueled by 4% increases in consumer spending. Against the backdrop of an economic expansion, perhaps consumers will come to the rescue and the bulls will be rewarded. It seems as though everyone is making an argument to be more bullish nowadays.

Will the ADP Translate, and Will it Matter?

Yesterday the ADP employment report surprised sharply to the upside when it reported a December employment gain of 297,000 jobs, versus an estimate of 100,000. That was certainly good news, and it may just be confirming some of the positive trends that we’ve seen lately in such things as unemployment insurance claims, the Conference Board’s Employment Trends index, and average hours in the workweek.

As always happens, the bulls have trumpeted this news, and the bears pick away at the details of the report. Tomorrow will bring the over-hyped monthly payroll report, and market watchers will focus on the unemployment rate, and total nonfarm payroll jobs created. The consensus is currently for a job gain of 150,000, with 175,000 anticipated out of the private sector (meaning losses from the government sector). Anywhere around the consensus would be encouraging from a cyclical perspective, and it wouldn’t be surprising to see a decent number that coincides with the pickup in the aforementioned trends we’ve been watching. But there is no use in guessing what the actual number will be since the median difference between estimated and actual is close to 100,000, and any miss within around 100,000 is statistically insignificant anyhow.

What I really wonder about is whether a good number will matter much in the short term. We’ve been monitoring elevating levels of complacency among stock investors lately and worrying that the market might be due for a countertrend correction. Watching the market’s reaction to tomorrow’s payroll report will be as interesting as the number itself. I’m watching to see if a good report is met with selling, which might be an indication that a short term top is in. A bad number followed by buying might be equally interesting and imply that right now even bad news can’t keep this market down, so maybe stretched is about to become ultra-stretched. Tune in tomorrow, it should be an interesting show.

Chart: ADP Employment Report (yardeni.com)

Looking at Alternative Investments

Pinnacle clients will soon be noticing that their statements have a slightly different look. Instead of all of the alternative investments in the portfolio being reported together at the end of the holdings reports, we now split them up into equity alternatives and fixed income alternatives. When asked I usually define alternative investments as those asset classes or investment strategies that have a low correlation to both stocks and bonds. However, it is helpful to further differentiate among the alternatives to get a better understanding of what they mean to us in terms of our portfolio construction.

I divide alternative investments into three general categories. First are asset classes that historically have low correlations to stocks and bonds. The best example of this in our current portfolio is gold (GLD) and long-only commodity future indexes (UCI). These exchange traded funds and notes are not actively managed and their correlation to stocks and bonds is entirely dependent on the performance of the underlying asset class. The second group of alternatives falls into a group I call “alternative strategies.” The Merger Fund and TFS Market Neutral fund are examples of this group in current Pinnacle portfolios. While the funds are very actively managed, the underlying strategy is designed to consistently deliver low correlations to stocks and bonds. While the managers can get “hot” or “cold,” unless something horrifying occurs correlations should stay low. The final group falls into what I call “managed alternatives” and would include Leuthold Core Fund and the Hussman Strategic Growth Fund. In this group equity managers have the freedom to take the portfolio relatively long or relatively short (in Hussman’s case he can take the portfolio to 0% net equity) so the correlation of these funds to the broad market will vary greatly depending on how the managers position the fund.

Of the three types of alternatives, it is the last group that presents the most problems for us as portfolio managers. We know that over time the correlation of these funds can change and when they do we have to decide if we need to adjust our overall risk allocation to reflect the change. Neither fund has consistently beaten its benchmark during the current bull market. Hussman has been generally bearish and Leuthold has had issues with security selection. Both of these managers are brilliant but I’m guessing that we will be reducing our holdings in both funds in some, but not all, of our strategies as we enter the New Year.