Thursday, July 28, 2011

Risks Inherent in Risk Protection

Given the amount of macro risk currently facing markets, we have a number of hedges employed in our portfolios for different scenarios. If you’re a fan of the deflation argument, we own some long maturity Treasury bonds. If you’re more worried about inflation or monetary debasement, we own some gold. If the risk of further deterioration in the euro-zone and common currency is what keeps you up at night, we own a U.S. dollar index fund. If you’re skeptical about all of those scenarios, we’ve also simply increased cash weightings, willing to temporarily accept 0% yields as a trade-off for principal stability. These hedges all contribute to portfolio protection in certain scenarios, but they also have their drawbacks as they are volatile and carry their own risks.

Long maturity bonds are at risk to a reacceleration in the economy, and the debt ceiling not being raised in time. Gold is at risk to less global liquidity, a higher dollar, and a rise in real interest rates. The dollar is at risk to a continuing downtrend in real interest rates, debt ceiling dynamics, and plain old relative underperformance in U.S. real growth rates vs. other economies. Even money markets take on some risk in the form of embedded European debt exposure and uncertainty regarding the possibility of a U.S. credit rating downgrade.

Given that every hedge has its own risk, what’s an investor to do? If you want to insulate your dollars with 100% certainty, I suggest stuffing some cash in your mattress. Of course that only works if you can live with the risk that your house may catch on fire, you get robbed, etc., etc., etc…

Wednesday, July 27, 2011

Triple Digit Oil - Again

It was nice while it lasted. Oil recently fell from a high of $115 to $90 and gas prices fell from $4/gallon to $3.53 but that party is over. Oil crossed above the $100/barrel mark once again yesterday (as shown in the chart below) and higher gasoline prices are sure to follow as the summer ends. This is typical oil behavior as the driving season in the U.S. progresses but it is certainly an unwelcome move as once again U.S. consumers will surely feel the pinch. And this time around the IEA will not be releasing reserves.

We are actually glad that IEA will not be wasting more oil reserves as it seems oil may be running into larger economic forces. I am referring to China’s slowing as reflected in their Purchase Manager’s Index (PMI) that fell below 50, and a slow growth environment in the developed world which should lead to a drop in demand. If $100 is breached, the May high of $102 is the 61.8% Fibonacci retracement from the 2007 high to the 2009 low and might act as resistance once again.

The wild card in the oil market is the U.S. dollar. Oil is priced in dollars and therefore is likely to rise if the dollar continues to move lower. If our politicians cannot come to an agreement on the debt ceiling, or they kick the can down the road, we are operating under the assumption that the dollar would experience significant selling. Under this scenario oil could easily rise to the April high of $113 again. Just one more reason we need the stalemate in Washington to end.

Tuesday, July 26, 2011

Debt Ceiling Q&A

Due to the fast approaching August 2nd debt ceiling deadline, and increasing media coverage, many of our clients have come to us with questions regarding our views on the issue.  We compiled the most common questions and our answers into a brief Special Report, which is posted on the main Pinnacle website.

Please click here to read the Special Report

Monday, July 25, 2011

On Politics

This morning’s headline in The Washington Post reads, “Boehner seeks to release new debt strategy.” Once again I find myself lamenting how our job as investors has changed from being able to understand the business cycle to understanding the political cycle. Perhaps it’s because our offices are so close to DC where folks might be a little bit more “inside the beltway” in terms of their politics than other places around the country, but we have always had a firm rule not to express our personal opinions about politics with clients. Over the years this rule has served us well, with the exception of one memorable client dinner where an older client felt I had besmirched the reputation of George Bush by making a few comments about tax policy and she made certain that I knew, in very clear and uncertain terms, that she was a tried and true Republican who had attended the Bush inauguration. As I recall I ended up down on one knee (I’m not kidding, she was seated at the dinner table and I was on one knee talking to her) apologizing for any misunderstanding or hard feelings I may have caused about her political views. If Mindy Gasthalter, one of our wealth managers, is reading this, could you please stop laughing?

I have stated many times that I believe that no meaningful “grand compromise” will be reached in the U.S. about the state of our budget deficit until the financial markets impose a solution. We have just put together a series of questions and answers for Pinnacle clients that walks through the reasons that we feel that the likelihood of a “market riot” is still small...the high probability is that this isn’t the moment that financial markets will melt down over the issue. The problem is that brinksmanship politics demands that politicians take this debate up to the very last moment and create maximum fear and anxiety in order to cut the best possible deal from their own partisan point of view. Isn’t it too bad that the country has to be held hostage as we go through this childish process?

That we are forced to try and guess when the financial markets will punish politicians for playing this game of poker with the debt ceiling is ridiculous. The political class knows very well the implications for not reaching a solution to the debt ceiling debate. With one week to go they are now going to try and “bluff” the rating agencies that may downgrade U.S. debt if the compromise solution merely “kicks the can down the road” in terms of a meaningful reduction in the deficit. The problem is that our politicians reflect that partisan nature of the electorate, and the electorate is so divided between “haves” and “have nots” that the political process itself doesn’t seem to work anymore. I recently wrote a paper which quoted Francois Trahan’s recent conclusion that “macro’ forces were currently responsible for more than 80% of stock market volatility. I’m guessing that politics, both here and in Europe and in China, must contribute 70% of the 80%. I am SO ready to go back to studying earnings and interest rates.

Friday, July 22, 2011

Finally Growing into “The New Normal”

A few years ago, while deeply entrenched in the financial crisis, the very smart folks at Pimco coined the phrase “The New Normal”. It essentially meant that over a 3-5 year time frame the developed world economies were in for a subpar period of growth due to the inevitable increase in financial regulation, an end to the shadow banking system (aka “financial innovation”), a projected increase in the savings rate, private sector deleveraging, and the prospects for higher taxes and inflation. The phrase became an instant buzz word on Wall Street, and seemed to imply that investors should be very cautious in their investment approach, even though the horse had arguably already left the barn.

I can remember the theory taking hold back in 2009, and at the time I was concerned that investors were taking a sound long-term theory (which I think it is) and using it incorrectly given the cyclical backdrop at the time ("Don’t Mistake the Secular for the Cyclical," and "Is the New Normal a Repeat of Decoupling?"). A few years later, after a giant stock market rally off the bottom, the phrase seems to have fizzled and is rarely uttered on the same financial TV programs that saturated the airwaves with the slogan back in 2009.

But despite the very healthy rally in financial markets and less mention of secular issues that have been masked by the magnitude of the rally, I would contend that the New Normal is just kicking in. You can see it if you look at the jobs market, which is still ailing several years into an expansion. You can see it as maxed out government debt loads are beginning to affect behavior and fiscal policies are becoming more hostile for financial markets. You can see it in some of the regulatory reform that is starting to bite certain financial institutions (ask Goldman Sachs how they feel these days), and lastly you can see it in the enormous reserves that are still trapped in the banking system rather than being turned into new lending and multiplying through the economy. While the buzz of Pimco’s catchy phrase has gone silent recently, I believe that investors should be on the lookout more than ever these days for the New Normal’s impact on the economy and financial markets.

Tuesday, July 19, 2011

Tail Risks

We are beginning to field a higher volume of questions than usual from clients who are worried about the debt ceiling debate. And why not? We all remember the conversation leading up to the Lehman Brothers bankruptcy, which went something like, “they can’t be so stupid as to let Lehman go under.” Or perhaps clients remember the 700 point decline in the Dow on the day that the first TARP vote got shot down in Congress. Policy makers are more than capable of making mistakes that can do significant harm to financial markets, and those who are worried about the debt ceiling debate are, at least in my mind, right to be concerned. If lawmakers blow the August 2nd deadline for reaching a deal investors should expect a dizzying amount of short-term volatility in financial markets. For that matter, if the European Union and all of the assorted parties in Europe can’t figure out how to avoid a sovereign debt default by Greece, or Ireland, or Portugal, or whichever country is grabbing the headlines in a given week, we will also see an enormous amount of market volatility…and it won’t be buyers who are leading the charge.  The problem is that the financial markets believe the deal will get made, and so the impact of no deal is not yet priced in.  It's when an unexpected event occurs that markets misbehave.

When investors worry about huge increases in market volatility it is often called “tail risk.” The term refers to the ends of a curve showing a normal probability distribution. Most of us remember bell curves, or Gaussian curves, from some distant college course on probability. The middle of the curve represents the average, and as you move away from the average on each side of the curve the probability of an event occurring decreases exponentially. When you get out to the ends of the curve, where the probabilities are the lowest, that is called the “tail” of the curve. Presumably the probability of a default on U.S. sovereign debt is so low that it would be measured way out in the tails of the probability curve. The problem is that while the probability of these events occurring is very low (well…not in the case of a Greece default which is actually fairly high as currently priced by bond investors), the implication of a U.S. default are drastic. It is a classic case of asymmetric risk. The probability of the event occurring might be as low as 1 in a hundred but if the event does occur it could result in a financial panic.

The question is, of course, what to do about this? The answer begins by realizing that Pinnacle portfolios are diversified and unleveraged. Almost by definition the vast majority of Pinnacle clients would experience a small percentage of equity market volatility in their portfolio. Beyond that there are a variety of techniques we might use to “insure” against this event occurring. The problem is that all of these insurance techniques have a significant cost so if the higher probability prevails and the debt ceiling issue is resolved before the deadline, we could effectively “shoot ourselves in the foot” by incurring unnecessary insurance expense. That market volatility has increased leading up to August 2nd is one of the least surprising and most anticipated developments that I can imagine. Stay tuned for more news about what, if anything, we will do to further hedge client portfolios against these unlikely events.

Friday, July 15, 2011

The Hathaway Effect

When over 70% of daily stock trades are being executed by robotraders - supercomputers using complex algorithms, often unintelligible even for the very same whiz who programmed them - strange things can happen. Some can be painful, like the May 6, 2010 flash crash, when the DJIA lost and recovered roughly 9% of its value in a matter of minutes. Some, however, are just odd.

With headquarters in Omaha, Nebraska, Berkshire Hathaway is an American conglomerate holding company whose CEO and chairman is the well known value investor Warren Buffet. Anne Hathaway is a talented 1982-born American actress who has been on the rise in the past few years, starring in hit movies such as The Devil Wears Prada (2006) and Alice in Wonderland (2010). Other than name and nationality, the two seem to have nothing in common, except that Berkshire Hathaway shares (BRK.A and BRK.B) seem to post significant gains on days when the homonymous actress is populating the news. Blogger Dan Mirvish was the first to spot this pattern, pointing out a few occasions since 2008 where the correlation was striking:
  • September 26, 2008 - Passengers opens:  BRK.A up 1.43%
  • October 3, 2008 - Rachel Getting Married Opens:  BRK.A up 0.44%
  • January 5, 2009 - Bride Wars opens:  BRK.A up 2.61%
  • February 8, 2010 - Valentine's Day opens:  BRK.A up 1.01%
  • March 5, 2010 - Alice in Wonderland opens:  BRK.A up 0.74%
  • November 24, 2010 - Love and Other Drugs opens:  BRK.A up 1.62%
  • November 29, 2010 - Anne announced as co-host of the 83rd Academy Awards:  BRK.A up 0.25%
  • February 28, 2011 - Anne co-hosts the 83rd Academy Awards:  BRK.A up 2.94%

The idea is not outrageous. In fact, with today’s technology it is very easy to program softwares to pick up on key words, and more sophisticated ones can read for sentiment too. We actually crunched the numbers (see table below) and found that the average daily return during major Anne Hathaway news appearances since January 2008 was 1.38%, while it was -0.02% on all other days. A simple statistical test based on sample size and standard deviations indicates that the two average daily returns are statistically distinguishable from each other with 98% confidence.

2008 to Date
Anne Hathaway Event
No Anne Hathaway Event
Number of Days
Average Daily Return
Standard Deviation

The fact that Anne’s news appearances correlated with positive returns in Berkshire Hathaway shares, instead of generating simple trading volume increases, makes us wonder whether these robotraders could actually read for sentiment (news regarding Anne Hathaway are seldom negative). Just in case, you may want to think twice before naming your company Lohan or Sheen.

Wednesday, July 13, 2011

As the Government Turns…

Or, maybe All My Congressmen is a better fit. I guess since so many long running daytime soap operas have recently been cancelled (including CBS’ As the World Turns and ABC’s All My Children), our federal government has decided to fill the daytime TV void. At least that’s the way it seems with the over-the-top theatrics going on in Washington right now.

There’s plenty of media coverage and opinion out there regarding the current debt ceiling debate. We don’t have any particularly unique insight to add to the guessing game of what’s going to happen or when. If the 11th hour deal to avoid a government shutdown a few months ago was any indication, then it’s not terribly surprising that this is going down to the wire, too.

For us, it simply means to expect increasing volatility as each day passes and the stakes continue to increase. The equity markets have been gyrating pretty wildly lately, with a 7% selloff from late April through mid-June, followed by a 7% rebound into early July, and now a 3% decline over the last 4 trading days. Gold hit a record high yesterday. The Treasury market is remarkably subdued, with yields on the 10-year back down below 3%.

Call us na├»ve, but count us among those who believe our elected leaders realize the enormity of the situation and will eventually come to their senses and reach some sort of agreement to avoid a U.S. default. The way this saga is dragging out, if I didn’t know better, I might believe you if you told me that a now out of work soap screenwriter was responsible for it.

Tuesday, July 12, 2011

Was It Ever In Doubt?

The Federal Reserve released the minutes from their June 21-22 meeting today and market participants immediately reacted to one sentence, “A few members noted that, depending on how economic conditions evolve, the committee might have to consider providing additional monetary stimulus…” Ah, QE3 officially back on the table and this time the market only had to fall 7%. But was it ever in doubt? With the Federal Reserve so focused on deflation, I don’t think so.

“Never in Doubt” seems to be a theme inside Washington these days. We know the debt ceiling agreement will be reached before the August deadline. The disastrous consequences are known by both sides and that means the situation will be resolved. The ten year yield is still only 2.91% which either makes bond investors the stupidest people on the earth or they are just enjoying the theatre in Washington for what it is – theatre.

But are there situations we should doubt at all in this world? Greece will default so they should just do it. Gold is going to $2000 per ounce, at the very least, with the current fiat currency problems. U.S. Treasury bonds are the worst investment over the next 10 years. Emerging Markets are the best investment over the next 10 years. It all seems so easy.

Friday, July 8, 2011

Earth to Jobs, Where Are You?

Yesterday the ADP survey reported that more jobs were created than forecast, and investors rejoiced in jubilation on a bet that the soft patch was already ebbing. Fast forward one day and the euphoria is gone. Today’s job report was miserable - just 18K. After yesterday, the whisper number of the street exceeded 140K with the estimate being about 105K. 18K! And this follows a whopping 54K last month. Jobs are crucial to extending the current cycle. Without jobs wages will continue to stagnate, spending will begin to decelerate, housing won’t find a bottom, and all that money the fed pumped in is going to stay stuck in the banking system. Anyone betting on the soft patch being temporary was just forced rethink that thesis again.

Wednesday, July 6, 2011

Big Week but We Need Bigger

Last week the S&P 500 gained 5.6% en route to the biggest weekly gain in two years, and the 29th biggest weekly gain ever. I think we can now debate this kicking of the European can or the 9.58 second 100 meter dash as the greatest sports feat this decade. The bailout package is in jeopardy and the market refuses to give up those gains. Truly Epic! However, as big a move as last week was, it still has some work to do before we can say that the consolidation is over.

First, momentum has not broken the 2011 downtrend. There are many momentum indicators but the Relative Strength Indicator (RSI) has to be my favorite to analyze. The chart below shows the S&P 500 price chart in the top panel and the RSI in the bottom panel. The RSI is still in a clear downtrend since the beginning of 2011 as marked by the white line. I would like to see this line broken before I become more confident that the market is going to continue higher. Then I would like to see this indicator reach extreme levels above 70 as further bullish evidence.

What provides additional pause is the price chart in addition to the RSI. The price level of the S&P 500 has reached the February high of 1340 but has met resistance at this level at the exact time the momentum has reached resistance. If these two levels hold and the price level starts to fall again we could be setting up a trend reversal. And that trend reversal could take the shape of a head and shoulders reversal (yes, Rick, another head and shoulder pattern. This is an inside the investment committee joke). I thought the saying was summer doldrums!

Tuesday, July 5, 2011

$200 Billion in the Room

Last week I had the privilege of traveling to Bachelor’s Gulf in Colorado to network with some of Charles Schwab’s largest institutional clients. I’m guessing about 100 firms from around the country attended the Explore conference and the total assets under management represented by everyone who attended was more than $200 billion. As is usually the case in these kinds of conferences, the conversation swirled around topics involving leadership skills, business succession plans, incentive compensation schemes, and other topics of interest to business owners who suddenly find themselves managing businesses that most people would no longer consider to be “small.” In fact having $1 billion under management is , to steal a phrase from PIMCO, “the new normal” for firms that have been in business for fifteen years or longer. Pinnacle certainly fits the description.

As usual the one topic that was not discussed was how the different firms invest money. You would think after a decade of horrible returns that investment strategy would be at the top of the list but that is rarely the case, and the Explore Conference was no exception. However, I thought it was notable that two of the speakers focused on political issues that might impact our business. David Brooks, the well-known Op-Ed columnist for the N.Y. Times, and Greg Valliere, the analyst with the Washington Research Group and commentator for CNBC, spoke to the group in two different sessions focused on recent political events. The current debt ceiling debate was uppermost on everyone’s mind, followed by who might be the Republican Party candidate for president in the upcoming election. Of the two speakers, it was Brooks who managed to shock the audience with his comments about the debt ceiling debate.

Greg Valliere’s view about the debt ceiling debate was pretty much consensus, meaning that we are going to be in for a lot of political theatre leading up to the August 2 deadline but all the parties know that a deal has to be cut in order to prevent a possible economic catastrophe with the nation’s creditors. Brooks offered his view that a deal wouldn’t be cut and gave several plausible reasons why that could occur. You could almost feel the air leave the room as the audience contemplated what a default on U.S. Treasury debt might mean to our managed assets. If the market is at all concerned about Brook’s point of view, you wouldn’t know it from last week’s market action as the risk-on trade was definitely back “on” last week. However, Investors should be ready for extreme market volatility throughout the summer depending on what the headlines bring regarding the debt ceiling debate. Hopefully Brooks is wrong but I am reminded that hope is not the best investment strategy.

Friday, July 1, 2011

New Holding: Aerospace and Defense ETF

On 6/9/2011 we initiated a new position in the Aerospace and Defense industry in all of our models with the exception of Dynamic Conservative. The specific security we bought was the Powershares Aerospace and Defense ETF (symbol: PPA), and the top holdings are large companies like Honeywell, United Technologies, and Boeing. This was an intra-sector trade in Industrials as we sold the broad Industrials sector to purchase PPA. There were several reasons we made the relative switch, and we wanted to share a few of them with our clients.

Industrials, as a sector, are extremely overvalued. The sector currently trades at an 11% premium to the market while price-to-book, price-to-sales, and price-to-earnings are reaching extreme measures. However, at the industry level, aerospace and defense companies are currently trading at neutral to slightly undervalued on most valuation methods. Concerns over governmental/defense budget cuts related to the current debt ceiling negotiations weighed the industry down over the last few quarters but we feel the market has priced in the potential for significant defense budget cuts. Analysts consistently revised earnings down at the end of 2010 and beginning of 2011, and have now started to revise earnings up in what we feel are a reflection of that analysis.

The trade also reduced the beta of the Industrial exposure within client portfolios. The broad Industrial sector has a beta of 1.25, which means the industrial sector should move by 1.25% for every 1% move in the S&P, on average. On the other hand, the Aerospace and Defense industry has a beta of 1. Generally speaking, the aerospace industry is viewed as a defensive industry within the overall Industrial sector. The long delivery cycles have made this industry a safer space for investors during soft patches as investors demand higher earnings visibility.

Additionally, there were was good movement in the relative strength (RS) of the industry versus the broad sector. The bottom panel of the chart below reflects the RS improvement. When the RS is moving up it reflects PPA outperforming XLI (broad industrials). Recently, the RS made a lower low which is a sign of strength marked by the black line, and broke the long downtrend from the market bottom in 2009 marked by the red line. Combined with the fundamental analysis, we felt it was a good opportunity to make this relative trade.