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.

Friday, September 9, 2011

Dollar Starting to Pay Off

For months we have been wondering when the dollar will finally start to move higher versus the euro. The problems in Europe are massive and they will not go away. And yet the Euro seemed to be hanging around -- the damn thing has alligator blood. Well, the dollar is finally having its day. The market is pricing in a 95% chance of default on Greek debt, and Germany is prepared to shore up German banks in case of default. Euribor is spiking once again and the global system is experiencing tremendous amounts of stress. This feels eerily similar to 2008, only the epicenter is in Europe.

After a four month consolidation at levels close to the all-time-low in the dollar, the greenback has risen above the 76 range resistance and is trading above the 200 Day Moving Average (yellow line) for the first time since September 2010. Momentum is making a new high and the move is pushing the dollar above its one standard deviation trend as measured by the Bollinger Band. These are all great technical developments for our currency, but they are not great developments for the ‘risk assets,’ including stocks. Since 2008 the dollar has a 55% negative correlation to the stock market. That means when the dollar is up there is a very good chance that the stock market is down. Today, the S&P 500 is falling 2.5%.

For a brief moment there, I was in a good mood.

Wednesday, September 7, 2011

Fear the Ostrich

Yesterday, we received an email that basically said that market emotions were running wild, and that those who just held during this period would be rewarded. It sounded pretty 'Buy and Hold' to me, and one of our wealth managers suggested we write a refutation.

Here were my key points to rebut the idea that inaction is the best approach in all market environments:
  • Most Advisors ignore the business cycle that clearly exists and that has an effect on asset prices.
  • Most Advisors think technical analysis is akin to voodoo.
  • Most Advisors are willing to invest your money but not willing to invest their time or money on an investment team.
  • Most Advisors realize that buy and hold is a much better business strategy than investing strategy.
  • Most Advisors would rather hope that markets get their clients to retirement than actually work on a strategy to get them there.
  • Most Advisors are like ostriches, putting their heads in the sand and betting that 'Buy and Hold' will continue to work.
Luckily, we at Pinnacle aren’t most advisors.

If you're currently working with a 'Buy and Hold' advisor, then you’d better hope we're wrong in our assessment that there's a high probability we're in a persistent bear market. In a bull market, a rising tide lifts all boats, but as legendary investor Warren Buffet once said, “It’s only when the tide goes out that you learn who was swimming naked.”

Fear the ostrich.

Tuesday, September 6, 2011

Asking the Wrong Question

In academic terms, or in terms of the Capital Asset Pricing Model, known as CAPM, the risk of owning the market is called systematic risk. Nowadays, as one financial institution after the other seems in danger of collapsing, we hear much about systematic risk. Nevertheless, for professionals who try to manage risk in portfolio construction, it seems like a good trade-off -- business risk for market risk. As a result, portfolios are diversified by asset class, where each asset class is owned as a diversified portfolio of securities designed to eliminate the business risk of owning individual companies. The goal is to only capture market risk and returns. Of course, informed investors must then choose how to do so. They can buy an index fund to capture the risk and return of the asset class (by actually owning the market), or they can hire a money manager who is constrained to actively manage securities in the asset class the investor wants to own. Investors use mutual funds, wrap-accounts, limited partnerships, and other investment companies to hire money managers. It really doesn’t matter what the structure is -- we know from dozens of studies that, on average, if the active money manager is constrained by investment style and is only allowed to own securities in one market as defined by one asset class benchmark, the results are going to be very close to owning the index or market.

This question -- whether to own the market risk and return by owning an index fund or to hire a money manager and try to "beat the market" -- is what everyone means when they talk about active management. That's a shame, because we’ve known for more than a decade that everyone is asking the wrong question. The correct question is, if we have traded off business risk for market risk, then what is the “real-world,” practical risk of owning the market? Traditional thinking says there is little danger to owning markets, so long as you hold them long enough. In the short-term everyone agrees that no one can forecast the returns of markets, but in the long-term, market returns are expected to regress to their long-term mean (or average) return. In terms of asset allocation, 'buy and hold' means to own an asset class long enough for it to earn its long-term average return, and presumably do so with long-term average risk or volatility. The problem, as most everyone is now learning, is that risk markets have not reliably earned their long-term average returns for more than a decade, putting many financial plans -- not to mention pension plans -- at risk.

So what’s to be done?

Wall Street concocted a strategy that included another trade-off. Exchange the risk of markets for the risk of financial strategies that deliver returns that are not correlated to the markets. These new strategies, run by managers who are presumably smarter than the average style-constrained money manager, include private equity funds and hedge funds that are the darlings of institutional investors everywhere. Market-neutral, long-short, event driven, convertible arbitrage, global macro... the list goes on. All are designed to solve the problem of markets that are misbehaving, and can presumably generate positive returns when markets do not. Unfortunately, the uncorrelated strategy solution has its own problem: These strategies only work some of the time, and there is so much money chasing them that the returns are being arbitraged away.

It turns out that accepting business risk, market risk, and low correlation-strategy risk, all have their unique problems. Pinnacle’s solution to the problem is unique. Stay tuned for that.

Friday, September 2, 2011

Time to Change the Models?

Economic data took another hit today as the payroll numbers came in showing no growth. Yep, I’ll say it again, zero growth in non-farm payrolls! Those encouraged by a few data points the last few days are rethinking whether or not there could be a business cycle change occurring right now. At the moment, we’ll stick with our high probability of recession/bear market forecast, and continue to allocate defensively until the weight of the evidence changes materially.

At Pinnacle we are in the business of assessing incoming economic data, and I can say that it’s becoming tougher by the day as many analysts begin to question the efficacy of economic models that have largely worked in the post-WWII period. A great example of this is the message coming from the Conference Board’s Leading Economic Indicator. This indicator, which consists of 10 different economic variables (shown below) that have traditionally led the economy, has actually increased in the last few months, despite a lot of other negative data building around it.

When one digs inside the numbers, it’s not hard to see that a very large rise in money supply along with a steep yield curve have propped up the reading of the overall index recently. Normally these two indicators should be great harbingers of a healthier economy, but right now, I’m not so sure about that. Many analysts are arguing that money supply is rising quickly due to chaos in Europe rather than as a reflection of a healthy banking system. Analysts are also quick to point out that the yield curve is only steep because we live in a world where the Federal Reserve has pegged short-term interest rates at zero.

The point is that many models that are used by investment firms were built to work based on the cycles of the past couple of decades. However, the post-financial crisis world we now live in contains structural problems that may be overriding some of the old economic bellwethers that could be relied on to predict the future direction of growth. In short, it may be time for investment professionals to consider adjusting their models to account for the current environment. And for those who also attempt to read the economic tea leaves as we do, well I guess we can expect more bags under our eyes as we wrestle with whether or not we are in the midst of profound changes in the way to look at the economy going forward.

Thursday, September 1, 2011

Q’s Signal End to Rally?

We continue to believe that the stock market has likely entered a new bear market and have positioned our portfolios to outperform if further market declines are in store. However, with short-term technical indicators signaling oversold conditions when the S&P 500 dropped to 1100 in early August, we decided to wait for a bounce to slightly modify our more aggressive portfolios. This strategy has been a wise one as the S&P 500 has risen 8.5% in a couple of weeks, and we decided to act yesterday. In our aggressive policies, we rotated a few more chips from cyclical sectors to defensive sectors.

Why did we act yesterday? Well, there are a few reasons but the main reason in my mind was the QQQ chart. The QQQ, which is an ETF that tracks the Nasdaq 100 Index, has been a leader for the overall market since the bull market bottom in 2009. With 14% of the index invested in Apple it is easy to understand why. In looking at the QQQ chart, I notice the price level has rallied back to the 50-day moving average (the blue line in the chart below). This moving average provided resistance to price advance yesterday and again today as the market rallied right back to that level again only to sell off heavily after reaching it. Additionally, the momentum of price as measured by the RSI hit the 2011 downtrend marked by the red line in the bottom panel. This indicator tells me that the bounce may be ending.

There are other reasons to suggest this bounce has run its course including separate technical indicators signaling that the market is now short-term overbought, but other analysts feel there may be more upside. Ned Davis is looking for 1250 on the rally (and possibly more) and John Kosar at Asbury Research is looking for 1275 based on a triangle break to the upside. They are probably right, as they have been at this much longer than I, but cashing in on the 8.5% bounce feels great…for now.