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.