Monday, February 28, 2011

A Good Reminder

One of my favorite analysts is Dennis Gartman, the highly regarded Editor and Publisher of the daily Gartman Letter. Here is what he had to say in his Thursday, February 24th, letter regarding oil futures:

“At this point, all we can rationally say is that one can pick-a-number when it comes to prices. We shall believe almost anything at this point, and we say that with a sense of both urgency and calm; with a sense of confusion and rationality; with a sense of awe and respect. There is really little else that one can or should say. These are those interesting times we hear so much about.”

Last week we also heard from Chen Zhao, Managing Editor of BCA Research, who when discussing China and food prices felt obligated to remind us of the following:

“…what are these market moves telling us about underlying economic conditions? Those who have been around long enough know there is no “scientific way” to distill useful messages from market noise. Interpretation is all about perception, hunches and gut feeling.”

I must admit to being a little puzzled by all of this angst considering that the S&P 500 Index still hasn’t been able to muster a 5% top to bottom decline, even with the revolutionary change in Egypt and the near civil war in Libya. Nevertheless, when the experts are throwing up their hands in awe about current market conditions and reminding us that that there is no “scientific” way to discount the risks of current news, it is a good reminder that Pinnacle portfolios have several built in safe-guards to ensure that we don’t make a big investment mistake in volatile markets.

First, we run diversified portfolios that own several asset classes that often act as performance hedges to our base-case view of market events. Second, we don’t use leverage in our portfolios which significantly reduces portfolio volatility. Third, we trade incrementally based on our “weight of the evidence” approach to changes in the news…no big bets here. Fourth, we celebrate our use of perception, hunches and gut feelings, but we also honor rules-based quantitative approaches to decision making just in case our hunch is wrong. Finally, our investment time horizon is at least long enough to allow us to try and find more durable and long-term themes to invest when the daily news gets crazy and daily market volatility is frightening.

These safe-guards are all designed to help us add value to portfolios while defending against making win-lose portfolio decisions. It may not be sexy, but when events become unpredictable (think Libya here) it’s a good reminder that sound portfolio construction techniques can be very valuable.

Friday, February 25, 2011

Are We Finally Getting a Meaningful Correction?

For the past several weeks, we’ve been intending to boost risk exposures in our portfolios. In our view, the cyclical backdrop has been steadily improving (notwithstanding current geopolitical concerns), which should continue to be supportive of equities for the next few months, at least. However, given the market’s surge since late November, we’ve been patiently (some might say “wrongly”) waiting for a correction that would alleviate some of the growing bullishness in the market. As is often the case, the market has refused to cooperate for the most part as it keeps grinding higher, up until this week. The spreading turmoil in the Middle East has been driving commodity markets higher, which finally captured the stock market’s attention as oil prices breached the $100/barrel threshold.

Now, we find ourselves in a similar place as late January, when I last wrote an entry about a possible correction forming. Before today, the S&P 500 was down almost 3% from its recent closing high. Since the market has been routinely shaking off brief setbacks lately, we’ve been wondering, once again, if that was it.

According to data from Ned Davis Research, a 5% correction in the S&P 500 Index has historically occurred every 50 days, on average. In secular bear markets (which we believe we’re still in), they occur every 32 days on average. Through yesterday, it’s now been 126 days since the last 5% correction, which occurred last August when the S&P fell by 7%. In short, we’re “overdue.” But, back to that whole market not cooperating thing, there have been periods much longer than this between 5% corrections in the past, too. So while we have reason to believe the market is due for a deeper decline (despite today’s rebound), we need to be prepared for the fact that this market may continue its impressive (or, frustrating for waiting dip buyers like us) resilience.

Thursday, February 24, 2011

The Dollar as a Safe Haven

When equity markets are under selling pressure, as they have been this week, capital tries to find safe haven investments to flee to until the selling pressure eases. Over the last few years, and especially during the credit crisis of 2008, the safe haven for capital usually was the US dollar and US Treasury bonds. As the equity markets fall the price of Treasury bonds and the dollar rise because they are viewed as conservative or safe places to protect money. The chart below of the S&P 500 and the dollar demonstrates this relationship.

The S&P 500 is the white line in the chart using the right scale, and the US dollar is the orange line using the left scale. Dollar rallies (shown as green trend lines) and S&P 500 sell-offs (shown as violet trend lines) occur coincidently in time. Also, dollar sell-offs (shown as red trend lines) and S&P 500 rallies (shown as blue trend lines) exhibit this same relationship.

However, the last few days have created an interesting divergence in this relationship, as shown in the boxes at the far right of the chart. The S&P 500 has been falling but so has the US dollar. A few days do not make a trend (or in this case a relationship change) and we would expect the dollar to rally if the selling pressure continues. If this relationship does change, it will be very telling that the market no longer views the dollar as a safe haven play. I wonder if the Federal Reserve would see this as a sign to reassess the effect that Quantitative Easing has on our currency.

Wednesday, February 23, 2011

Hussman’s Revenge?

Portfolio manager John Hussman has had a tough year in his growth fund (which is a holding in three of our investment strategies), as his very cautious forecast has led him to maintain a very defensive posture by hedging his equity exposure despite a rapidly rising market. For months, he’s argued that the market is facing a specific set of conditions (overvalued, overbought, overbullish, with yields rising) that historically have preceded abrupt market declines that can knock out months worth of gains in a very quick burst before clearing and becoming safer for investors.

Yesterday’s decline on increasing geopolitical risk in the Middle East has quickly wiped out all the gains since the first week in February. It’s only one day, I know. But after months of a relentless climb, I wonder if the markets are in the midst of being “Hussman’d.”

Chart: S&P 500 Index

Tuesday, February 22, 2011

Being a Risk Taker

Pinnacle analysts do not get the luxury of taking a personal risk questionnaire to predetermine their attitudes towards risk. To be successful in professionally managing money requires the ability to determine when risk should be put “on” and when risk should be “taken off.” It is the ability to objectively determine when risk is worth taking that separates the best investors from everyone else. Easier said than done! Of course, buy and hold investors believe that risk should never be taken off and stocks should always be held in a portfolio. Alas, secular bear markets are excellent “real world” laboratories for illustrating the folly of permanently putting risk "on.” Nevertheless, it is interesting to consider the difficulties of seamlessly moving from being a risk manager to a risk taker.

For me, the many structural economic problems that remain after “the Great Recession” has made the transition from risk manager to risk taker more difficult than usual. I believe that being a risk taker is the more difficult investment stance to take in most market conditions, regardless of the post-Great Recession environment. At market bottoms when P/Es are low it is easy to believe that they will move even lower. At mid-cycle, corrections always loom. Once new highs are achieved the fear is that the breakout is false and the last buyer will be punished the most. I believe that informed and intelligent analysts are well aware of the bearish case to be made in virtually all market conditions. The negative viewpoint seems informed, intellectual, rational, and realistic. Too often the bullish viewpoint seems to be based on optimism, hardly the most professional method of evaluating markets. In bull markets risk managers prefer to “buy the dips,” since that allows portfolio managers to feel like they are at least doing something to manage risk in a raging bull market. Buying into new highs just feels wrong.

Today’s market conditions exemplify the problems with trying to manage risk in a momentum driven market. Since the market’s severe correction last summer, stock market prices have launched themselves to new highs on a steep trajectory that has been coupled with falling volatility. In short, there have been no dips to buy (the S&P 500 had a 3.7% decline in November of last year). No doubt, the major beneficiaries of this market move have been the risk takers as opposed to the risk managers. History tells us that in market conditions like these, risk managers can catch up to risk takers very quickly as financial markets tend to have very steep and quick corrections from overbought conditions. Even so, being a risk manager has been a thankless job for months now. Pinnacle’s equity benchmark mercilessly punishes risk management in bull markets. At some point we will either have a steep market correction, or transition from a bull market to a bear market. Either will allow us to once again earn a premium over benchmark returns.

Friday, February 18, 2011

Clash of the Technical Titans

One of the dynamics within our investment team is that people have their views, and they will not always be in harmony. This is a good thing, and balances our team, but at times it makes for difficult discussions and decisions. Currently the team is somewhat divided regarding how aggressively to position portfolios at this time. What’s interesting is that we share the same view of higher markets over the next few quarters, but the shorter term timing currently has us divided. The crux of the current disagreement rests on which technical measures matter more right now.

We have one technical camp that thinks we need to be positioned more aggressively here. They reason that massive liquidity, great seasonal tendencies, excellent trends, and solid momentum have created a solid wave that we should ride while the sweet spot exists. I’ll admit that I haven’t been in this camp, and that this camp has been winning the battle this year. I tip my cap to those in the group who have been aligned with this view.

The other side of the technical coin, and the one I have currently embraced despite its short term pain, goes something like this: market sentiment is showing extreme levels of complacency, mild divergences have been forming, markets participation has been narrowing, trends are very overextended, and the more the market ignores this and continues up, the more susceptible it is to a painful reversion to the mean on the next correction when the rubber band ultimately snaps back. On a snap back some froth will clear and weak hands will shake out, and that will be a better time to get more aggressive. That hasn’t worked out thus far, but I’m not ready to abandon this view yet.

I imagine we’ll continue to have interesting and difficult discussions as this Clash of the Technical Titans sorts itself out over the next few months.

Wednesday, February 16, 2011

A Staunch Defense of 'Vilified' Market Timing

Our fearless leader, Ken, was quoted extensively in a recent column titled "A Staunch Defense of 'Vilified' Market Timing" that appeared in Canada's The Globe and Mail newspaper.

Please click here to read the article.

Tuesday, February 15, 2011

Trend…Counter Trend

I am reminded of the classic Saturday Night Live skits where Dan Aykroyd and Jane Curtain faced off in their news update, Point/Counterpoint. Jane would take one side of an issue and then Dan would start off his comments with the famous words, “Jane, you ignorant slut.” Delivering all of this with a straight face was the perfect parody of weekend television anchors opining on various topics of the day. So, in this blog, I present Trend, Counter Trend, where it becomes clear that the current investment environment is….unclear.

Trend: The S&P 500 Index has doubled in value from its March 2009 low. The market is overbought and its time to take your profits and run.

Counter trend: Forget the usual metrics. Based on forward earnings the market is still cheap. Value investors who get out too early are going to get crushed as momentum carries the markets all the way back to their 2007 highs.

Trend: Emerging economies around the world have taken a drubbing recently. Everyone is screaming about reducing allocations to emerging markets and rotating to the U.S. If you haven’t sold you haven’t been paying attention.

Counter trend: China is battling a property bubble and food inflation with tighter interest rate policy. The property bubble is exaggerated and the food inflation is a short-term problem. Buy the dip. This is the buying opportunity of a lifetime.

Trend: Commodity prices, especially food commodities like wheat, soybeans, and corn, have been skyrocketing. With this year’s unusual weather limiting global food supplies, expect even higher prices to come.

Counter trend: Food inflation is transitory. Most of the supply issues are already in the price. Now that commodity inflation is making headlines, it’s time to sell. Get out of commodities now.

Trend: Everyone knows that interest rates have to go significantly higher. Bond vigilantes are going to ignore Ben Bernanke and move rates higher with him or without him. Higher rates are a headwind for the current stock market rally.

Counter trend: Bonds are cheap. If rates get back to 4% on the 10-year Treasury you should back up the truck and buy. The U.S. financial system is still a mess as is evidenced by the broken money multiplier. There is too much slack in the U.S. economy to be bearish on bonds.

I wonder how Dan and Jane would have delivered this material. We actually have these discussions every day in the investment team. Now that I think of it, it really doesn’t get a lot of laughs.

Monday, February 14, 2011

Are We in a New Secular Bull Market?

I just read the February letter from Tony Boeckh, author of The Great Reflation, and one of our highly regarded independent analysts. The title of his letter, “Are Equities Too Expensive for a New Secular Bull Market?” is provocative for those who believe we are still mired in a secular bear market. Secular bears look at long-term valuation measures and conclude that the stock market is too expensive for a long-term, multiple year bull market to occur. In our work, we look at several valuation measures, but the most conservative in terms of earnings is to use Robert Shiller’s methodology of normalizing, or averaging, trailing earnings over the past ten years. Averaging the earnings over 10 years smoothes the earnings number so that it isn’t distorted by cyclical peaks and troughs as the economy moves through the business cycle. The current 10-year average earnings are about $55 so the market’s P/E ratio at current prices (1321 S&P 500 close on 2/22/11) is 24x. History tells us there has never been a secular bull market beginning from such a high P/E ratio.

Boeckh, however, offers some other methods of looking at long term market valuations. He suggests using a long-term earnings trend line to estimate normalize P/E’s instead of using the 10-year average. Using the logarithmic trend of 60-years of earnings gets us to $66 of earnings, which means that the current market P/E is 20x. The long run average P/E is 17, so the market is expensive, but not frighteningly so. He then further adjusts earnings to show earnings yields (the reciprocal of the P/E ratio) versus BAA bond yields. Corporate earnings look very attractive in today’s very low interest rate environment. Finally he adjusts the P/E ratio for the amount of cash on today’s corporate balance sheets. Value investors would normally make an adjustment in the price component of the ratio since cash is considered to be easily returned to investors. The net result of his analysis is that the 2009 market lows will turn out to be THE market lows and that we are in the early stages of a new secular bull market.

What does that mean to us? Well…very little, actually. Our own valuation work shows the market to be fairly valued. While it is interesting to consider secular market cycles, our work is focused on identifying shorter market cycles within the secular trend. There are many cyclical bull and bear markets within a secular bear. This cycle is no different, with a bear market from 2000 – 2002, a bull market from 2002 – 2007, a bear market from 2007 – 2009, and now a bull market from March of 2009 to present. Most assuredly, this bull market will be followed by a new bear market. The question is when? Boeckh doesn’t believe this new secular bull will give investors the same high returns that secular bull markets have delivered to investors in the past. If this is the beginning of the next secular bull, then I couldn’t agree more. In my mind, actively managing portfolio risk will be a priority for years to come.

Friday, February 11, 2011

Tech Stocks on Fire

It’s not exactly a replay of the late 1990s, but Technology stocks have been rallying hard of late. Tech is among the leading sectors of the S&P 500 so far this year (measured using sector ETF performance), and a few Tech sub-industries are roaring.

Not even a bad earnings report from Tech bellwether Cisco Systems can keep Tech stocks down these days. Yesterday, Cisco was getting pummeled in pre-market trading, down around 10% on heavy volume. We naturally expected our positions in a Networking ETF to fall in sympathy, since CSCO is the third largest holding inside the fund. Much to our surprise, however, the other top names in the fund had big rallies, and while Cisco ultimately closed down by a whopping 14% for the day, the Networking ETF rose by about 0.8%. That’s a nice return on a more normal day, much less on a day when a top holding is getting walloped. That the sector was able to shake off bad news like that was impressive to say the least.

Pinnacle has carried an overweight in Tech in almost all portfolios since approximately last summer, and we continue to view it as a very attractive sector based on a number of different factors, and given our fairly positive cyclical outlook for the economy and stock market.

Chart: iShares Networking ETF (black line) vs. CSCO stock (brown line)

Thursday, February 10, 2011

30 Year Treasury Bonds

The 30 year US Treasury bond has had a rough couple of months. The yield on the 30 year US Treasury bond was 3.45% on August 25th and has since risen to a yield of 4.73%, which means that the price has fallen over 18% in roughly 6 months as price and yield move inversely to each other. It is not very surprising as general commodity prices have skyrocketed while trust in paper assets has declined, which in turn has stoked inflation fears around the globe. This has led to frequent discussions between Pinnacle analysts regarding topics including hedging techniques and the overall technical state of the Treasury market.

The chart below shows the Generic 30 Year US Treasury Yield back to 1985. This bond bull market has been quite impressive although the chart below shows that the bull may be ending. The white line represents the downtrend line in yields from 1996 to 2011. During bond sell-offs, the yield found support at this line 4 times before this latest sell-off pushed the yield above the downtrend line. But is this enough evidence to call the bond bull over?

Viewing the last 999 days gives a slightly different picture. The yield has found support at exactly this level four or five times over the last few years. The green lines drawn on the chart represent the support zone. If we do see yields break higher out of the support zone this could add to the possibility that yields will move significantly higher. If the support zone holds we will likely see lower yields, and 4 out of 5 times that happened equities followed right with them.

Wednesday, February 9, 2011

Homebuilders Defying Conventional Wisdom

There are still plenty of analysts and pundits that worry that housing markets remain weak, and some believe that housing prices may be poised to drop another 10% over the next year or so. I guess I’m in the camp that says we’ve seen the worst of the housing crisis overall. Even if we are forming a bottom that takes some years to base out, I just don’t see the surprise factor that was embedded in housing a few years ago. A few years back, surprise that housing could go down at all was compounded by the real surprise that a housing boom and lax lending standards had formed systemic rot on the balance sheets of global financial institutions.

Despite all the negative fundamentals, it’s not lost on us that homebuilder stocks have been rallying lately. Since the last dip in late November, homebuilders have outperformed the S&P 500 by about 10%. It could be that this is just another outperformance spurt that will ultimately fizzle, like we’ve seen several times from the homebuilders over the last few years. But perhaps a better economy and more jobs will solidify home prices, and share prices of the builders are beginning to pick up on this theme. We’ll have to watch closely as this industry is volatile, but it’s been interesting to watch the builders rallying at the same time that many are predicting another big leg down in housing.

Monday, February 7, 2011

Submerging Markets

One of the best known investment themes is that the growth of emerging markets like China, India, Brazil, and Russia will support global growth and actually contribute to the earnings prospects of U.S. corporations, which will help to sustain the current bull market. The idea that these emerging economies can sustain their economic growth at a much faster pace than old or “developed” economies is called the theory of “decoupling.” The emerging countries have stronger balance sheets, faster growing populations, very low costs of labor, and other well documented advantages that support GDP growth rates that are multiples higher than in Europe, Japan, and the U.S. My own “seat of the pants” review of various public pension plans and retail client accounts reflects this new found optimism in the prospects for the emerging markets. I have observed that some portfolio asset allocation targets have higher percentage weightings in the emerging countries than they do in the U.S., a situation that was unthinkable a decade ago.

However, this year there has been a subtle, or lately, not so subtle shift in the consensus view of investment prospects for the emerging countries. In the short-term at least, the thinking is that these countries could very well under-perform the U.S. The reason is that the business cycles for these economies seem to be slightly out of sync. The U.S. economy remains in a below trend economic recovery from the Great Recession where there are several well recognized structural headwinds to growth. The most well known concerns are relatively high unemployment, shaky residential real estate values, suspect bank balance sheets, and a high amount of structural debt, including problems at the consumer, federal, and state levels. U.S. policy makers have responded with an expansionary response in terms of both fiscal and monetary policy. The result is an ongoing fiscal deficit (short-term bullish), 0% Fed Funds rate, steep yield curve, and a bloated Fed balance sheet. The good news is that the consensus believes that all of this bullish policy response is kind of a “free lunch” because core inflation in the U.S. remains very low. Investors get to “eat” the results of excess liquidity in terms of higher stock prices and record profit margins, with little risk of higher interest rates and inflation….at least for now.

On the other hand, emerging markets seem to be well into the inflationary part of the cycle. In the case of China, where policy response is limited because their currency is pegged to the dollar, the result has been higher interest rates and higher bank reserve requirements. The fear is that commodity driven inflation is now a real problem. Food inflation, coupled with concerns about a Chinese real estate bubble, have investors worried. That caution has been playing out over the past year as emerging country stock prices have begun to trail the U.S. rally noticeably. We are currently trimming our emerging market allocations in Pinnacle portfolios. As always, it is somewhat unnerving to invest alongside the consensus. But it seems reasonable to us that the current headwinds facing emerging market investors are worth acknowledging by reducing our asset allocation.

Friday, February 4, 2011

Schwab Investment Outlook

On Wednesday, Sean and I drove to Baltimore to attend the 2011 Investment Outlook hosted by Charles Schwab. The all-day conference consisted of probably something like 75 to 100 other investment advisors, and the agenda consisted of some interesting and timely topics. Most of the investment experts that they brought in as presenters were very good, and included people like Richard Bernstein (formerly with Merrill Lynch, now with Eaton Vance) and Bill Miller of Legg Mason.

While there was a healthy dose of disagreement at times from the various panelists, the general mood seemed to be fairly positive. We noticed that several speakers thought the U.S. economy was picking up and if anything would likely surprise to the upside this year. As a result, a common theme seemed to be that U.S. equities are poised to outperform their international counterparts in 2011, and in particular relative to emerging markets. That would certainly be a “surprise” to most investors based on mutual fund flows that have heavily favored emerging markets equity funds over domestic equity funds in the past few years.

Another area where there seemed to be some agreement was in regards to the municipal bond market. Several speakers took issue with recent fears of imminent bankruptcies and defaults at the state and local level, claiming that many states are well on their way to addressing budget problems and that in fact there is now an attractive opportunity in munis due to the degree of recent selling. As clients or regular readers probably know, we have been building a tactical position in municipal bonds in recent weeks in some of our portfolios. While we acknowledge there are certainly problems and reasons to be concerned, the indiscriminate selling by municipal bond holders seems excessive to us.

Overall, we both thought it was a day well spent, and we came back with a few specific investment ideas that will be explored in the coming weeks.

Wednesday, February 2, 2011

Transports Not in Synch with Industrial Average

One chart comparison I looked at today was the Dow Jones Transportation Index versus the Dow Jones Industrials Average. Yesterday the Dow Jones Industrials Average just broke out to a new cycle high. Meanwhile, the economically sensitive transport sector is lagging, and is still well of it’s it’s mid January high, with a much uglier technical chart. The transportation index is viewed as very economically sensitive, as the majority of the index is dominated by trucking, air freight, railroad, and airline names.

What I think is really interesting is the context of the underperformance. In the last few weeks, the US data has broadly been surprising to the upside. One would think with an accelerating US economic story, that the transports should be flourishing, not lagging. Of course, the world has gone global, and it may just be that this economically sensitive group is one of the first US markets that is acknowledging that the Emerging markets are targeting a slowdown, and any slowdown will likely reverberate through the developed world.

Tuesday, February 1, 2011

Trading Bands

It is time for the semi-annual trading procedures post. To most this is rather uninteresting reading (only surpassed by Ken’s Modern Portfolio Theory rants) but we feel it is important to continually educate you on the inner workings of Pinnacle. To assist with trading, we invested in iRebal which is a software program designed to rebalance client groups (a collection of accounts owned by the same family) to model or strategy targets. Model targets are the percentage allocations of each security we want to own in the portfolio. The model targets in iRebal are used to rebalance our client portfolios to maintain desired allocations. Additionally, as a tactical asset allocator we often change the model weights to increase or trim current positions, and add or remove securities. In order for these functions to work, we had to make a few decisions that impact the real world application of our trading systems.

The main decision that we are concentrating on in this post is how to set our trading bands. A trading band is the iRebal terminology for the target range for each position in the model. We set our trading bands to +/- 1% which means that a position can deviate from the target by 1% in either direction. As an example, we have a gold position of 3% in our model and due to the trading band a client could hold as little as 2% to as much as 4% and still be “on target.” If the gold position falls below 2% a purchase is initiated, and if the gold position rises above 4% a sale is initiated. The 1% trading band eliminates many trading problems including frequent trading, insignificantly small trades, and helps reduce commission costs incurred when implementing our strategies.

However, due to our methodology of placing incremental trades (our rule is that we may make 1% tactical allocation changes to the model weights) in certain circumstances a client may not receive a trade as anticipated by a change in our model. It is easier to use an example to describe what I mean by the previous statement. Let’s say a client has a 3.2% gold position in their portfolio with a target of 3%, and we change the model target to 4%. The current gold position is only 0.8% below our target weight which is inside our trading band of 1%, so a buy may not be initiated (I use “may” because the trade still could go off depending on the sell side of the trade, but I don’t think we need to complicate the issue in this post). If a 1% change is made to our model targets, we estimate that 15% of clients may not receive the trade. In these cases clients who have been informed about a trade in our managed accounts may wonder if we made a trading error and somehow forgot to execute the trade in their account.

We do weigh all these factors into our decision in setting the trading bands at 1%. Our measured strategy dispersion, which is the variability in client returns in a similar model, is only about 0.47% based on an average of our 5 models. The small dispersion number means we can have confidence that individual Pinnacle clients who own any one strategy will have very similar returns. For this reason we feel the 1% trading band is the proper setting. However, if the dispersion number starts to grow we will have more in depth discussions regarding our trading settings to ensure proper management of all client accounts.