The ETF Advantage

At Pinnacle, we have embraced the Exchange Traded Fund (ETF) universe for a variety of reasons, including low expenses, tax efficiency, and trade execution advantages. As their popularity has grown in recent years, ETF product offerings have grown as well, which provides us with a wider array of investment options to choose from. We currently use ETFs for all of our U.S. equity exposure. With diverse offerings in sectors and industries we can efficiently rotate our holdings as better value opportunities arise. Additionally, another big advantage in trading ETFs is that they trade intraday like a common stock, whereas mutual funds only trade at the end of the day. The intraday trading capabilities allow for more precise trading strategies such as stops and limits, and give me (in my role as Pinnacle’s Portfolio Trader) an opportunity to create value for our clients when favorable market conditions arise. Yesterday was a great example of that.

We recently decided to add a couple of new ETF positions in our models, funded by selling mutual funds and cash. We were able to execute all trades on the same day because mutual funds have a 1 day settlement and ETFs have a 3 day settlement. On the open yesterday the market fell 2% as concerns over Greece and the U.S. labor market weighed on investors. However, stocks started to stage a rally just before noon as news of a possible stock split in Apple made the rounds. For Pinnacle clients this presented a great opportunity to purchase the ETFs we had targeted to buy.

The two pictures below show the intraday movement in the Sector SPDR Energy Select ETF and the trade execution details (L: 12,355 @ $55.2531 means we bought 12,355 shares at a price of $55.25). The range of prices in this security was $54.72 to $56.04, and as I just mentioned the execution price for our purchase was $55.25. This was not the exact bottom but at the end of the day our purchases had already gained 1.44%. This is a gain we wouldn’t have been able to earn for our clients if we had used mutual funds instead of ETFs, since those orders would’ve executed at end of day prices.

Matthews Asian Conference Call

One of the benefits of being on the institutional side is the closer relationship and additional access with the funds we invest in than a typical retail investor experiences. Most fund companies devote additional resources catering to investment professionals, like investment advisors and brokers. Whether it’s written updates or conference calls, the ability to hear directly from the portfolio management team is an invaluable part of our ongoing due diligence of the fund, as well as a benefit to our overall investment strategy.

This afternoon, I participated in a webcast involving the director of research and two portfolio managers from the Matthews Asian Funds. We’ve owned the Matthews Asian Growth and Income Fund (Symbol: MACSX) for many years in our portfolios. While nothing in our portfolio is “sacred,” we view the fund as an excellent way to gain access to the fast-growing Asian region of the world. It doesn’t hurt that the fund’s performance has been oustanding, either (see chart below).

The Matthews investment team continues to be very positive on the longer-term prospects for the Asian region as a whole, which may not come as a huge surprise. However, they aren’t blindly bullish, either. They readily admit that it may be a rocky ride from time to time as those economies mature. As far as the current backdrop, they’re a little cautious because valuations have risen as stocks have rebounded over the past year.

Looking forward, they’re expecting certain companies and industries that are dramatically underweight in most Asian indexes to benefit as those economies transition away from being heavily manufacturing dependent and towards more of a service orientation, like most western economies. They specifically mentioned health care as being one of the significantly underrepresented areas that stands to benefit from such a transformation. In that regard, they warned of the “backward looking” nature of most index-type approaches that focus on the Asian region.

Chart: MACSX (red line) vs. S&P 500 (blue line) for the past decade

Will China Revalue Their Currency Sometime Soon?

Lately, currencies have stolen many of the investment headlines as Eastern Europe struggles and the very premise of the Euro has come under fire. The Japanese Yen is also under close watch, as is the U.S. dollar, which has caught a nice bid, mostly due to Europe’s woes. Beyond some of the more immediate headlines, we have been reading quite a few analysts who believe that the Chinese may be getting closer to letting their currency (the renminbi – RMB) appreciate this year. The RMB operates under a managed floating exchange rate system where the value is based on supply and demand with a reference to a basket of foreign currencies. The basket is dominated by the U.S. dollar, the Euro, the Yen, and the Korean Won, with smaller weightings to the British Pound, Thai Baht, Russian Ruble, Australian Dollar, Canadian and Singapore dollars. The daily dollar trading price of the basket is allowed to float within a 0.50% band of the parity price of the RMB, which is published by the People’s Bank of China.

The value of the RMB has been appreciating slowly versus the U.S. dollar since July 2005, having dropped from just over 8 RMB/dollar to approximately 6.83 RMB/dollar today. Many believe a partially pegged currency has artificially created a cheap currency for China, which has helped fuel their export-driven growth boom. With economic growth rates far in excess of developed countries, and with Chinese officials signaling that they’re prepared to pull back the reigns to avoid the potential for another massive boom/bust cycle, we may be nearing a point where it makes sense for them to let the RMB rise. However, a key concern for them is whether Chinese domestic demand can support a stronger currency. There seems to be no doubt in the investment community that the RMB is undervalued, and that in the long term it appears destined to appreciate versus the dollar. The question is one of timing and magnitude.

Our best guess for now is that a continued slow appreciation of the RMB will likely coincide with their progression towards becoming a fully industrialized nation. Even those analysts who are predicting a rise are looking for a very moderate move of anywhere between 3-5% this year. That may not seem exciting, but we have been toying with the idea of adding some RMB currency exposure to select fixed income portfolios that we manage due to the very low short-term interest rate hurdle that exists. Currently, real interest rates appear a bit expensive and so for now we’ve decided to watch and wait for a better entry opportunity. But when the time is right, there are a few ETFs that we can access in order to gain exposure to the Chinese RMB.

Key Point in the Rally

From the middle of January the S&P 500 corrected 8%, and has since rallied off the February 8th bottom to the tune of 5.25%. There were some very nice technical features regarding the recent low including a higher low above the last correction at the end of October, and strong support from the 200-day exponential moving average. These are both bullish signs. Now could be the next important stage for the rally as the S&P 500 has gained back 61.8% of the pullback from the high of 1,150. The analysis I am referring to is called the Fibonacci Retracement which is used by technical analysts to find support or resistance in price movement. The rule states that during a trend continuation an index will gain back a large portion, the upper limit being 61.8%, of a decline during a downtrend before continuing to the downside (the reverse is also true during increases in price). We have now hit that level.

Below is a year to date chart of the S&P 500. Using the January 19th high of 1,150 and the February 8th low of 1,044, today’s closing price of 1,108 is just a shade below the 61.8% retracement level of 1,110. If the market finds resistance at this level and once again resumes the decline we will be watching for a sizeable correction to occur. However, if the market breaks above this theoretical resistance level we would call the current fall a pullback in a bull market and anticipate a continuation of the year long rise in prices. This is one tool out of hundreds that we regularly monitor at Pinnacle which has at this moment caught our attention. We will be watching closely to see how stocks react at this key level.

Speaking in Amsterdam and Boston

Over the past few weeks I’ve had the privilege of speaking to several hundred Certified Financial Planners. I was invited to speak in Amsterdam by a gentleman who heard me speak last year at the Financial Planners Association National Conference in Anaheim, CA. Since I have never been to the Netherlands and have heard endless tales of marijuana smoke, red light districts, canals, and other tourist attractions, I accepted their offer to speak to more than 200 financial planners who recently earned their CFP designations. The Dutch, as you may have heard, take their money seriously, and I was informed more than once that the first publicly-traded company was the East-India Trading Company, which was formed in Holland and basically created the business of global trade. I felt obligated to reply that that the Dutch also gave the world its first massive investment bubble, which had to do with unbelievably inflated prices for tulips in the 1600s, but that’s a story for another blog post.

My trip to Boston entailed a whole lot less flying time, but a whole lot more stress and it was only by the grace of the fantastic Howard County, Maryland road crews that I was able to escape the snow drifts and speak to a similar group of more than 200 CFPs, all of whom seemed interested in this idea I had that Buy and Hold is Dead (AGAIN). It is interesting that I only changed one or two slides for presentations that I made to CFP groups on both sides of the Atlantic. And, it was interesting that the first question from both groups of planners at the end of my talk was the same. I went something like this: “How do you know that you won’t get your forecast wrong and buy or sell the market at the wrong time, which would constitute an investment mistake?”

Here’s the answer I gave – “We are one month away from the ten year anniversary of this secular bear market where buy and hold investing has proved to be disaster from just about any point of view for financial planners. Buying and holding the market while it has delivered negative absolute returns for a decade (and even worse inflation-adjusted returns) is probably the biggest mistake that a planner could make. Retirements have been shattered and financial plans have been completely invalidated. In that context, are you really worried about the consequences of making a poor forecast? The industry has already made the biggest possible mistake imaginable. Anything we do from here will be an improvement.” Planners on both sides of the pond seem to be oblivious to the fact that delivering cash returns or less for a decade constitutes a monster, undeniable, investment mistake. I almost hated to tell them that there has never been a secular bull market that began from today’s normalized ten-year P/E ratio of 21. Sigh.

Consumer Stocks Power Ahead

One of the more interesting developments since stocks bottomed last March has been the behavior of consumer discretionary stocks. Consumer Discretionary is a classic early-cycle sector, meaning that it typically performs very well in the early stages of an economic recovery. The reason for this pattern is mostly due to the fertile conditions that exist in the wake of a recession – interest rates have usually fallen to low levels, inventories have been burned off, and consumers begin to anticipate brighter prospects for the future.

In the current cycle, however, there have been a lot of bearish prognostications that consumers will remain dormant for a lengthy period of time due to overconsumption, bloated debt levels, and large declines in asset values that negatively impacted net worth. The implication being that the Consumer Discretionary sector would underperform and should be shunned indefinitely.

It turns out that those investors who stuck with historical tendencies have been rewarded. The chart below shows an ETF that tracks the Consumer Discretionary sector (red line) versus an ETF that tracks the S&P 500 (blue line) since the March 9, 2009 low in stocks. The Consumer Discretionary ETF is up by +89%, compared to +65% for the S&P 500 ETF. The third line (in green) at the bottom measures the relative strength between the two. As it rises, it indicates that the Consumer Discretionary sector is outperforming the broad market. Just yesterday, the relative strength line reached a new high for this cycle, meaning that the gap between the two continues to grow. While no two cycles are exactly the same, the strong performance of the consumer discretionary sector sure seems awfully familiar.

Keeping an Eye on the Baltic Dry Index

One of the many leading indicators we keep an eye on at Pinnacle is the Baltic Dry Index (BDI). The index tracks worldwide international shipping prices of dry bulk cargo. Since the dry bulk materials shipped serve as raw material inputs to the production of finished goods, the index tends to be a good barometer of global growth. During the Great Recession the BDI plummeted by nearly 95%, with much of the loss occurring on the back of the credit freeze that unfolded in the wake of the Lehman Brothers collapse. After a brutal decline, the index began climbing in early 2009, well in advance of the markets, and while most economic data being reported was still quite horrific. In other words, as advertised, it did a good job of leading the rebound in global growth off the bottom.

Lately this index has turned down, and in the process, it has broken the uptrend that had been in place since early 2009. This is not a particularly positive data point, but to keep things in perspective, this index is volatile, and we’ve already witnessed a few temporary and benign setbacks in the BDI during 2009. In addition, there are many other leading indices we follow that still look very healthy and imply further improvement in growth this year. Lastly, according to a recent report by Ned Davis Research, the BDI has a history of rallying at the start of the Chinese New Year, which is taking place this week. So perhaps the index is poised to snap back in line with other leading indicators we are following.

At Pinnacle, we don’t view any one data point as a reason to change our view or portfolio allocations. Instead, the weight of many data points will continue to drive our forecasts and investment decisions. For now we continue to think that the economy and markets will likely grind higher in the first half of 2010. That being said, we are paying close attention to this recent downturn in the Baltic Dry Index, and will be watching other leading indices very closely for any signs that our current forecast is breaking down.

Baltic Dry Index 2008-2010