No Buyers Left For Gold

Sentiment is the attitude of the investing community towards the anticipated price action of a particular security. For instance, if the investing community thinks that the price of the S&P 500 will go higher, sentiment is said to be bullish. There are various ways to monitor the sentiment of the market and these tools become very important, when used in conjunction with other market indicators, to determine important trend changes. Due to herd mentality (Psychology 101 will have to wait for another time), at important market peaks the overwhelming majority of investors have the same exact thought – that prices will go higher. It is at these moments that prices are most vulnerable because there are no buyers left. I think gold might have reached such a condition in December.

We have been noticing in the pit for awhile now the increasing amount of commercials about buying gold. No doubt you have seen at least 5 companies broadcast to the world that they want to buy your gold. We even saw an actor from the movie Good Will Hunting in one of the commercials. Gold’s surge in price has certainly attracted interest and there is a huge amount conviction among investors that this price appreciation will continue. Jack Crooks from Black Swan Capital provided us with some anecdotal evidence that the majority of the attendees believed this to be true during a recent currency conference. In this light, it is understandable that gold moved lower over the last two months.

At Pinnacle, we've invested in gold for a variety of reasons including but not limited to hedging sovereign risk, hedging currency concerns, and future inflation concerns. We also believe gold will be an outright performer during this cycle, and therefore deserves more than the hedge label. So even though we cringe a little at the sight of gold commercials we continue to view the recent decline as a price correction in a long-term bull trend. However, we will be closely monitoring important support levels to ensure we are not trampled by the herd as well.

Markets Hate Uncertainty

One thing financial markets least like is the cloud of uncertainty that can occasionally surround key issues and fundamental drivers in the marketplace. Lately, there has been increasing uncertainty on a number fronts. I mentioned several of them in a blog post last Friday, including newly proposed bank regulations, sovereign debt concerns in parts of the Euro-zone, and monetary tightening in China. Another that I failed to mention in that piece, but appears to have been an additional catalyst late last Friday, was the doubt that crept into the market regarding Ben Bernanke’s reappointment as Chairman of the Federal Reserve.

Bernanke appeared to have locked up reappointment in December, as the Senate banking committee approved by a 16-7 vote to bring back “Helicopter Ben” for another term. At the time there were some senators that opined that the chairman should lose some of his power going forward, but the assumption was that there would be continuity in terms of who would be leading the Federal Reserve. However, recent political shifting in the wake of the Massachusetts Senate election brought back some doubt in regards to this issue. As political agendas appear to be shifting from health care to Wall Street bashing, last week a number of senators began to circulate the idea that Bernanke’s nomination was no lock. As they did so, the doubt in regards to Chairman Bernanke’s future could be clearly seen in the pricing of future contracts at Intrade.com, which is an online prediction market that allows members to speculate on non sports-related future events (top chart below). As speculators downgraded the possibility of Bernanke’s return, the S&P 500 Index seemed to follow suit (bottom chart below).

While it’s impossible to prove that the uncertainty regarding the Chairman’s reappointment was the primary cause of the S&P drop, it seems reasonable to assume that it was at least a partial contributor to the increased volatility we experienced last week. At Pinnacle we realize that there are many intertwined cross currents that affect market prices, and with stocks appearing to be short-term overbought, it may have just been that investors were looking for any catalyst to purge some of the recent complacency out of the market. Whatever the true reason, to us it was another reminder of how the markets hate uncertainty.

The Great Rotation

For those who give a lot of weight to the “January effect,” and believe that the first few weeks of stock market performance in any year is a good barometer of what to expect for the remainder of the year, last week sets up a major disappointment brewing in 2010. The S&P 500 Index with dividends reinvested closed the week down -1.99% from the beginning of the year and the most cyclical sectors of the market were further in negative territory. Semiconductors have had the most auspicious start to the year closing the week down -8.65% since January 1.

The investment team continues to examine our base case that the broad market can grind higher through the first half of the year based on the proposition that the economy is expanding and stocks should outperform. Our stated range for the S&P 500 to the upside remains at 1,200 - 1,300, even though we acknowledge that the stock market is, and has been, due for a correction within this cyclical bull market. Last week’s market performance can certainly be viewed in the light of a long-expected correction that, if recent history is any guide, will turn around long before the broad market reaches its 200-day moving average.

Nevertheless, we are prepared to begin rotating the portfolio out of the more volatile and cyclical sectors of the market and into more defensive sectors if and when the market moves higher. Last week we began the process with sales of our energy services position, a trim of metals and mining, and the sale of our remaining ETF positions in high-yield bonds in favor of a more conservative high-yield bond fund. We expect that this rotation could result in significant changes in U.S. sector allocations throughout the first part of the year. In-house we call it “the Great Rotation.” Of course, there is the possibility that last week was the beginning of a new cyclical bear market that will take the broad market down towards the lows set last March. If that is the case, we are satisfied that our current portfolio construction will defend a significant market decline should it appear from here.

Overdue Correction or Something Bigger?

The markets have had a few big down days recently based on fears of liquidity withdrawal, overly-restrictive new financial regulations, and overseas stress emanating from the region of the PIIGS (Portugal, Italy, Ireland, Greece, Spain). Naturally, thoughts of how big this latest correction might be are swirling through the minds of investors.

That we are having a correction is not very surprising. The current bull market rally started in March, and is up by a whopping 73% since then (using the S&P 500 Index). Meanwhile, the worst correction we’ve had so far was about -6.5% over several weeks last June. Throughout the rally we’ve watched credit markets stabilize, many measures of domestic and global growth have rebounded, and earnings have surpassed overly pessimistic forecasts of Wall Street analysts. In addition, valuation has gone from cheap to slightly expensive, many shorter-term technical measures have gotten extended, and sentiment has shifted from too gloomy to quite complacent.

Investors are logically wondering if the market rally is over, or if it’s just a long overdue correction that will eventually be resolved by another leg higher. We’re currently siding with the latter. But we can’t allow ourselves to grow complacent, and as this correction unfolds we’ll be monitoring certain things. Specifically, we’ll be looking for credit spreads to stay contained, we’ll be watching the number of new 52-week lows in stocks, and we’ll be scrutinizing the economic data and fourth quarter earnings reports. We'll also be watching intently to see if technical damage from the decline begins to damage the positive longer-term trend that's currently in place. Should the weight of the evidence take a turn for the worse, then we’re prepared to change our view and alter portfolio allocations materially.

No one can ever know precisely whether a sudden decline is merely a short-term pullback, or something worse. But right now the weight of the evidence indicates that this is probably just an overdue correction within the current bull market. Stay tuned…

Leading Indicators Jump

The Conference Board’s Index of Leading Economic Indicators (LEI) was released today, and it was much stronger than expected. It rose 1.1% in December; economists forecasted only a 0.7% increase. In addition, the 6-month annualized increase held above 10% for the 4th straight month, after reaching 12.8% in September, which was the highest since 1983. And the 6-month diffusion index, which is simply the percentage of the ten underlying components that are higher than they were six months ago, remains at a very healthy 80%.

More interesting to us was that the detail of the report revealed that the gain was largely driven by three factors – the record-steep yield curve (shown as the “interest rate spread” on the table below), the recent increase in building permits, and the ongoing decline in initial jobless claims. This is significant, because when the LEI first began to turn higher in mid-2009, critics argued that it was entirely due to the financial components of the index (like stock prices and the money supply) while the economic components were dormant. So, it’s encouraging to see some of the economic factors joining the party.

No matter how you look at it, the LEI is sending a strong message that the economy is poised to continue to recover and grow for a least the next several months, if not longer.

Euro Breakdown

We’ve been watching with great interest, as have a lot of other investors and observers, the behavior of the euro over the past several weeks. It’s fallen rather quickly from $1.51 to $1.41 in that time. Today, it fell decisively through its 200-day moving average, which is widely watched as a longer-term trend indicator. The drop has largely been blamed on growing economic problems in that region, particularly in Greece, which is scrambling to try and repair its tattered public finances. The potential ramifications for the other eurozone countries, depending on how the Greece situation is ultimately resolved, has reached the point that many are starting to question the longer-term viability of that monetary union, and the euro as a common currency.

Why is this important to us? Well, the direction of the U.S. dollar is near the top of our list of things to watch in 2010. One of the key questions is whether it made an important bottom in 2008, when it rallied during the flight to safety caused by the financial crisis. Although it sold off again in 2009, it held above the 2008 lows, and has recently been rallying. We’ve been of the opinion that the structural headwinds facing the U.S. economy – bloated debt levels, large budget deficits, and high unemployment – would cause the dollar to resume its decline and eventually make new lows. But currencies are largely a relative game, and the severity of the problems faced by the other major industrialized economies (i.e., Europe and Japan) is causing us to reassess our view, and wonder if the greenback might continue to benefit from simply being the lesser evil.

Euro with 200-day moving average (blue line)

Sector Blow-out

If you happen to have a desire to sit down and wade through more than 400 PowerPoint slides about the ten different S&P market sectors, then you would love our investment team “sector-blowouts.” I have found through long experience that in order to properly prepare for two days of blowout meetings, one needs to stoke up on a lot of caffeine (in any form…I prefer Coca-Cola), you need to get a lot of sleep the night before, and occasionally you need to have emergency medical personnel standing by in case any one of the team members actually loses consciousness during the presentations.

Sector Blowouts occur once each quarter. Our analysts cover each S&P sector on a daily basis as a part of their on-going due diligence and we discuss opportunities and issues with each sector at our routine team meetings during the week. These discussions occur in the broad context of our discussing the entire portfolio, including macro-economic issues, fixed income, international markets, geopolitical issues, etc. However, we have found that it is helpful to occasionally meet to strictly focus on U.S. stock sectors and history informs us that our successful ability to rotate sectors to take advantage of changes in the market cycle has added to returns in the past. So once each quarter we tackle all of the sectors at once, which the analysts have aptly described as the “sector blowout.”

If you want to know about sector valuation based on mean reversion, forward P/Es, relative P/Es, or price to sales, price to book, and dividend yield. If you are interested in how a sector performs before and after the beginning of an economic expansion, or before or after the Fed has their first rate hike following a recession, or the relative weight of the sector in the overall S&P 500 Index, investors’ passion for a sector based on their ownership of overall sector funds, or the sector’s earnings to total S&P earnings. If you want to know the pricing power of a sector, its sensitivity to moves in currency, and the amount of earnings that are generated overseas, you will be in the right place. You might be entertained by knowing what our independent research is saying about each sector, how much we own in each sector, and the relative performance of each sector. You get all of this and more in a Pinnacle sector blowout. I’m sure that our analysts will be writing about sectors on the blog in the coming weeks. It’s all part of “doing the work” around here. Unless you are going to make portfolio decisions on a purely quantitative basis, I’m afraid it’s unavoidable. Just be prepared with the proper medical attention…just in case.

2010 Outlook

Apparently something odd happens at the beginning of each calendar year where all of the economic and market issues that created uncertainty in December suddenly are resolved. In January, it seems that all investment pundits, analysts, managers, newsletter writers, bloggers, and anyone else who cares to wade into the pool proudly announces their forecast for the upcoming year. Magically, all that was murky and unclear in December gets resolved and the forecasts stand as beacons of light in the uncertainty of the current market climate. The 2010 forecasts are, as usual, all over the map as some investors are looking for a continuation of the market rally that began last March, and others are convinced that the market is due for a severe sell-off.

Please forgive us for not participating in this exercise. The same issues that clouded our forecast a few weeks ago still seem unresolved to us, and the new calendar year hasn’t helped at all. We are continuing to focus on interest rates and the dollar, the sustainability of the economic recovery, and even if we are having a recovery at all given the problems with seasonally-adjusted economic data. We are discussing whether the Fed will follow through on their pledge to remove economic stimulus and whether the mortgage market and other credit markets will implode if the Fed takes away the punch bowl this year. Earnings are a continuing source of concern as we consider whether consensus forecasts for 2010 are too optimistic. Clearly some kind of transition must take place this year in terms of top-line growth for corporate America. There are a lot of moving parts and unresolved questions as we enter the New Year.

The thing is we are evaluating these issues in real time, looking at the data as it comes in and incorporating it into a thought process that gauges the probabilities of future events. What are the odds of a double-dip recession, $85 S&P operating earnings, a bottom in housing prices, a 2% Fed Funds rate, etc? As we consider the probabilities of these and many other events, it leads to incremental changes in our portfolio construction as we add or trim positions based on a high or low conviction forecast. At the moment, we think the odds of the S&P reaching 1,200 to 1,350 are at least 50-50, which leads us to have a neutral or benchmark level of risk in our managed accounts. Not surprisingly, this is the same positioning that we had two weeks ago. To say the odds of a continuing bull market is a 50-50 proposition is not exactly the kind of ringing endorsement of an investment view that investors want to hear in January. However, we think it’s the best we can do. If the data changes our outlook, or our conviction, our clients will be the first to know. They will see it in the transactions that are executed in their portfolio. We will leave the grandiose market prognostications to others.

Index Confirmation

The origin of technical analysis, or forecasting future price movements through patterns and trends, can be attributed to a few individuals. Charles Dow is generally considered to be the founder of modern technical analysis due to his work at the end of the 19th century. He wrote editorials in the Wall Street Journal which have now become collectively known as Dow Theory (he did not use this title). The theory assisted Charles in creating his famous indexes – the Dow Jones Industrial Average and the Dow Jones Transportation Index (formerly known as the Dow Jones Rail Index). There are six basic tenets of Dow Theory, and the two previously mentioned indexes are used to analyze one of them.

One important condition under Dow Theory is that markets must “confirm” each other. Dow argued in his editorials that markets reflect business conditions and by analyzing the markets, one could determine the likely course for stock prices. Dow stated that if business conditions are good, then companies will produce more goods. Then they would have to ship more goods to consumers by using the rails, or any other transportation method. Therefore, the two averages that he created will move in the same direction to confirm an existing trend. If the averages do not confirm, or move in the same direction, then the prevailing trend should be questioned.

The chart below shows the Dow Jones Industrial Avg. (white line) and the Dow Jones Transportation Index (brown line) from September 2009 through today. For roughly two months, the DJIA traded in a range between 10,300 and 10,500, but broke above the resistance line in red at the end of 2009. A few weeks later, the Transportation Index created a range between 4,100 and 4,200, but recently this index also moved above resistance (green line). Therefore, the two averages have “confirmed” each other, which tends to be a reliable signal that the existing trend will continue. Of course, this is only one of the six basic tenets!

“DIVEST”

I was somewhat surprised that the movie critic for the Washington Post recently named Pixar’s Finding Nemo as the most important movie of the decade. I just watched it again and my favorite character is Dory, a Regal Blue Tang fish played by Ellen DeGeneres, who has a very bad case of short-term memory loss. I won’t go on about the movie because you’ve already seen it, but I find myself identifying more and more with Dory and her memory issues. So, here is my acronym for helping you (and me) remember the most important investment issues to keep an eye on during the first half of 2010. Here it is…DIVEST.

D – Dollar: The dollar has been in a secular free-fall for years but rallied during the worst of the financial crisis on a flight to quality. The dollar has also been negatively correlated to the U.S. stock market for many years. Would a dollar rally on fears of European sovereign debt defaults cause a stock market sell-off?

I – Interest rates: The Fed has kept the funds rate at 0 to 0.25% and shows no signs of raising the rate anytime soon. However, if we get into the virtuous growth cycle that accompanies economic recoveries, will it force their hand?

V – Valuation: So far during the recovery earnings growth has outperformed expectations and the market’s P/E multiple is about fair. Based on normalized earnings the valuation is slightly expensive. If this rally continues will earnings keep pace or will we see bubble valuations as we progress through the year?

E – Earnings: Earnings growth has been fueled by sharp cuts in corporate spending. Investors are looking for the next phase of earnings growth to come from improving sales. Will consumers begin to spend again as we get further into an economic expansion, or will earnings falter as companies run out of costs to cut?

S – Stimulus: The Fed has expanded their balance sheet by more than a trillion dollars. The fiscal deficit is huge. Cash for clunkers, new home credits, etc., all contributed to economic growth. As these programs end during the year, can the financial markets continue to advance or was the 70% gain from the March low about all we can reasonably expect?

T – Technical Analysis: I would have rather just called this momentum, but the T worked well in my acronym. Will the market’s momentum continue to take prices higher regardless of the fundamentals discussed in DIVES? If not, then DIVES is what the stock market may do this year.

Year-end Thoughts on Correlation

I suppose I’m one of the most vocal critics of Modern Portfolio Theory (MPT), the body of academic work that lays the theoretical groundwork for today’s status quo method of portfolio construction, otherwise known as Strategic Asset Allocation. MPT is based on Harry Markowitz’s Nobel Prize winning paper, Portfolio Selection, in which he shows us how to craft “efficient portfolios” with the best or optimal mix of asset classes to earn the highest returns with the lowest amount of risk. I believe the investment industry has distorted Markowitz’s work over the years and the practical application of how it is used in portfolio construction is a scandal.

The secret sauce of Markowitz’s MPT formula is that by combining the correlation of returns with the standard deviation of returns, otherwise known as how asset class returns zig and zag with each other as well as how much asset class returns zig and zag by themselves, you can increase the returns of the portfolio at the same time that you reduce the risk of the portfolio. Of course, this all depends on a good forecast of zigging and zagging. As we close the books on 2009 Pinnacle investment performance, I’m struck by how Pinnacle analysts are forced to deal with MPT in the real, practical playing field of trying to deliver benchmark-beating performance. Because stocks and bonds are the only two asset classes in our benchmark, and because the S&P 500 Index (our stock proxy) is having an excellent year, we are forced to balance two important goals. One is to remain diversified in our portfolio construction as a matter of good risk management, and the other is to have enough risk or “juice” in the portfolio to outperform the S&P as our risk proxy in a bull market.

The problem, of course, is that the two goals can be mutually exclusive in the short-term. If we succeed in providing effective diversification, then the high octane securities we own to beat the S&P may zig and zag at precisely the wrong time, creating a situation where the portfolio has less volatility overall, but delivers lower performance…in the short-term. As we watch the performance of commodities, gold, the dollar, and international stock positions as we approach year-end, we only know that they are volatile enough by themselves to outperform the stock market. We can’t know if they will move up or down on the same days as the U.S. stock market, an unfortunate state of affairs if we are only focused on relative returns. At worst, we should end the year with about the same returns as our benchmarks but we will have done so with significantly less portfolio volatility.