On the Road Again

I will be leaving tomorrow morning to speak at the FPA NorCal conference in San Francisco. I understand the conference is sold out again this year and once again about 500 of the top financial planning professionals on the West Coast will attend. I will be speaking about tactical asset allocation as the financial planning industry remains fascinated by the idea that portfolios must be actively managed in order to earn returns in excess of what the market will give you. Many in the planning business still believe it is pointless to try to outperform the markets, although they seem to have no problem charging fees to basically earn the risk and reward that markets will give you for free. I understand that there are still many potential clients who are so overwhelmed by the investment process that they are gladly willing to pay for a firm to basically do what they could do on their own in about one hour. For those advisors who provide buy and hold asset allocation services and charge fees based on assets under management, I suppose the best I can say is congratulations…it's great work if you can get it.

I will be seeing and hearing from many of these advisors after my talk on Tuesday. I’m sorry but in my old age I just don’t believe that “managing client relationships” is the most important service we can provide when we are charged with constructing client portfolios. Yes, you have to be patient to be a successful investor, and yes that includes investors who are utilizing active investment strategies. We believe that excess returns are earned over time - defined as cyclical moves within longer term secular market cycles. Our preferred time horizon to make our bones is between one year and five years. This is completely different than buying and holding a diversified portfolio of asset classes and saying that market performance will be realized over your life expectancy.

When discussing our craft with my fellow planners I like to say that there are two unbreakable rules for successfully managing client relationships. Rule number one is to reduce client expectations as much as possible. Rule number two is to always, without fail, meet your clients’ reduced expectations. The problem with buy and hold investing is that it takes this set of rules too far. By promising expected returns in a time horizon that is so long that it is meaningless, the bar is set too low. The result is that client expectations will always be met…and that is the problem. When investment professionals stop trying to beat the market and get paid to advise their clients to be patient, I believe that consumers should revolt. I can’t wait to mix it up in San Francisco. It should be a lot of fun.

Update on Sector Performance

In recent communications, we’ve been highlighting how a notable sector leadership shift has occurred this year in which defensive sectors have risen to the top. I thought I’d use today’s entry to provide an update on the latest trends.

In short, we’re continuing to see outperformance by defensive areas of the market. The table below displays sector performance (using sector ETFs) since March 16th, which is when the S&P made its 2011 low. The index is up by about 5% since then (although it’s down by about 3% so far in May). As shown, only one cyclical sector (Consumer Discretionary) is ahead of the S&P since mid-March as defensives have asserted themselves.

We’re not entirely sure what to make of the rotation to defensives at this point. Either the bull market is simply transitioning to a more mature phase where gains continue but at a more modest pace, or investors may be positioning for the possibility of a volatile summer following the end of QE2 in June. We continue to really like parts of the defensive trade, but are a little cautious in the very short-term due to the degree of the recent run-up.

Sector Performance 3/16 - 5/25
Sector	ETF	Return
Telecom	IYZ	13.6%
Health Care	XLV	13.2%
Consumer Staples	XLP	11.1%
Utilities	XLU	9.6%
Consumer Discretionary	XLY	6.1%
S&P 500	SPY	5.4%
Materials	XLB	5.3%
Industrials	XLI	5.0%
Technology	IYW	3.6%
Energy	XLE	3.1%
Financials	XLF	-2.3%

Watching for Signs of European Banking Risk

The PIIGS (Portugal, Italy, Ireland, Greece, and Spain) simply can’t get out of the news lately, and the problems on the periphery of the Euro-Zone continue to create uncertainty and legitimate risk for financial markets. Debt downgrades by ratings agencies as well as the threat of restructuring, reprofiling, or just plain old default continues to hover over markets. The amount of world GDP being generated by each country is not very large, but the fat tail risk lies within the European banks that own the debt, and the possibility of cracks developing in the financial system should defaults begin to occur.

Given the problems in Europe, we are watching certain credit spreads that we believe will act as canaries in the coal mine if banking stress begins to build there. The Euribor/OIS (Overnight Index Swap) spread is one metric we are monitoring. The spread essentially compares the estimate of the effective Federal Funds rate over a given period of time (in this case three months) to the short-term rates that European banks charge each other. If the spread is widening (rising), it is one sign that there may be interbank lending stress in the system. When the spread is falling or stable, less stress is evident.

Lately the three month spread has risen off of a very low base, but hasn’t climbed back to retest the peak level from last summer, and is nowhere near the level reached during the credit crisis of 2008. The message from this indicator is that banking stress is currently contained, but it is something we’ll be keeping a close eye on given the deteriorating situation in Europe.

Divergences Among LEIs

We regularly follow several different types of leading economic indicators (LEIs), often times looking for divergences with the stock market – in either direction. What we’re witnessing today, ironically, is a divergence among LEIs, which makes interpretation more difficult than when they’re moving in a more uniform fashion.

In the chart below (warning – it’s a bit messy) are three of the LEIs that we follow, along with the S&P 500 Index (white line). In general, all three LEIs have risen for the past two years, confirming the bull market in stocks that began in March 2009. Now, however, some potentially concerning breakdowns are starting to occur.

The most disturbing is the downturn in the Citigroup Economic Surprise Index (yellow line), which is a daily gauge of whether economic reports are exceeding or missing consensus estimates. The index has plunged almost to its low from last year, which came on the heels of the Euro debt crisis and subsequent economic slowdown. The main difference is that when this index was at a similar reading last August, the S&P had already experienced a -16% decline and was beginning to bounce, whereas now stock are only slightly below their recent high. So, the current reading can be interpreted in two very different ways – the bullish view being that the market continues to be impressively resilient and confound the pessimists, and the bearish angle being that the Citi Index is foreshadowing another steep decline in stocks that just hasn’t occurred yet.

The other two lines on the chart are much less alarming. The orange line is the ECRI Weekly Leading Index, which has dipped a little recently but not by much. The green line is the Conference Board’s monthly Leading Economic Index, which was released yesterday for April and showed just a minor tick down from March. At the very least, it’s noteworthy that none of the three are still rising, and stocks have at a minimum stalled near their recent highs. But it’s still too soon to know which of the three LEIs is sending the right message.

Data Confirms Soft Patch, Market Shrugs

Economic data published today brought more evidence that a soft patch in the economy has arrived. Today brought the sixth straight week of initial unemployment claims above 400,000, the Conference Board’s Leading Economic Index fell more than expected with a -0.3% decline in April, existing home sales were subpar again, and the Philadelphia Fed manufacturing survey came in much less than expected. The good news contained in the Philly Fed report was that the prices paid measure fell and that the number of employees went up materially. The bad news was that new orders fell considerably, unfilled orders actually contracted, and the average workweek declined markedly.

The odd thing about the day was that markets appeared to shrug off the data, and the Dow Transportation Average, typically a good growth barometer, had a good day. Could it be that the commodity correction we’ve had is already enough to refresh the economy?  I'd like to believe that markets are already looking through the soft patch and pricing in a reacceleration of economic growth, but I think it’s way too early in the slowdown to get complacent right here...

Another Little Sign

Is a bigger market sell-off coming? We are currently debating this question in our investment team meetings, and the answer is not entirely clear at the moment. However, there are technical signs that are starting to emerge which are unsettling to the bulls on the team. We have written before on the deterioration in the commodity markets and specifically the copper market which tends to lead stocks, and also the relative weakness in emerging market stocks. In addition, the relative outperformance of the non-cyclical sectors of the market which Carl wrote about last month has continued with increasing momentum. Finally, we have reached the season of selling as the old adage states that it's time to “Sell in May, and Go Away.”

Now a new, albeit smaller, sign has recently caught our eye. The chart below shows the percentage of stocks trading above their 200-day moving average (MA) on the NYSE. The 200-day MA is generally considered the long term average to determine the health of the stock market, and the chart is showing a couple of short term concerns. The first concern is that the amount of stocks over their 200-day MA was unable to break the February peak as the price of stock indexes broke out to new highs (called a bearish divergence). The second concern is that the number has broken below the March low, and now stands at a new 2011 low of 68% of stocks trading above their longer-term MAs.

The evidence still leans bullish overall as the long term trend is still healthy, momentum has not entered bearish territory, and most breadth indicators have not deteriorated. But more cracks are starting to appear. As a result we have started our sequencing process which Ken wrote about on Monday, and we will continue to monitor the health of the market in hope that the cracks will heal. But since hope is not an investment strategy, we will be prepared to act if necessary.

Sequencing

Lately I’ve been reading a lot about sequencing. The term is used in reference to how the Federal Reserve might go about communicating and then changing current monetary policy. The sequencing might go something like this: 1) The Fed ends quantitative easing as scheduled by the end of June but announces that it will continue to reinvest maturing bonds in U.S. Treasury securities, thereby keeping its balance sheet from shrinking, 2) Two months later the Fed announces that it will no longer reinvest bond proceeds and allow its balance sheet to gradually shrink, 3) Two months later the Fed changes the language in its monthly statement so that it no longer implies short-term interest rates won’t change in the foreseeable future, and 4) Sometime in the first quarter of 2012 the Fed raises short-term interest rates for the first of many increases to occur during the year. Of course, no one really knows if this sequence is correct and we suspect that the Fed, like everyone else, will react to economic data as it develops.

We have been having our own discussions about sequencing in the investment team over the past few weeks. Recent events have us pondering the possibility that the economy will slow to the point that it will impact risk markets. The signs are there if you care to see them. They include the commodities market imploding last week, bonds rallying, QE2 inexorably ending in June and market participants wondering if the risk markets are beginning to price this into current prices, the Arab “spring” beginning to look a little “chilly,” the dollar showing signs of rallying, unemployment claims spiking up again recently, and leading economic indicators showing signs of slowing. All of the above may be nothing more than the “wall of worry” that bull markets always climb. After all, earnings continue to come roaring in and this quarter looks like another slam dunk for corporate America. But still…we’ve been thinking about how we might take risk off if necessary.

The sequencing might go something like this. First we are selling our Germany ETF in DA and DUA portfolios and preparing to sell our commodity futures position in all portfolios as soon as this week. Next we rotate to more defensive industries within our cyclical sectors like Energy, Tech, Consumer Discretionary, etc. Next we rotate from cyclicals to defensive sectors like Health Care, Staples, and Utilities. Finally we rotate from defensive equity sectors to cash. A similar sequencing will occur in the fixed income allocations of our portfolios but we haven’t really focused on those discussions just yet. Sequencing seems to be the name of the game of late.

The Strange Case of Two Unloved Secular Stories

I find it interesting that Pinnacle is currently underinvested in two long-term or secular themes. One is the China growth story and by extension, our investment in emerging market ETFs and funds. The second is the commodity bull market story. Notably both themes are related to the other in obvious ways since China is the world’s largest importer of commodities. Also notable is that we think both ideas are largely correct. China will be a leader of global economic growth for years to come and in a world of increasing scarcity commodity prices should continue higher over time. The reasons we are underweight are somewhat complicated.

China is currently fighting a battle with food and energy inflation as well as a real estate bubble. Chinese policymakers have been tightening monetary policy in order to slow the economy and prevent an asset bubble from harming the economy. We have been commenting that Chinese policy is out of sync with much more accommodative U.S. monetary policy with the result being that Chinese and other emerging markets are under performing the U.S. stock market this year. As China and other emerging markets tighten policy and slow economic growth, commodity prices will also have to adjust to slower growth. In addition, the U.S. Federal Reserve is due to stop buying Treasuries and complete their quantitative easing program this June. If less accommodative U.S. monetary policy results in slower U.S. growth that should be a headwind for commodity prices as well. If the Fed ends up raising interest rates early next year that could result in a stronger dollar which might also result in lower commodity prices. In fact, we believe the dollar is currently oversold so any short-term bounce could further weaken commodity prices adding to the devastating price declines last week.

As tactical investors we invest our portfolios in a time frame that is much shorter than the secular or long-term time horizons required for many investment themes to mature. No doubt we will soon find a way to reenter both the emerging markets and the commodity markets since it is clear that there is a long-term story for both that deserves to be invested. But for now, we seem to be content to watch both stories from the sidelines. We have established target prices to sell our commodity position. Hopefully commodity prices will rebound from last week’s disaster and we will get to sell at the top of our target range. We do participate in both themes (China and commodities) indirectly by owning gold, energy stocks, international funds that own companies that do business with China, and U.S. stocks that derive a large percentage of earnings from emerging markets generally and specifically China.

Soft Patch Upon Us

A number of indicators have led us to believe that the economy is probably slowing at the moment. For example, regional manufacturing surveys have been trending down recently, unemployment insurance claims may have broken their previous downtrend, the Economic Cycle Research Institute recently issued a warning based on their Long Leading Index, defensive equity sectors have been outperforming, commodities took a big hit last week, and treasury bonds have been rallying. On balance, it would seem that recent evidence is pointing to an ebbing in global growth.

Some slowing doesn’t have to be catastrophic, and could have the positive side effect of reducing commodity prices (which should help profit margin pressures that were building) and giving the Federal Reserve plenty of reason to remain accommodative, or dare I say an excuse to implement a QE3 program? In other words, this could be the elixir that leads to one last leg higher for the equity market. On the other hand, any time growth begins to slow investors should be on guard for worse than a benign outcome, and we will be keeping our antenna up in case an easing in growth looks like it’s becoming material, and of a more malignant nature.

From a positioning standpoint, we are now focusing on our commodity positions, which don’t seem like a good bet if growth is slowing. In the very short term they are likely oversold after last week and could bounce. If we get it, we think it will be a good chance to sell. We are also taking a look at some of our high beta positions, and will be scrutinizing our bond exposure given a slower growth environment since we are currently underweight duration. We don’t feel it’s time to adopt a maximum defensive posture yet, but some minor adjustments and a close eye on incoming data is the order of the day.

Employment Gains Continue

With recent economic data turning decidedly mixed, raising concerns about the possibility of another economic slowdown similar to the one experienced last spring and summer, it was encouraging to see the monthly employment report released this morning surpass expectations.

Total nonfarm payrolls grew by 244,000 in April, handily beating expectations for a lesser gain of 185,000. Private payrolls turned in an even better performance, expanding by 268,000, which was well ahead of estimates of a 200,000 job increase. Private payrolls are now at their highest level since March of 2006.

While it’s encouraging to see employment continuing to achieve steady, although still somewhat lackluster, progress, we also need to keep a close eye on leading economic indicators, some of which have suddenly stalled a bit. But overall, today’s report was good news, as increased hiring should be a key factor in bolstering consumer spending and extending the current expansion.

Out With Commodities?

Commodities have certainly been on the mind of investors as price gains have been astronomical since a big correction early in 2010. Agriculture stocks were up 70% since then to their recent highs, silver was up just shy of 100%, and even broad commodity indexes were up 37%. These are amazing price moves which have initiated talk of bubbles in the commodity space (which is certainly warranted regarding silver). And perhaps we have begun the inevitable bursting of the bubble as commodity prices have been plunging over the last few days. However, a look into the recent past may put this decline into context.

The chart below is a price chart of DJP (the DJ/UBS Commodity Index ETN) from 12/31/10 to 5/5/11. You can see at the far right that commodity prices have fallen 7.65% in just four trading days. This drop is definitely newsworthy, and could be the harbinger of things to come in commodity prices, but look to the left of the chart. As recently as March, commodities fell 8.09% in five trading days, and from that drop in price preceded to rally 12.02% over the next two months. So this correction is not out of the norm so far and could provide an opportunity to add to current commodity positions. At Pinnacle we are watching the commodity space intently, and having discussions regarding whether to make any adjustments to our commodity positions as I write this entry.

Anecdotally, in 2007, Blackstone Group issued their Initial Public Offering very close to the top of the buyout binge America craved in the 2002-07 bull market. Fast forward to today and Glencore could mark the top of the commodity craze that has led the market higher since 2009. Glencore is the leading integrated producer and marketer of commodities in the world. Only time will tell if the next bear market is about to begin but the similarity is eerie.

Interest Rates & Group Think

Today I had the chance to attend a CFA luncheon in Baltimore with Carl Noble where Jim Grant was the keynote speaker. For anyone not familiar with Jim Grant, he is a very accomplished writer, historian, and value investor, and he writes an excellent newsletter called Grant’s Interest Rate Observer. Jim is also an excellent speaker, and I would encourage anyone that gets the chance to go hear him pontificate about the markets in his very unique style.

As he has been for some time, Jim is bearish on bonds (he thinks yields will rise) and the U.S. dollar, and very bullish on the price of gold. On the topic of yields, we have shared his view that they will likely drift up if the economy stays supported, but have also acknowledged that the view certainly seems consensus at this point, which is a little bit worrisome from a contrarian investing standpoint. As I sat and watched the reaction to Grant’s view on rates, the feeling I got from being in the room was that most audience members agreed with what he was saying. I mean, who can’t see that rates at these levels can’t go much lower, right?

As it turned out, I got the last question of the day and had a chance to ask Jim what a contracting money multiplier and huge bank reserves meant to his view, because the behavior of these metrics might lead some people to believe that the U.S. is currently dealing with Japanese-like deflationary symptoms that could cause interest rates to stay low for a lot longer than most folks think is possible. Jim was undeterred and essentially believes that Japan’s cultural differences were the biggest reason for their lost decade, and he believes and sincerely hopes that we don’t head down the same economic path as Japan.

At the moment we continue to be positioned to benefit from higher rates, if for no other reason that our cyclical view is for continuing economic expansion, and investors had piled into bonds in the Great Recession and may still be unwinding that trade. But I have to admit that I occasionally get the nagging feeling that current "group think" is all for higher rates at the moment, which leaves the herd vulnerable to rates moving lower and staying there longer than most expect.

The Osama Bin Laden Bull Market

For many years I have punctuated many discussions about protecting against a market “melt up” by saying, “What would happen if we came in tomorrow and they captured Bin Laden?” Well, last night we found out that Bid Laden is dead. It is something of a surprise to me that as of 3:45 PM this afternoon the S&P 500 Index is actually down 4 points to a price of 1,361. This is just another example of why I find it impossible to explain market behavior on a day to day basis. Maybe the lack of investor enthusiasm has to do with today’s ISM (Institute of Supply Management) report which came in at 60 (above expectations) but with the prices paid component also above expectations. Prices paid is an indicator of inflation in the pipeline so maybe investors remain spooked about what happens when the Fed stops the QE2 program. I don’t know. I would have thought that getting Bin Laden would have people feeling good about the country and that would have led to a positive “Black Swan” surprise moment for stocks that would take the market up to sharply higher prices on the day. Wrong.

Of course this isn’t the first time I’ve been wrong about how events have played out in the market recently. I freely admit to thinking that the Japanese nuclear disaster would lead to significantly lower stock prices as investors worried about the impact of slower Japanese GDP growth as radioactive water was leaking into the ocean. I could visualize mass selling while radioactive clouds drifted over Tokyo. It turns out that investors were unimpressed by that particular event as well. Stock prices have pretty much headed higher since the tsunami/earthquake/nuclear event on March 12th. In the U.S., stocks fell 3% in two days following the disaster but from March 16th to April 29th they have gained 8.74%. Apparently bad news won’t shake the bullishness from the market, but good news doesn’t seem to be able to move the market to extremes, either.

At a March 12th meeting of Pinnacle’s investment analysts, it was explained to me that Japan was such a small part of the geopolitical puzzle that the unlikely event of a full nuclear meltdown would have little impact on global financial markets. Today we must conclude that Bin Laden’s death is also being discounted as being irrelevant to the health of the global economy. Either he is presumed to not be a relevant force within al Qaeda, or al Qaeda is presumed not to be a relevant force, or….well…I don’t know. At any rate, now I’m going to have to think of a different positive Black Swan event to use as my example for what happens when unexpectedly good news hits the markets.