In Celebration of Market Timing

I am a market timer. I reduce portfolio risk and earn excess returns by selling securities that are overvalued and buying securities with the proceeds that are undervalued. Once I couple the purchase of a security with the sale of the security, I am no longer a buy and hold investor, and I must cheerfully and defiantly define myself as a market timer. In making this statement, I am joining the ranks of the most reviled investors on the planet, all of whom are considered to be uneducated, easily swayed by investment fads and mass media, and most importantly, are doomed to fail in their investment strategy. The reason for certain failure is that, unlike buy and hold investors, the decision to sell based on the valuation of securities is fraught with risk that timers will improperly assess value and sell too early or too late. On the other hand, buy and hold investors live in a mythical world of certainty where security valuation doesn’t matter, and so they ignore valuation in their investment process. This leads to the somewhat ironic state of affairs where proud market timers who are using valuation to minimize portfolio risk are instead considered to be high risk investors, and buy and hold investors who ignore security valuation are considered to be risk averse.

We all realize that the popular perception of market timing is one where portfolios are traded in extremely short investment time frames, and portfolio diversification is considered irrelevant because investors are willing to take the risk of going to an all-cash position when they feel risk positions are unsafe. I happen to believe that this manifestation of market timing is a high risk strategy, but only because I don’t believe that investors should ever be 100% certain in their forecasts, and therefore being 100% in stocks or cash is a little too much risk for my taste. Nevertheless, the idea of being out of the market when it is deemed to be a high risk investment due to poor valuation deserves at least polite applause, regardless of the tactics that are employed.

To be a “market timer” is to join a group of investors that should be celebrating their determination to properly manage portfolio risk. I believe that searching for good values, coupled with portfolio diversification, are the two unbreakable rules of investing and the two tactics that can’t be ignored by investors in properly managing risk in their portfolios. So let’s hear it for the market timers out there. (If I were a musician I would make up a fight song for them.)

Steel Magnolias

For the calendar year 2009, steel stocks have the led the stock market higher. Most stocks in the sector have posted well over 100% gains. To put those gains in context though the stocks still need to rise another 250% to reach their May 2008 peak levels. Steel stocks sold off heavily last year before bottoming in November due to foreign countries glutting the market with excess supply, demand falling off a cliff because of the financial crisis, and profit margins eroding.

However, as the aftermath of the Lehman collapse has subsided, steel stocks have been the beneficiaries of many outside factors. Reflationary policies have been enacted in almost every market and fiscal programs of enormous size, specifically in China, have been supportive of the steel industry. In conjunction with the demand boost, steel companies have aggressively cut production to remove the inventory overhang and bottom line costs to stabilize profit margins.

This is a big reason why research firms including Ned Davis Research (NDR) have upgraded the industry to overweight positions. Analysts at NDR studied which stock market groups typically benefit the most when the economy begins to recover from a recession, which they believe is now occurring, and steel stocks were one of the top performers. With cheap valuations, inflation expectations rising, aggressive fiscal policies and perhaps a stabilization of the global economy it is no wonder the stocks have performed so well this year.

Time to Sell Treasury Bonds?

Treasury bonds have recently endured a vicious correction, with yields on 10-year Treasuries rising from an all-time low of 2.04% on December 18th to 3.94% yesterday (June 10th). Using an Exchange Traded Fund that invests in a portfolio of 7-10 year Treasury bonds (symbol: IEF) as a proxy, the total return loss in Treasury bonds during that time has been -10.3%. That’s not exactly the kind of return investors usually expect from a perceived “safe” investment like Treasury bonds.

What’s been behind the recent rout in Treasuries? For one thing, risk appetites have slowly been returning to normal as the economy seems to have passed the worst of the downdraft, allowing investors to gradually move out of Treasury securities and into higher yielding debt and stocks. In addition, it seems that bond investors have a few concerns these days that are causing them to demand a higher yield, including massive new issuance as the government borrows trillions of dollars to pay for all of the bailout efforts; fears of foreign countries with large Treasury holdings selling them to diversify into other securities; expectations of stronger economic growth in coming months; and inflation worries as oil and other commodities have rebounded of late.

So, should investors immediately sell all of their Treasury holdings? Is a return to the double-digit interest rates of the late 1970s & early 1980s right around the corner? We don’t think so. The size and scope of the financial collapse has created a tremendous amount of idle capacity in the global economy, and so we don’t think that inflation is an immediate threat. And, there’s still a lot of uncertainty about the economic outlook, despite some positive developments lately, meaning that any setback could cause another stampede back into the safety of Treasury bonds. We think there’s a better chance that bonds will trade in a wide range, similar to what we believe may be in store for the stock market, with large moves in both directions as the economy works through a bottoming process. In short, we’re still confident that Treasuries play an important role in a diversified portfolio – for now, anyway.

Behind the Numbers – Non-Farm Payrolls and the Net Birth/Death Model

Last Friday’s headline payroll number was a bad one when viewed on an absolute basis, but it was much better number than expectations (-345,000 actual job losses in May vs. -520,000 expected). As one picks through the report, there appears to be a little something for everyone. The bears can hold onto an unemployment rate of 9.4% (with the comprehensive U-6 version over 16%), a workweek that is at all-time lows, average hourly earnings that are at the worst levels since 2005, and a household survey that was even worse than the establishment survey that garnered the headlines. The bulls, on the other hand, should be quick to point out that the jobs number was the best since late last fall, that most components are showing considerably smaller losses than the average for last year, that both March and April losses were revised down (which breaks the downtrend), that temporary and retail employment (which are usually leading in their nature) were up, and that the unemployment rate is always a lagging indicator that will be viewed by markets in the rearview mirror.

One of the oddities buried within the payroll report is something called the CES Net Birth/Death Model. It’s a statistical model that was created to reduce a known source of sampling error within the report. The payroll survey can’t capture on a timely basis changes in employment generated by either new or terminated businesses due to the time lag between businesses being created and destroyed, and the time it takes for them to be included in the survey. To adjust for this flaw, the Bureau of Labor Statistics, which is the government agency responsible for tracking employment data, developed a model to approximate how many new businesses were created (birth) or destroyed (death) each month. The latest report showed 220,000 of these jobs were created during May (see chart below), which is the highest ever in the month of May. Bears and conspiracy theorists have been pointing out that these birth numbers at best fly in the face of common sense, and at worst are an attempt by the government to cover up how bad the job market really is. The bulls would say that for all the quirks and flaws in this report, perhaps the only message that matters is that the labor market appears to be stabilizing along with credit, housing, and the overall economy. There is a saying that that beauty is in the eye of the beholder, and I guess the same is true of the latest employment report…

Source: Bureau of Labor Statistics

“Let’s Suppose” and the “Equals” Sign

It turns out that two of the most destructive forces for the economy are the words “let’s suppose” and the use of the = sign. When we put the two together they form a combustible combination that gives seemingly well intentioned and rational investors the power to disintegrate assets “at will.” This is because investors have a desperate need for quantitative models that will justify and “prove” their investment thesis, if for no other reason than it provides much better job security than having an investment thesis based on their good judgment and common sense. Unfortunately, this state of affairs gives rise to some of the most egregious misuses of the scientific method that one could imagine.

For example, let’s suppose that 8 pumpkin pies = ½ of a new Cadillac CTS. Therefore, 16 pumpkin pies = 1 Cadillac CTS. Why not? As I sit in my office, I suppose that 1 lamp = 1 roll of tape, and therefore if I buy 5 rolls of tape the equation is 5 rolls of tape = 1 current lamp + 4 more lamps. When we “suppose” in order to use an = sign we turn outrageous and silly statements into a scientific formula that sounds persuasive. Let’s try some other assumptions on for size with an = sign to follow. Let’s suppose that investors have perfect structural knowledge, meaning that they know why prices change today and in the future. Let’s also suppose that they have perfect economic foresight, meaning that they perfectly know how current news will impact future prices. Then our equation becomes today’s prices + news = future prices. It may sound impressive, but we might as well be talking about pumpkins and Cadillacs. Assumptions like these must carry a high burden of proof that they are correct.

How about these assumptions? U.S. residential real estate prices never go down in value. Markets always function normally so standard deviation properly measures risk. Investor behavior doesn’t impact markets so price changes can be measured by the same method used to measure the movement of grains of pollen in water (Brownian Motion). Or, the market is always in equilibrium except for the news, investors have the same risk tolerance, the same access to information, the same indifference to taxes, investors can borrow at the risk-free rate….and on and on. These are the basic assumptions used to justify the rational expectations pricing model, which is known to most investors as the efficient markets hypothesis. It is a powerful and troubling example of what happens when the words “let’s suppose” get followed by an = sign. It is usually a recipe for financial mischief of all kinds. Our world is full of quantitative models used to justify investment decisions. Investors must beware of the assumptions in these models.

UNG Showing Signs of Life

Watching the commodity markets come alive during the reflation trade in the last few weeks one commodity in particular has caught our attention. The UNG is an ETF that tracks the performance of Natural Gas prices. In a ten month span from July 2008 to April 2009 the price of Natural Gas dropped almost 80%. Below is the chart of the UNG through 6/2/2009.

Our research of an investment idea typically involves both fundamental and technical analysis. From a technical standpoint the chart looks very encouraging. There are three attractive features on this chart. The first is that the ETF seems to have formed a double bottom with a supportive higher low. By this I mean that the low of $13 at the end of April was not breached when the price fell again at the end of May closing at $13.70, at which point the price rallied. The second is the rising volume through this bottoming process. Marked by the pink arrow, on up days the volume has been very heavy, indicative of strong interest by major players. The third is the breach of the 50-day moving average of its price. There was a false breakout above this moving average during the April bounce, however the 20-day moving average (not shown) has moved above the 50-day, which has not occurred since the middle of July 2008, which indicates accelerating shorter-term momentum.

Using two widely accepted upside targets we can see a lot of upside potential if the technical data proves to be supportive. The 200-day moving average is currently at $23.25 which is 50% above current prices, and even higher is a 50% Fibonacci retracement at $38 on the ETF. So with strong technical data and nice upside possibilities, it’s time to dig into the fundamentals. Stay tuned…

A Strong Bottom of the Order

Long-suffering Orioles fans are enjoying an improbable turn of events. Even though the top five batters in the Orioles’ lineup have scored more runs than the top of any other lineup in baseball (I’m pretty sure about this…just go with me here), lately it’s the very bottom of the lineup that’s causing all of the excitement. Last week 40,000 fans showed up to welcome rookie phenom, Matt Wieters, to the big leagues. However, other players like Luke Scott, Nolan Reimold, and Cesar Izturis have been lighting it up for the past several weeks, allowing the top of the lineup to come back to earth in terms of its otherworldly performance, and providing a lot of excitement for fans who appreciate the benefits of a strong lineup from the top to the bottom.

During the month of May, it turns out that the bottom of Pinnacle’s portfolio “lineup” also had a superior month, as our alternative investment and other typically less volatile holdings turned in some excellent performance. While all of the attention has been on the middle of the lineup, meaning the performance of the stock market during the rally that began on March 9, 2009, during the month of May it was the unsung heroes of the portfolio that played catch-up, aided no doubt by the falling dollar. Our conservative international value funds, gold, commodities, and many of our managed funds in the alternatives group, all outperformed during the month. There are many factors that impact the relative performance of these presumably non-correlated and low correlated asset classes, but for the moment, Pinnacle investors are benefiting from a strong bottom of the lineup. When you consider how well the middle of the lineup, namely our U.S. equity positions, have performed for the past 7 weeks, it’s easy to see why investors feel a little better about their portfolio values of late. It’s also easy to see why adding portfolio volatility/risk on the basis of low correlations can be a risky proposition in itself. What goes up together can go down together, but that’s a story for a different blog post.

The following chart shows the performance of Pinnacle’s alternative investments and conservative international funds for the month of May: