Paul McCulley Strikes Again

Paul McCulley is the managing director of Pimco (Pacific Investment Management Co., one of the largest bond investors in the world) and each month he writes a piece called Global Central Bank Focus. This month, in an essay called, “Because I Said So...,” McCulley discusses the “old” rules for Central Bank policy for fighting inflation and relates the “new rules” for inflation fighting to parents who sometimes tell their children, “Because I said so.” I can’t do full justice to the piece on the blog so please read it for yourself at:

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/McCulley+Sept+Because+I+Said+So.htm

For those of you who are not economic wonks, McCulley reminds us that for many decades our central bank has targeted inflation without regard to the prices of assets or the impact of potential future asset bubbles. The rule for inflation targeting is called The Taylor Rule after economist John Taylor. The rule suggests the elements for the inflation targeting equation are: 1) The neutral rate of inflation that would theoretically exist if inflation and employment were both at “target,” 2) The inflation rate itself, 3) The gap between actual inflation and target inflation, and 4) the gap between the actual unemployment rate and the theoretical “full” unemployment rate. McCulley points out that asset prices are nowhere to be found in this equation for targeting inflation, and that U.S. central bank policy has been to suggest that asset prices are implied by the other inputs to the Taylor Rule, so the Federal Reserve doesn’t need to forecast asset bubbles as they appear in the economy. The stated policy is to wait for the bubbles to burst and then use a “mop up” strategy when the bubbles actually do burst.

Well….its clear that something has to change in our approach to asset bubbles, and McCulley opines that in the future the Fed will have to take a countercyclical approach to policy that “leans against” boom bust cycles by changing capital/margin requirements for banks and by reforming the bankruptcy laws. But what really caught my eye were McCulley’s final thoughts about forecasting asset bubbles and creating new paths for central bank policy, since forecasting is a subject we spend a great deal of time studying here at Pinnacle. He says, “Yes, that will sometimes mean taking action that is not fully anticipated, based on old rules of the game. But just like parents, central banks (read money managers) must exercise judgment, and sometimes, good judgment does involve making decisions on the basis of where the gut says the brain is going.” Thanks, Paul. I couldn’t have said it better myself!

End of another Program

On September 19, 2008 the money market guarantee program was instituted following the Reserve Primary Fund breaking its $1 Net Asset Value. The program covered all money market mutual funds regulated under the Investment Act of 1940 which maintained a stable share price of $1. In essence the government was trying to calm investor fears after the second $1 break in US history, and prevent a strong run on the banking system. Broker dealers bought into the system and it worked well enough to prompt an extension of the program. Now that program is set to expire on September 19, 2009.

Currently there is $3.5 trillion invested in money market funds. The average money market, seven-day compounded yield is .06% according to the Money Fund Report. The government has hopes the program will slide out of existence under the radar but I don’t think that will be the case. For the past few weeks the dollar has been hammered, gold and commodities have soared, while bonds have remained relatively flat to up. With the enormous amount of cash in the money market funds, and the incredibly pathetic yield, perhaps treasuries are being bid to secure the government guarantee that is set to expire. We shall keep our eyes open on the 19th to see if it does indeed slowly fade into the night.

Go-Go-Go-Go-Go-Go GOLD!!

The world is going wild as gold continues to grind higher, and many believe this is just the beginning of a strong bull market. Gold has constantly been in the news and rightfully so. The Chinese have for a very long time expressed concern about the dollar as the world’s reserve currency, and now the United Nations has joined the parade. It has been acknowledged that the Chinese are even looking to invest in gold on dips to diversify their reserves. The developed world has started to fiscally destruct and the aftermath of the implosion of the western banking system is still being felt. Gold has so many benefits that make it appealing during these uncertain times. It offers protection from risk aversion and currency devaluation, defense against inflation and monetary experiments.

With this backdrop, over the last week gold has broken out to the bullish side of a technical trading pattern called a pennant (indicated by the white lines in the chart below). This suggests good things to come for the precious metal as the technicians are looking for a $60 gain on that breakout. Additionally, the widespread media coverage could lure investors to the metal and give another boost. But the bulls have to contend with a strong ceiling as gold is failing to hold $1000 per ounce for the second time this year (the horizontal red line). This seems to be an important psychological barrier to overcome so it will be interesting to see if the buyers or sellers win this short term battle.

While interesting, the short term move has little impact on our long term strategy. We feel confident in our decision to maintain a 5% hedge in gold. Longer-term, global fundamentals remain uncertain and gold provides security for many possible outcomes. After all, gold is gold.

Market Valuation – Is Intrinsic Value Higher Than the Current Market Price?

One measure of overall stock market valuation that we monitor is showing us that the intrinsic value of the market continues to grow, which is somewhat counterintuitive to what you might expect to happen after a 50% market rally. The methodology I’m referring to is a modified version of the Benjamin Graham intrinsic valuation model. This model was originally built for individual stocks, but The Leuthold Group, a well-respected institutional research firm, has modified it slightly to value a market index instead of individual companies. Recent calculations indicate that fair value on the S&P 500 Index is approximately 1,100. Since the S&P 500 is currently trading at about 1,000, it implies that the market is undervalued by approximately 10% (see chart below).

The increase in intrinsic value has been driven mostly by the dramatic improvements in credit markets that have occurred this year. As fear has abated and risk appetites have expanded, the AAA corporate bond yield has collapsed from 7.7% down to approximately 5%. This lower yield flows through the intrinsic value calculation and has driven the surge in fair value Some bearish pundits are screaming that the market is already overvalued after the equity rally we have experienced, and that is a reason to be underinvested in equity markets right now. Personally, I wonder how many of those pundits ignored the warning coming from credit markets before the financial collapse. Could it be that the credit markets are again well ahead of the equity markets in assessing the overall economic and financial landscape? If so, that might just leave further room for equity markets to firm and catch up to the positive message being projected by the corporate bond market.

Do You Hear That Sigh of Relief?

The stock market has come rocketing off the March 9th lows and the rally is now at 50%+ and counting. Buy and Hold investors who had been holding their breath and hoping that something positive would occur in the markets to rescue their portfolio are wondering if their prayers have been answered. Even though the S&P 500 is trading 35% below its October 2007 peak, and is still trading below its March of 2000 value, and even though portfolio returns have dramatically underperformed any reasonable and conservative estimate of growth for a decade, you can hear the strategic buy and hold crowd breathing a huge sigh of relief.

50% market rallies do a wonderful job of helping investors take their eye off the ball. While six months ago the media was screaming that buy and hold is dead, now that story is being put into mothballs while writers scramble to cover the next bull market. How sad. The buy and hold is dead story has nothing to do with short-term market fireworks in either direction, and everything to do with a theory that supposes that such extreme market volatility shouldn’t be happening in the first place. Active portfolio management is all about understanding the intersection of traditional market valuation, economic cycles, and investor behavior as measured by market sentiment and market breadth. It is worth repeating that classic modern portfolio theory and the efficient markets hypothesis (buy and hold) refute the need for any of the above. In theory, buy and hold investors can sit back and wait for anticipated returns to appear right on schedule, which is some unspecified time in the future. This remains a dangerous strategy for investors.

I am personally enjoying returning to my former status of investment genius as the bull market continues. The 2003 – 2007 bull market seems like it occurred a long time ago and I am not immune to feeling great about excellent year-to-date portfolio returns. But cyclical rallies in secular bear markets do not make the case for buy and hold investing. These are the rallies that need to be invested with caution and respect. Buy and hold investors who are just now looking up to see if the coast is clear just might be heart broken as structural headwinds inevitably crush buy and hold returns in a continuing secular bear market.

Another September Swoon In Store?

There are lots of studies that analyze the so-called “seasonality” of market behavior. The most well-known is probably that of “Sell in May and go away,” which is backed up by statistics showing that the market has historically produced most of its returns in a given year during the November-April period, implying that investors are better off to simply sell in May, and go away for the summer and early fall. Due to the events of the past year, however, that hasn’t played out as expected – from last November through this past April, the S&P 500 lost -10%. Meanwhile, it’s gained 17% since April. So, the current cycle is a good example that there are always exceptions to accepted wisdoms, and that things often play out much differently than historical averages might suggest.

Now that September has started, is there any reason for investors to be concerned, strictly based on the calendar? Some would say yes, and they would have plenty of ammo to back up their argument. According to Ned Davis Research, since 1926 the S&P 500’s average return in September is actually a loss of -1.1%, and positive returns have occurred in less than half of the 82 Septembers in the sample (45%, to be exact), making it the worst month out of the year by both measures. In addition, the September-October period in particular has hosted many of the most notorious events in stock market history, such as the “Black Monday” stock market crash in 1987. Just last year, Lehman Brothers failure on September 15th triggered a -40% collapse into the November 20th market bottom. Since that painful event is still so fresh in investors’ minds, it’s understandable that anxiety levels may be creeping higher as we enter fall, especially since the market has rallied +50% off of the March 9th low.

So, since the seasonal pattern seems to be changing to a historically unfavorable environment, is it time for investors to sell and get more defensive? While it’s important to be aware of, we don’t necessarily think that will be the case this time. With the market having moved up aggressively, it may be due for another breather, perhaps something similar to the -7% correction that occurred during June/July. But, with an economic recovery underway, we wouldn’t be surprised if this fall plays out much differently than last year, with a more favorable outcome for investors this time.

ETF Methodology in Practice

When deciding on which Exchange Traded Fund to buy, there are different methodologies from which to choose. Carl wrote about the differences in construction in his post called Cap-Weighted vs. Equal Weighted. As he mentioned, there can be important biases built in to the products which could provide benefits or downfalls in different markets. For instance, the equal weighting methodology lowers the market capitalization of the index and may be more beneficial in a bull market. However, it is important to realize that each fund can dramatically drift from the stated construction rules and performance could be affected.

We owned an ETF called the First Trust NYSE Arca Biotechnology ETF (FBT) which is designed to replicate the price and yield of that exact index. The index is an equal weighted, 20 member biotechnology index which includes well known companies such as Genzyme and Amgen. But it was through a lesser known, small cap company called Human Genome Sciences (HGSI) where we experienced the dramatic drift (beneficially) in construction. The company had successful Phase 3 trials for their new Lupus drug called Benlysta and the stock exploded from $3.30 a share on July 17th to $18.80 today.

The explosion in the stock price took the equal weighted index and propelled HGSI to a 22% weight from 5% (20 stocks equal weighted). And the fund had stated in its prospectus that it would only rebalance the stocks every quarter back to a balanced state. With a 22% weight HGSI would dominate the performance of the ETF and it would no longer provide us with the equal weight methodology for which we originally invested. We decided it would be prudent to sell the fund and capture the gains provided by HGSI, and find a better alternative. With the explosion of ETFs over the last few years there are several options for most sectors and we will continue to evaluate them to ensure that we are invested wisely.