Playing Chicken

Playing chicken is a game where two players play and one wins if the other loses his or her nerve. An example might be two cars racing towards each other at high speed where both drivers know that one of them will have to turn in order to avoid a dangerous collision. The loser is the driver who turns first. Of course the loser is called the “chicken.” For most of us, avoiding dangerous games of chicken comes under the category of common sense, and for investors the idea of playing chicken is the opposite of sound risk management.

Nevertheless, I can’t help but think that the current market environment for investors is something akin to playing chicken. The stock market is being driven by accommodative fiscal and monetary policy that can’t be continued indefinitely. The Federal Reserve has expanded its balance sheet with a dizzying array of programs called TARP, TALF, PPIP, and more, all designed to bail out banks that are too big to fail. In addition, the Fed is buying bonds in the open market to add even more liquidity to the mix. The resulting yield curve is very steep and cash yields nothing, driving investors into risk assets in the short run. Another not so surprising result of 0% interest rates is a falling dollar, which is another bullish development for corporate earnings - in the short run. Third quarter GDP was a strong 3.5% fueled in large part by stimulus programs that distorted both new home sales and auto sales. Finally, momentum investors and carry traders who borrow dollars at 0% interest rates and invest them in stocks, commodities, and bonds worldwide are having a field day. After all, we’ve seen this play before. The last time the central bank reduced interest rates to such low levels for such a long period of time was in response to the 2000-2002 market crash/recession, and the result was a five year bull market in virtually every risk asset class around the world. The stock market is exhibiting all of the symptoms of a momentum and liquidity driven bull market. After last year, who wants to miss out on this action? In fact, many institutional managers simply can’t afford to miss any of these gains considering the horrifying results they turned in last year.

But….the stock market is beginning to get expensive. The ten-year normalized P/E ratio for the S&P 500 has climbed over 20 times earnings from a low of 13 times earnings in March. Stimulus programs are due to end. At some point the dollar is sure to rally. Higher taxes, higher regulation, and higher savings rates are looming in the near future. It’s hard to find an analyst who thinks this bull market will take out the 2007 highs. So investors are nervously trying to stay invested, looking to see who will be the first to get out of the game. It feels like a game of chicken to me. We are hurtling towards the market top at the end of this cyclical bull market….and if you are the first one out and the market continues higher you lose. However, of great interest to investors is that in this game of chicken, being the last one out of the market will create the biggest loser.

Consumer Confidence Slipping

The preliminary reading of November’s University of Michigan Index of Consumer Sentiment was released this morning, and it declined for the second month in a row. The index fell to 66 (versus estimates for an increase to 71). After reaching 96.7 in January 2007, it fell sharply for the rest of that year and through most of 2008, before hitting bottom at 55.3 last November. The index is based on a survey, with two underlying components – Current Economic Conditions and Consumer Expectations, with Expectations receiving about twice the weight.

There’s been a lot of discussion recently regarding the eventual withdrawal of some of the tremendous fiscal and monetary stimulus that’s been unleashed on the financial system. Consumers’ spirits have certainly been lifted over the past few quarters by some of those efforts, including the rebound in asset prices, tax cuts, the homebuyer’s tax credit, Cash for Clunkers, etc. But as the recovery continues and authorities eventually try to wean the economy off of some of these temporary supports, consumers’ reactions will be critical. So far, it’s not overly alarming that there have been back to back monthly setbacks. But if consumers react poorly as various stimulus measures wind down, it could be an important sign that the economy is still too fragile to grow on its own.

Transparent Portfolios and Hedge Transactions

Last week we put on a hedge transaction in our managed accounts by buying an Exchange-Traded Note (ETN) designed to track the VIX volatility index. Like many institutional money managers, we have been cautiously participating in a bull market characterized by enormous liquidity-driven momentum. As the price of the stock market continues to float well above both its short-term and long-term trend lines, each dip in price raises the specter that the market will finally take a well deserved breather, having rallied by close to 70% in the 8 months since the lows set in March of this year. Last week, for the first time in months, the market closed below its 50-day moving average and we thought it was prudent to manage the risk that the market might continue to correct down to its 200-day moving average, a normal event for a correction in a bull market, but would result in a further 11% or greater market decline.

By choosing the VIX (Chicago Board of Options Exchange Volatility Index) as our hedge we were betting that if the market sold off, then volatility would dramatically increase from very depressed levels. Having watched the index jump by about 15% as the market fell to its 50-day moving average, we were betting that it could move an additional 30% or more if the correction continued. Unfortunately, we stopped out of this trade with a 12% loss as the market turned on a dime and headed higher again. Our 4% position lost 12% resulting in a “cost” for putting on the hedge of approximately 0.48%, plus transaction costs, plus the cost of whatever interest we lost from selling cash and bonds to put on the trade (which were minimal in our estimation). We view this “cost” as a very acceptable price to pay for managing the risk that the market is due for a significant correction, even if it didn’t turn out to occur last week. In our view, it certainly was better than selling our current risk positions in an attempt to time a short-term market decline. Buying and selling the VIX was an easy transaction to put on and take off, and while the results didn’t work out, I view the risk and reward of this transaction as not only acceptable, but necessary in volatile markets like these.

In my book, Buy and Hold is Dead (AGAIN), The Case for Active Management in Dangerous Markets, I write that one of the challenges that active portfolio managers must meet is transparent portfolios. By transparent, I mean managed accounts where clients can see the transactions in their portfolio, in contrast to investing in say a hedge fund or a mutual fund where the client does not see the transactions in the fund. The reason that transparency represents a challenge to active managers is that each client can view portfolio transactions through the lens of whatever their personal investment biases happen to be. In this case our hedge position has resulted in a very short-term transaction that resulted in a loss. We will have certain clients reasonably asking for an explanation for this trade…..concerned that the transaction lost so much in so little time. And we will have some of our wealth managers asking the same questions…since they have to explain this to our clients (SIGH). I don’t think anyone will be thrilled when we do a similar transaction the next time the market rolls over so far above its long-term trend line.

A Letter to “Do –It- Yourself” Investors

I was on a radio show today and I was asked, once again, to give advice to listeners who were contemplating active management for their portfolios. This may sound self-serving, but I’ve given the matter a great deal of thought and the best advice I can give is don’t do it. If you are going to invest your own funds and you are not willing to spend hours studying the financial markets each day, then my best advice is to diversify your portfolio and buy and hold. Yes, I am the author of a book called, Buy and Hold is Dead (AGAIN), but it simply makes no sense to attempt to tactically or actively manage a portfolio without a huge investment of your time.

Why? Because actively managing money today is one of the most difficult crafts you could possibly try to learn. The combination of being in a secular bear market where risk assets are likely to deliver less than average returns combined with a financial environment fraught with any number of new and hard to understand risks makes active management itself a high risk proposition - if you don’t know what you are doing. I have spent the last decade unlearning buy and hold investing strategies and learning how to actively manage money. I do it for a living. I am surrounded by professional analysts who do nothing but eat and sleep investment research all day long. And when we meet to discuss today’s bewildering market environment where there are so many variables to consider, so many risks to discount, and so many possible outcomes to consider, our discussions require our very best in terms of experience, expertise, and judgment. I know that individual investors don’t want to hear this, but for the most part they should stay out of the way. Professional investors like me will take your money in the arena of the marketplace.

It’s time to let a professional actively manage your portfolio. I know you’ve managed your portfolio by yourself for years, and yes I know that you had a bad result with financial advisors in the past. But if truth be told you probably haven’t made much money over the past decade, and there is a good chance the financial markets won’t bail you out for years to come. It’s time to let someone who knows what they are doing manage your money. If you still insist on doing it yourself, then buy and hold. Diversify your assets and take what the market will give you. It isn’t the best strategy, and it could cost you your retirement if the bear market continues, but at least you won’t screw up and make a big mistake trying to actively manage your portfolio in difficult markets like these.

Indexes Often Mask Underlying Trends

It’s an accepted practice in the world of investing to report investment performance or trends based on broad indexes. That’s why you typically hear media outlets reporting the Dow Jones Industrial Average or the S&P 500 Index as representative of the overall stock market. While there’s certainly nothing wrong with that, simply focusing on these broader indexes can mask important underlying trends taking place. For example, the S&P 500 Index consists of 10 broad sectors. So far this year, the top performing sector (using sector ETFs) is Technology, with a 36.6% return. On the other hand, the worst performing sector is Utilities, with a mere 1.3% gain. Of course, if you take this a step further and focus on the individual stocks, the discrepancy is much, much wider.

The same holds true with commodities. We’ve owned a broadly diversified commodities fund that tracks the Dow Jones/UBS Commodity Index for several years. The index consists of 19 underlying commodity futures contracts. The security we own (which is an Exchange Traded Note) has performed fairly well this year; it’s up 15.8% so far. But since we know that several individual commodities are up much more than that, we were curious what's been holding it back. As shown on the chart below, it turns out that the very economically-sensitive base metals (aluminum, copper, etc) have performed the best in response to the unfolding economic recovery, energy (oil, gasoline, etc) and precious metals (gold, silver) have also done very well, but the agricultural commodities (corn, wheat, soybeans, etc) have lagged.

The point here is that drilling down below the surface can often reveal important underlying trends that can be much different than what’s implied at the broader index level. And with a growing number of more targeted investment choices, we have more options than ever to try and take advantage of this effect, which may provide additional opportunities to add value for our clients.

Chart - Base Metals (red), Energy (blue), Precious Metals (green), Agriculture (pink)

Well…That Was Easy

The Pinnacle investment team has been patiently waiting for a serious correction in the recent torrid bull market for months. To us, a correction in a bull market means something like a 10% - 15% decline – enough for us to feel good about buying a dip in an upwardly trending market. Unfortunately, the market has not given investors the opportunity to jump in and buy a dip for months, with the closest thing to a correction being a 7% decline that occurred from June 12 to July 10 earlier this year. But now, for the first time since July, the tone of the market seems to be changing with the market once again declining 6% from its high of 1097 on October 19th. We are going to implement a hedge position as a trade to take advantage of a possible nasty short-term correction. It seems like it aught to be easy enough to do, but…

• Should we hedge by buying a 2X position in the U.S. dollar assuming the dollar will rally on a market decline, or buy a 2X inverse S&P 500 Index fund that should earn two times the decline in the market, or buy the VIX volatility index (Chicago Board of Options Exchange volatility index)?

• If we choose the VIX, can we be comfortable with the tracking error between the exchange traded note for the VIX Index (ETN available through iPath called VXX) and the actual underlying VIX index?

• If we put on the hedge, where do we get the cash to execute the trade? We have some cash in our managed portfolios for the buy, but what else needs to be sold to take a 4-5% position in the hedge?

• We first looked at this transaction last week and since that time the VIX has had a big move to the upside. Is it too late to buy it now that it moved more than 10% higher last week?

• We executed a complicated transaction in our fixed income allocations last week and now we can’t execute the hedge trade until the prior week transactions settle. Will the market allow us to still get in while we wait the extra days for the prior trades to settle?

• One of our analysts feels like we have seen the ultimate top to this cyclical bull market that began in March of this year and so he likes the hedge trade. Another analyst is worried that we won’t get much more on this correction and doesn’t like the trade. Another analyst thinks the trade works as is.

For Pinnacle’s investment team, the details of this transaction are just business as usual.

ISM Manufacturing Continues to Signal Economic Healing

Yesterday, the Institute for Supply Management’s manufacturing survey, an important growth barometer that we monitor, exceeded expectations (55.7 versus analyst estimates of 53). The Institute was founded in 1915, and is a non-profit trade group with a membership base of more than 40,000 supply management professionals and associations. On a monthly basis it releases separate surveys that measure activity in both the manufacturing and service sectors of the economy. Yesterday’s manufacturing report was constructed by surveying more than 300 firms on different aspects of manufacturing conditions (see table below for the composite (PMI) and its underlying components). Readings above 50 represent expansion and readings below 50 indicate contraction. Some might question why investors follow the survey due to the shrinking percentage of GDP that is derived from manufacturing, but we feel that manufacturing still captures the ebb and flow of the business cycle, and therefore is well worth watching.

What the survey does well is capture the directional movement within manufacturing, what it doesn’t do well is measure the magnitude of the growth or contraction. For example, 50 and above implies growth, but tells you nothing about how robust that growth might be. Some of the individual components of the report were encouraging, particularly employment and production, which had robust gains for the month. The bears may take solace in the weaker new orders component, which could be spun as a harbinger of what will occur as Cash for Clunkers and other stimulus programs expire. At Pinnacle, we don’t put too much emphasis on any one data point, as there is a lot of noise that can occur. However the trend of the data is very important. The latest data point is the third in a row above 50, which seems to confirm that the strong leading indicators we have written about previously correctly anticipated future growth.

Currently, the market appears to be in the middle of a long overdue correction where good data is being brushed over. That’s not all that surprising given recent overbought conditions, and it’s possible that negativity may intensify before this market adjustment is complete. Right now seems to be a time for investors to tune out the headline noise, and focus on the overall weight of the evidence coming out of the data we are following. There’s no guarantee how the data will unfold going forward and we will continue to remain flexible in our forecast, but the ISM data seems to reinforce the idea that the economy is in the midst of healing after a particularly nasty down cycle. If that’s true, than the cyclical bull market should have room for further upside after we work through the current rough patch.