On the Lookout for Asset Bubbles

QE2 is in the air, and lately the thought of it has certain markets all lathered up (or down). Risk assets have caught a bid on the dollar tanking. The inverse dollar trade has propelled returns in commodities and emerging market stocks, which have been rising fast on the back of a more highly liquid world and the belief that growth rates abroad can decouple from the sagging developed world.

The ultimate impact of a QE2 operation is very cloudy, and there are good reasons to be skeptical that it may not be the magic elixir to fix structural problems in our economy. But even if it doesn’t have an economic impact, the extra liquidity may find a home in asset prices, and perhaps even inflate another bubble or two.

Gold and emerging market equities are two asset classes that smell like they could have the makings of a bubble. Bubbles are awful when they burst, but fortunes are made for those that can find early developing bubbles, ride the major portion of the gains, and get out before they pop and wreak havoc on returns.

On the subject of QE2, we are skeptical that it can jump start the economy, but we are also aware that it may just be creating asset bubbles and manias in select sectors and asset classes. What inning are we in? Is it too late invest? Now that’s the making of an entirely different blog.

The Bullish Case

If you are feeling skeptical and concerned about the economy and the stock market, don’t worry. You have plenty of company…unless you are an institutional investor who is being whipsawed between bearishness and bullishness from month to month. You should know that if by the end of this missive you don’t believe the bullish case I’m making then most professional investors would say your view is bullish for equity markets, since bull markets “climb a wall of worry.” In this case, you are a “retail” worrier so your skepticism is as bullish as any bull could want. Please keep in mind that the following bullish case is made within a secular bear market, which means that the market will go up…until it comes down again as the secular bear market grinds on. Bulls think the market should move higher from here because basically….the fix is in.

The worst of the economic downturn is behind us. Leading economic indicators have rallied from their lows, and while some are flattening out, they still are greatly improved from the downturn in 2008. Double dip recessions are exceedingly rare, and there is no historical evidence that the economy should downshift in the face of massive additional monetary and fiscal stimulus. Make no mistake…if the recent lousy economic numbers continue the Fed will act with another $1 trillion or so of monetary stimulus. The bullish bet is that the additional money will either stimulate the economy and get the virtuous growth cycle kick-started resulting in higher employment, stabilized housing prices, higher capacity utilization, more bank lending, etc., which will result in higher stock prices. Or, the additional $1 trillion will do none of the above, but will find its way into the stock market nonetheless, driving stock prices higher. Bullish investors see this as either a virtuous return of price inflation or a non-virtuous return of asset inflation. Either way…happy days! By the way, the last cyclical bull in a secular bear lasted for exactly five years, from October of 2002 to October of 2007. It turned out that the entire bull market was built on smoke and mirrors, but who cares? By that measure we have at least another three years to enjoy the current cyclical bull.

The world is indeed different in the post-Lehman, flash crash, over-indebted place we now inhabit. It is the emerging markets of China, India, and Brazil that will lead the global economy out of recession. Unlike the U.S., Japan, and Europe, where the sovereigns essentially brought nothing but bogus debt onto their balance sheets, the balance sheets of the emerging countries look pristine. For that matter, on a relative basis, so do the balance sheets of blue chip U.S. companies that earn a large percentage of their profits overseas. Bonds might be horribly overvalued…you can currently lend the U.S. government money for 10 years at 2.4% interest. The Fed has pegged the Fed Funds rate at 0%! Cash pays nothing. So liquidity is flowing to emerging markets and commodities. Once we get a few more months of higher U.S. equity prices, then you, dear reader, will be clamoring for more U.S. stocks as well. Corporate earnings have been booming as productivity growth continues to surprise to the upside. So, the market is cheap and is likely to go higher. We are entering the most bullish seasonal time of the year and seem to be dodging the September-October blues. And the third year of presidential terms has a great track record for bullish stock market results. So there you have it....I told you you wouldn’t believe me!

Nothing Else Matters

I have had this old Metallica song, with slightly different lyrics, in my head for the past month…

Yeah, trust I seek and I find in you

Every day for us more QE2

Close your mind to a different view

Because nothing else matters

So is it really that easy? Our friends at TEAMThink posted a video from David Tepper in which he argues that it is just that easy. David Tepper is one of the best hedge fund managers of the past decade. According to Mr. Tepper, in scenario 1 you have strong growth and equities rally due to better underlying fundamentals. In scenario 2, you have weak growth but a Federal Reserve “put” will be in play in which everything, including equities, will go up, at least in the short term, because Quantitative Easing 2 (QE2) will be instituted. It is “a slam dunk trade due to the policies of the Federal Reserve.” I believe the other quote ringing in my ears is “Don’t Fight the Fed!”

But are those the only possible scenarios? Well, it seems that the market’s been using that playbook since July 1st when the S&P 500 bottomed at 1040. The S&P 500 is up 11% from that date while high beta assets have surged even more. After that run, it is natural to start questioning your underlying thesis that we should remain cautiously invested as the underlying fundamentals have remained soft. So what if the jobs market is still soft, it will get better or it will get worse but equities will rise. These are questions we have been asking ourselves.

Then again, there are other questions to ask. What if the market has already priced in a $1.5 trillion quantitative easing program but the Federal Reserve only gives us $750 million (or less)? What if Republicans gain Congressional seats and want to conduct a full audit of the Federal Reserve? What if QE2 destroys the dollar and equities rise only in nominal terms? What if currency wars erupt? What if High Frequency Signing manifests into a bigger problem as the real estate market shuts down? Bernanke? Anyone?

October Thoughts about Seasonality

Market seasonality has probably been more of a factor in our decision making of late than it should. Rick wrote about it in this space last week. To make that statement in a year where “Sell in May and go away” has proven to be a perfect timing indicator might seem a little harsh. In fact, many of the analysts we follow publish composites of past market performance based on a variety of time frames, and those composites, along with the more traditional seasonal themes like “the January effect” or “summer rallies” are always a factor in our decision making process. Of course the market still has not managed to take out the late April high from this year so “sell in May,” with perfect hindsight, was excellent advice. However, the past few months have been dominated by our seasonal concerns about September and October. September is, on average, the worst performance month of the year for the broad market, and October is well known for having more than its share of well documented market meltdowns and investor riots. Now that we’ve just closed out September with the best performance for the month since the Great Depression, a disturbing result for “seasonality gurus,” we’ve spent some time digging further into the subject of seasonality as it pertains to third-year presidential cycles.

Ned Davis Research gives us some excellent data that seems immediately relevant. Consider the following information:

The DJI (Dow Jones Industrial Average) has gained, on average, 6.4% in 9 cases where there has been a change in the Congress in the third year of a presidency. The DJI has gained on average 6.4% in the 13 cases of a third-year presidential cycle within a secular bear market. The DJI has gained 6.1% on average in the thirteen cases in the year of a capital gains tax hike, and the DJI has lost 3.6% on average in 18 cases where the market was 22-34 months after a cyclical bull market within a secular bear market.

For the most part the data seems benign except of course for the 3.6% loss 22-34 months after a cyclical bull within a secular bear. Since the current bull market began in March of 2009 that seems to increase the likelihood that 2011 would be a poor year for the market. Of course, the 6%+ gains in the other data seem to indicate a decent year might be forthcoming. Ned Davis’s market cycle composite indicates that the broad market should be rolling over right now and testing new lows before it finishes the year with a strong rally. The question is how much weight to give any of this past seasonal information? It has little to do with the market fundamentals and technicals we track so religiously. Additionally, it has nothing to do with the current global economic condition and it doesn’t speak to current market valuations. Yet, it is seductive in its premise that the past could repeat. Considering that we are experiencing a financial condition that is unprecedented – a Great Reflation following a Great Recession – market seasonality and past market cycle composites will remain a part of our process….but not overly so.

The Tension Between Risk Management and Wealth Maximization

There is no doubt that risk management is an important part of long term investment returns. One only has to be familiar with the law of numbers to realize that the percentage return to recoup a loss is in excess of the loss itself (i.e., a 50% loss requires a 100% gain to fully recover). As money managers at Pinnacle, we wear dual and sometimes conflicting hats. On one hand we want to maximize long term wealth for our investors, while on the other hand we need to manage risks to that wealth.

Today you don’t have to look far to find significant pockets of risk. There are risks to the economic recovery, risks in the amount of debt in the system, risks regarding regulation, higher unemployment, trade wars, etc. I can say with high conviction that the current macro backdrop leaves the potential for very risky “fat tail” (low probability) events unusually high. With that landscape in mind, it should put us at ease that we are being conservative in light of those risks.

That being said, we don’t feel such comfort on a day like today, when risk markets are exploding higher on the perception that central banks around the world appear to be opening up the liquidity spigots to try and reflate the system further. On days like this we must confront the wealth maximizing hat, and wonder whether our management of the risks is warranted in light of today’s business cycle, technical, and valuation profile.

So for today we are left feeling like a salmon swimming upstream, as we have forfeited potential gains as a trade off for increased safety. But tomorrow is Wednesday, and the team will be discussing what has changed in the three core tenets of our process (business cycle, technical conditions, and valuation). No doubt, we’ll be challenging our own assumptions to make sure we believe we are striking the right balance between risk management and wealth maximization at this time.

A Great Third Quarter

It was a great third quarter and I’m happy that we will soon be reporting some excellent numbers. Many of our clients tend to view their results in the context of their monthly statements, however, the quarter offers a different, longer-term (but not long term) view of the world. I thought I would offer a few comments about the markets in general and Pinnacle portfolio performance in particular…much to the chagrin of the rest of the investment team who would prefer that I keep my mouth shut until we get our “official” GIPS compliant numbers. As our client’s know, they will soon be receiving our Quarterly Market Review. It is a beautifully written piece by Rick, Carl, and Sean offering clear, concise commentary and statistics about the past three months. I offer none of the above here but that is, of course, the great thing about writing a blog.

The past three months saw the broad stock market get whipsawed every month in terms of performance. July was a record breaker in terms of +7% performance, August was a record breaker in delivering a negative 5%, and now September with a more eye-catching +9%. For investors executing trend following systems the quarter was probably a nightmare. I show the S&P 500 gaining more than 11% for the quarter, bonds earning more than 2%, developed country international stocks +16% on a significantly weaker dollar, and gold gaining more than 9% for the period. Interestingly, only gold actually set a new high during the quarter as both U.S. and International stocks finished the quarter below the highs they made this past April. I’m guessing (here’s where Sean is going to get mad at me) that Pinnacle Conservative Growth investors gained 5% - 6%, Moderate Growth investors earned about 7% and Dynamic Appreciation investors gained about 8%. I didn’t check the DC and DUA strategies this morning…the Ravens-Pittsburg game is coming on soon and time is of the essence. My point is that there was some serious wealth creation delivered to Pinnacle clients over the past three months, and that’s good news. Investors who chose to remain in cash waiting for the world to end during this past quarter just got slaughtered.

On a relative performance basis the news may actually be a lot better than I thought it would be. I’m guessing that we delivered very close to benchmark performance for our DMG investors and only trailed by 100 basis points (give or take) in our DCG and DA models. I’m also guessing the relative performance might be worse for our most aggressive clients considering the monster rally that occurred and the relatively conservative stance in our managed accounts. In fact, I would say that if my guestimates are anywhere near accurate we dodged a bullet during the period in terms of relative performance. It’s easy to see, in hindsight, that our conservative stance was unwarranted during the period, yet I think our performance held up quite nicely. I have often written in this space about the problems with managing risk when you own a diversified portfolio of asset classes where correlation can move all over the place. We had several days in August where our downside market capture (beta) was only 20% - 30% of the broad market in our moderate portfolio strategy. To finish the quarter gathering 60% or more of the markets upside feels like a major victory. As you will read in our Third Quarter Commentary, the game “is still afoot.” Stay tuned…

The Fight in Dollars

In September alone, the U.S. dollar was down 6% which is an annualized loss of 51%. This has led to big precious metals gains for the month as gold advanced 6% and silver soared 13%! The Federal Reserve has continued to monetize debt through permanent open market operations (POMOs) with dollar depreciation and asset inflation the result. But they are starting to get the attention of other nations in the fight over weaker currencies, and exports.

In the middle of September, the Bank of Japan had reached their limit when the Yen had risen to 82.80 versus the dollar and they decided to intervene in the currency markets. The yen dropped to 85 but has since reversed and is now trading at 83.30. Yesterday, Zero Hedge (another financial blog) reported that the Mexican government has intervened, and many other nations including Brazil, Peru and Colombia have also intervened to stem their currency appreciation. This, of course, comes on the heels of the fight between China and the U.S. over currency manipulation in which our own House of Representatives passed a bill that would raise tariffs on imports of a country artificially devaluing their currency. These are certainly dangerous waters to be surfing.

Brazil’s finance minister has blatantly stated that ‘we are in the midst of an international currency war’. And so far the United States has the upper hand as most international nations have clearly brought knives to a gun fight. That could very easily change though as these nations are major holders of Treasury debt. We sincerely hope that cooler heads prevail as trade wars were a big reason the recession of 1929 turned into the Great Depression. Since hope is not an investment strategy, we will gladly hold gold in our portfolio.