The Average Depth of a Lake

The other day, I found myself writing a response to an op-ed in the Wall Street Journal written by Burton Malkiel from November 18th. If you don’t know, Malkiel is one of the most stalwart of the buy and hold crowd, and his article, called “Buy and Hold is Still a Winner,” pointed out the usual arguments for buy and hold investing. At one point in the article he observes that if you bought and held the S&P 500 Index from 1995 through 2009 you could have earned an average return of 8%, but if you missed the best thirty days of returns through poor market timing your return for the period would have been negative. The corollary to this statement is that if you measure a slightly longer period, from 1990 to 2008, and you miss the 30 worst days of performance, your return increases from 5.06% annually if you bought and held, to 14.5% annually! For the average stay-at-home investor, buying and holding and rebalancing is something that you can do. To take a crack at the 14.5% annual return you might want to retain the services of a professional advisor.

But that’s not the point of this blog. I’m fascinated with investor fixation on average returns. The average return for a time period is one of the most useless pieces of information I can imagine. Malkiel tells us that the buy and hold return from 1995 to 2009 is 8% on average. But what if you get to the average by earning 0% on your money for the first 7.5 years and then earning 16% on the next 7.5 years? If you are withdrawing money from your portfolio to fund your retirement, the results could be catastrophic. Your spending would decrease your capital to the point that you would possibly not have enough left to meet your objectives, even though your money was earning 16% per year for the second half of the time period. Financial planning research tells us that it isn’t the average of returns that matters. Instead, it is the order of returns that matters. Active and tactical portfolio management allow investors to defend against disorderly markets when they can least afford them.

Average portfolio returns are like the average depth of a lake. If I tell you the average depth is one foot deep and you can’t swim, are you going to try and walk across to a far shore that is a mile in the distance? Obviously the average depth is a useful piece of information for someone, but it isn’t relevant to the decision at hand. What if the path you take across the lake is actually 100 feet deep, even though the average is one foot? It would take a giant leap of faith to start walking across if you can’t swim. To focus on average returns for asset classes creates a similar problem. Without knowing why assets returned whatever they returned, the information is useful, but somewhat irrelevant. Investors hoping to earn the average returns of stocks should beware. The data strongly suggests that when buying at high normalized (or smoothed) P/E ratios, the odds of earning historical average returns are very low. Unfortunately, the 10-year normalized P/E ratio is about 22 times earnings currently. Buying and holding from here is like walking across that lake.

The Holiday Effect

Well, it is now 12:30 on Wednesday November, 24th. It is the day before Thanksgiving and very likely 90% of traders are at home anticipating one of the biggest party nights of the year. Total volume on the day is ¼ of the usual total volume on a regular trading day. And the S&P 500 is up 1.3%, or 15 points, on the day. Of course that makes total sense with the latest news out of Korea, the ongoing European struggles with insolvency, insider trading probes conducted at large hedge and mutual funds, etc…

Yesterday, the market was down on huge volume. Traders unloaded stock because they did not want to be long going into this holiday weekend due to all of the reasons mentioned above, and many more reasons unnamed. With the absentee level extremely high and a huge sell off yesterday, the few determined traders working could drive the market higher today creating a short-term trading opportunity. The market has gained back nearly the entire loss from yesterday!

This is a phenomenon called Pre- Holiday Trading, which has been documented in academic literature. In 1988, Lakonishok and Smidt (and many others after them) examined stock returns on trading days directly preceding holidays. They used 100 years of data and found a strong pattern of high stock returns the day before the nine stock exchange holidays. Short-term traders would purchase stock on the preceding day and sell the day following a holiday. There are also other trading strategies using holidays as an entry point including purchasing before Christmas and selling at year end. These strategies have shown very strong gains and are clear examples of seasonality.

We have written on seasonality in past blogs but I thought this was a very timely and clear example. Certain human behavioral patterns are present in the stock market including calendar behavior. At Pinnacle, behavioral study and cycle analysis is just a small part of the overall process. But perhaps knowledge of all investment theory will lead our own investment process to a much more profitable place in the future. We just have to remember to sell on Friday!

Dip Buying 101

Pinnacle Advisory Group is presently engaged in an investment practice known as “buying the dip.” Dip buying implies that you have a bullish stance towards whatever security that you are purchasing, and that you are using a short-term price decline to enter the position at more favorable prices. Dip buyers sometimes affect a somewhat self-important attitude in that buying dips implies a value conscious approach to investing, which is usually regarded as highly rational and professional. After all, only overly emotional “retail” investors purchase securities when they are making new highs, allowing the herd to stampede them into buying right at the top. It is the cool, calculated, value investors who have the steely nerve to let the market “come back to them” before purchasing. Any purchase price that is lower than the latest price high represents a victory for dip buyers, who steadfastly and with great conviction refuse to look too far in the rear view mirror for fear that they will find out that even though they bought a dip, they actually acquired the shares at a far higher price then they could have if they had simply joined the crowd and bought as the shares were breaking out to new highs.

Dip buyers live in fear of bloody fingers caused by trying to catch falling knives. This expression refers to the trend follower’s creed that falling prices beget more falling prices, and so buying into a falling market is like “trying to catch a falling knife.” When dip buyers pull the trigger and buy they are hoping that they are not buying into a sustained bear market where they are doubling down on positions that are fated to continue to lose money. While dip buyers are proudly and expertly buying as prices fall, in the privacy of their office they are stockpiling Band-Aids for bloody fingers and planning for their exit strategy if things don’t go as planned. Even worse, dip buyers often have a target price that the security must reach before they execute their purchases. As the market begins to fall you can feel the anxiety of the dip buyers begin to rise as they get nearer to their price targets. It’s like rooting for a horse in a close race. “Come on Rose Bud!” How horrible it is to see a security price turn around and begin to rise again just before it hits your price target.

Momentum investors think dip buyers have lost their marbles. They wonder why in the world anyone would try to buy a falling market just when the market is establishing a trend to the downside. Sheer lunacy they would say, and in some cases they are right. In this particular case our assessment is that the weight of the evidence suggests that we won’t have a double dip recession. If we are right then buying a dip is an excellent strategy for adding to risk assets without waiting for a trend to develop or reverse. At the moment we are fine tuning our asset allocation and making minor mid-course adjustments in portfolio construction. The past week or so has seen the broad markets sell-off almost exactly as we expected. Perhaps we will get to our price target in the next few days and complete our transaction (we chickened out and added 1% even though we were still a little short of our target). Rest assured, if the market trades down and through its 50-day moving average we will complete our planned transactions, but the entire investment team will make certain that our box of Band-Aids isn’t too far away.

Unusual Excitement in the Muni Market

Lately we’ve been watching municipal (muni) bond exchange traded funds (ETFs) fall at a rate that hasn’t happened since the Great Credit Crisis of 2008. Most of the available research is painting a picture of an almost perfect storm hitting the municipal market at the present time. Municipalities currently face: tough budgetary constraints due to revenue shortfalls, severely underfunded public pension funds, the possibility of an extension of the Bush tax cuts, a recent surge in new issuance, doubts about the future of the Build America Bond program, and a large municipal bond insurer filing for chapter 11 bankruptcy protection. In addition, some think this is a reaction to the Fed not buying a larger percentage of long-term bonds in its recently announced QE2 program. Whew, that’s a nasty witch’s brew for munis, which is reflected in the chart below.

With various muni ETFs down a quick 5-7% since the beginning of November, we are currently internally debating whether the decline is just a short-term dislocation that presents a buying opportunity, or a warning signal for the health of the overall market. At the moment, we are furiously digging through the research to make sure we have an informed opinion regarding this situation. My gut feeling is that this is an overshoot that will likely present a short-term window for investors to capitalize on. But many years in this business has taught me that investors ignore credit markets at their own peril, and so it’s worth double and triple checking before acting. Municipal bonds are typically thought of as boring investment vehicles for conservative investors. However, right now things are pretty exciting in the muni markets.

Chart: iShares Municipal Bond ETF (MUB)

Bond Market Not Cooperating With QE2

Since November 2nd, the day before the Federal Reserve officially unveiled QE2 (consisting of $600 billion in new purchases of Treasury securities), the 10-year Treasury yield has climbed by 36 basis points, from 2.59% to 2.95%. Higher yields run counter to the Fed’s intentions, since they’ve specifically cited lower interest rates as one of the main reasons for implementing QE2. They believe that if they can drive rates even lower than they are now, it will help spur economic activity and support the recovery.

Although a 0.36% rise in rates may not seem that large, it’s already started to have an impact in the housing market. According to a weekly report from the Mortgage Bankers Association, 30-year mortgage rates rose from 4.28% to 4.46% last week, causing substantial declines in applications for both new purchases and refinancings (see the table below). Considering that the Fed is specifically trying to drive interest rates lower in order to help the housing market, they can’t be very pleased by the market’s reaction so far. It may just be a short-term phenomenon, or it could be a broader signal that the market doesn’t have much confidence in QE2’s ultimate effectiveness. The Fed is undoubtedly watching this very closely, and hoping that it’s the former, not the latter.

Boom Goes the Dynamite

The “Chinese Commodity Demand” theme, or the “Liquidity Driven Weak Dollar” theme, has been the investment theme driving the broad markets since the recent leg of the bull market took off in early July. We have written at length about this theme and it is amply expressed in Pinnacle’s current asset allocation. About 50% of our risk assets benefit from this theme one way or another, if you include diversified international funds, emerging markets, gold, commodities, energy, and industrials in the mix. On the one side we have the pundits who believe that growth in China and other emerging markets is propelling global economic growth, as seen most clearly in all assets related to the commodity complex. The other side claims that the U.S. Federal Reserve is on a clear mission to weaken the dollar versus foreign currencies which encourages asset inflation. They believe that the extra liquidity in the economy will find itself flowing to risk assets given that the banking system in the U.S. remains effectively broken. Pinnacle has one foot in each camp. In either case, our investments in the China demand theme or the liquidity weak dollar theme have supported portfolio performance for months.

However, we are most alert to the possibility that this theme can and will reverse at some point and when it does we expect that asset class correlations will remain high, meaning that U.S. stocks, international stocks, and commodities are going to get hit at the same time. And when they do, they are going to become very volatile. Last Friday was an interesting preview of why we have to remain careful about our weak dollar theme holdings. From November 4th through November 12th, the U.S. dollar index, as measured by the Powershares DB US$ Long Index (UUP) has gained +2.91% while during the same period the Currency Shares Euro Trust long Euro Index (FXE) has declined by -3.6%. The carnage has been predictable. On Friday our long-only Commodities Futures Index (UCI) got crushed, losing -5.2%. Our long-short commodity positions, Rydex and Direxion (RYLFX and DXCTX) were down by -3.21% and -3.81%, respectively. Since November 4th the long-only position is down -4.99% and DXCTX has lost -2.62% and RYLFX is down -2.92%.

Here are some other comparative stats since the dollar began rallying on November 4. The broad market (S&P 500 Index) is down -1.68%. Gold is -1.72%. Emerging markets are down -3%. U.S. Industrial Equal Weight ETF (RGI) is -2.06% The biggest surprises might be that energy related funds are doing well, with the broad based energy sector ETF (XLE) gaining +1.52% and the Oil and Gas Exploration ETF (XOP) gaining +3.29%. But if you are Ben Bernanke, Chairman of the U.S. Federal Reserve, and you are printing money like crazy with the expressed intention of lowering longer-term interest rates in the bond market, you must be very unhappy that since November 4th rates have risen and bond prices have fallen significantly. The 7-10 Year U.S Treasury ETF is down -1.93% and the 20-Year U.S. Treasury ETF is down -3.95%. BOOM! It’s highly probable that this reversal is temporary and reflects the overbought condition of these markets. Notably, Pinnacle portfolios perform with a fraction of the volatility of these securities. Nevertheless, we intend to buy this dip if it continues. However, like everything else in the current market environment, it requires our ongoing diligence.

Timing is Everything

Last week, the investment team met to discuss whether the events of the past few weeks, namely an important election, an announcement of additional quantitative easing by the Fed, and the recent close of the S&P 500 Index above its April high, means that we should change our investment stance. There has clearly been a change in the leading indexes that are so important in forecasting the economy's direction. Market-based indices like copper, broad-based commodities, and the Baltic Dry Index, as well as the Conference Board, ECRI, and the OECD, have all shown significant improvement. The stock market has reacted positively to the change in Fed policy from discussions about removing stimulus earlier this year, to keeping the current stimulus this summer, to the latest announcement that they are adding $600 billion of new stimulus. Key interest rate spreads that are early warning indicators of systematic market risk seem to be subdued, with the exception of the recent blow-out in PIIGS bond spreads. We are now into the 7th consecutive quarter of above-expected earnings growth where estimates have gone vertical for 2010 and estimates for 2011 are still staying steady at about $95 for the S&P 500. At an S&P price of 1,200 the P/E ratio for the market based on 2011 estimates is only 12.6 times earnings, hardly expensive in a zero interest rate environment.

There is a well-documented bearish case to be made, which we have explored in depth in this blog as well as our quarterly market reviews. The longer-term structural problems with the U.S. economy, and consequently the global economy, are frightening. But the shorter-term questions about the durability of the latest growth cycle remain in doubt as well. There seems to be little doubt that with the Republicans in control of the House of Representatives, investors shouldn’t count on fiscal stimulus to help the market going forward. And now that the Fed has committed to adding $600 billion to their balance sheet, there seems to be little chance of more monetary stimulus in the near future. So the question is where is the organic growth in the economy going to come from? The most popular answer seems to be that growth in the emerging markets will rescue the developed world from a dangerously slow growth scenario. Or perhaps the Fed’s prescription of zero interest rates and quantitative easing will do the trick. I remain a skeptic on both counts.

For now the team agrees that a minimum of benchmark levels of risk are appropriate across all of our investment policies, with the possibility that we could be more aggressive in our DA and DUA policies. The problem is that we are “running a little cool” in terms of risk assets at a time when the market looks very overbought on short-term sentiment measures. In short, investors are too bullish at the moment for us to feel comfortable adding to risk right now. The plan is to buy the dips, if we can get one or two before year-end. The tactics are sound, the plan seems to make sense, and we have high conviction in our assessment of the overbought condition of the market. Now all we need is for the market to cooperate and come back to us. A 5% correction from the recent high takes us right back to the 50-day moving average which is a great place to do a little nibbling. As always, timing is everything.