Looking at Alternative Investments

Pinnacle clients will soon be noticing that their statements have a slightly different look. Instead of all of the alternative investments in the portfolio being reported together at the end of the holdings reports, we now split them up into equity alternatives and fixed income alternatives. When asked I usually define alternative investments as those asset classes or investment strategies that have a low correlation to both stocks and bonds. However, it is helpful to further differentiate among the alternatives to get a better understanding of what they mean to us in terms of our portfolio construction.

I divide alternative investments into three general categories. First are asset classes that historically have low correlations to stocks and bonds. The best example of this in our current portfolio is gold (GLD) and long-only commodity future indexes (UCI). These exchange traded funds and notes are not actively managed and their correlation to stocks and bonds is entirely dependent on the performance of the underlying asset class. The second group of alternatives falls into a group I call “alternative strategies.” The Merger Fund and TFS Market Neutral fund are examples of this group in current Pinnacle portfolios. While the funds are very actively managed, the underlying strategy is designed to consistently deliver low correlations to stocks and bonds. While the managers can get “hot” or “cold,” unless something horrifying occurs correlations should stay low. The final group falls into what I call “managed alternatives” and would include Leuthold Core Fund and the Hussman Strategic Growth Fund. In this group equity managers have the freedom to take the portfolio relatively long or relatively short (in Hussman’s case he can take the portfolio to 0% net equity) so the correlation of these funds to the broad market will vary greatly depending on how the managers position the fund.

Of the three types of alternatives, it is the last group that presents the most problems for us as portfolio managers. We know that over time the correlation of these funds can change and when they do we have to decide if we need to adjust our overall risk allocation to reflect the change. Neither fund has consistently beaten its benchmark during the current bull market. Hussman has been generally bearish and Leuthold has had issues with security selection. Both of these managers are brilliant but I’m guessing that we will be reducing our holdings in both funds in some, but not all, of our strategies as we enter the New Year.

Investing in the Neutral Zone

I remember the old Star Trek episodes that began with distress calls from some poor spaceship stuck in the Neutral Zone, a vast negotiated area of neutral space designed to separate the Federation of Planets (the good guys) from the Klingons or the Romulans (the bad guys). For the most part, things never went well for the good guys stuck in the Neutral Zone. Captain Kirk, Mr. Spock, and the rest of the Star Trek crew had to fight their way out of many cunningly devised traps set for them by the Klingons and the Romulans in order to get back to safety.

It seems to me that for the past 18 months Pinnacle has also been stuck in the Neutral Zone. For us, the neutral zone is investing diversified portfolios so that they have the same volatility as our investment benchmarks. On a practical level, “neutral” means we haven’t taken a long or short position in risk assets relative to the benchmark. When we are in the neutral zone our incremental approach to changing portfolio asset allocation becomes even more…well….incremental. Small changes in asset class weightings take up a disproportionate amount of time relative to the size of the trades. The timing of even the smallest transactions becomes of paramount concern in the Neutral Zone because the smallest amount of gain or loss due to timing concerns can make huge differences in relative, if not absolute, returns. The importance of investment selection is also magnified when we are neutral to our benchmarks for similar reasons. When our analysts do not make a large relative bet regarding portfolio risk, then all of the nuances of portfolio construction and management become magnified. When you are stuck in the Neutral Zone, owning cash at 0% interest is a major concern. Eclectic managers who underperform for relatively short time periods also become a major concern.

The two worst enemies in the Pinnacle neutral zone are 1) a loss of perspective as analysts become overly focused on incremental decisions, and 2) problems with correlations. Yes, once again I’m carrying on about how asset class correlation can play havoc with short-term portfolio risk and reward assumptions. In the neutral zone any and all of the alternative investments in the portfolio can betray you because by definition their performance can zig and zag differently from the benchmark asset classes at any time. If you are trying to beat a relative benchmark, I suggest you hope for an encounter with Klingons or Romulans, because if you are unfortunate enough to run into peak correlations in the Neutral Zone, your chances of survival are limited.

China Plays the Role of Grinch

On Christmas Day, as investors in Whoville were away from their Bloomberg terminals celebrating with family and friends, China did their best Grinch impression and surprised markets by raising interest rates a quarter point in response to surging inflation. They raised their 1-year lending to 5.81%, while the 1-year deposit rate was increased to 2.75%. They’ve also been hiking reserve requirements for banks in an effort to cool their red-hot economy.

The interest rate action knocked Chinese stocks down by -2% today. There’s been a notable divergence developing between Chinese and U.S. equities over the past several weeks, with the FXI China ETF off -1.3% so far this month while the S&P 500 is up 6.6%.

With inflation rising above 5% in November, odds are that China will feel the need to continue to tighten going into 2011. The possibility of them overdoing it is certainly one of the bigger risks facing the global economy, since China has been considered the main engine of growth in the current environment. Achieving the proverbial “soft landing” has proven to be a difficult feat over the years. We'll be watching closely to see if they can pull it off.

Chart: China 1-year deposit rate

Letter to Santa

Dear Santa,

I know I’m sending this from my work address and your organization usually only serves the consumer market, but our analysts here at Pinnacle have worked very, very hard this year and have been very good. If it’s OK I thought I would ask your elves to make a few special gifts for us this year, over and above the toys and cookies in your sleigh. I don’t mean this to sound the wrong way Santa, but the first thing on our Christmas list this year is world peace and good will towards men. I know you get asked this all of the time, but I figure at $55 of normalized earnings for the S&P 500 Index, world peace has to be worth a multiple of 50 times earnings which means the stock market would rally to 2,750, a gain of about 120% from today’s prices. I just saw Miracle on 34th Street for the fourth time this year (I love that movie, Santa) and I know how hard it was to get the little girl a new home and a daddy, so maybe world peace is a little stretch for this year….but I thought I would ask.

The next think we want for Christmas is low correlations, Santa. I don’t know if your elves can build low correlations in their workshop with such short notice before Christmas and it occurs to me they might not know what low correlations are. Correlations measure how the asset classes in our portfolio move versus one another, and when correlations are low asset classes zig and zag at different times and that reduces the volatility of our portfolios. You see, Santa, if we know correlations will stay low than it’s easier for us to add risk assets to our portfolios so that we can make our clients more money in this bull market. They’ve been good boys and girls too, Santa (…I’m just sayin’), so if your elves are a little confused with this low correlation request please have them send me an email and I’ll explain it to them.

Our last Christmas gift would truly be miraculous, Santa. We would like all of the unemployed people in the US to get jobs and go back to work and be happy. At the same time, we wonder if your elves could kind of make Ben Bernanke, our Federal Reserve Chairman, not worry about this upsurge in employment. You see, Santa, if Ben Bernanke sees everyone go back to work then he is likely to raise interest rates and stop buying Agency and Treasury bonds in the open market. He might even begin selling some from the Fed’s balance sheet, and we know stock investors are going to be upset if the Fed begins to tighten their monetary policy. So please see if maybe your elves can do something about this as well.

It’s time to go, Santa. We are going to leave cookies and milk by the door of the Pit for you this year just in case you get our letter. We want to wish everyone a happy and safe holiday!

The Ghost of Lehman Past

Oh, it was a great day yesterday. We can breathe a sigh of relief because the S&P 500 hit its pre-Lehman bankruptcy level. Lehman Brothers filed for Chapter 11 on September 15th, 2007 and the S&P 500 high that day was 1250.92. Yesterday, the S&P 500 closed at 1254.60.

This level, as the market plummeted to its ultimate bear market low of 666 in 2009, was highlighted by many analysts as the launching point of fear. And although the price has now fully recovered, the fear in the system is still very much present. Ned Davis Research published a study of the Conference Board Consumer Confidence Index in their 2011 Outlook which shows that extreme pessimism still exists. Unemployment is still very high at 9.8%, necessities of life are inflating as income stagnates, housing is still searching for a bottom, and of course confidence has not returned. This is the most distrusted bull market for a reason.

But this leaves many questions about the future. Is the degree of pessimism warranted? Is this bull market built on smoke and mirrors which disintegrates when the liquidity is removed from the market? Or does Main Street pessimism even matter? Has the market discounted decent growth in 2011 which ignites a virtuous cycle? This is only the tip of the tip of the iceberg but a good place to start as we approach the New Year. Here’s to the Ghost of Portfolio Future.

Can’t Model the Art of Investing

At Pinnacle we are constantly reading investment views from some of the world’s smartest people. Recently I picked up a piece written by Howard Marks of Oaktree Capital called “All That Glitters.” The focus of the article was on gold, and it raised some great points to consider regarding the shiny metal and whether or not it’s a good investment at today’s prices. I wouldn’t be surprised if it shows up in a future issue of Advisor Perspectives, and I’d encourage anyone that has the time to read it if it does.

However, the passage from Mark's piece that prompted this blog was not about gold, but more a description of one of the arts of investing. The paragraph that I thought was articulated in brilliant fashion is below:

But it goes further. Especially in the short run, the superior investor may not be the one who's right about the merit of something, or even the one who's right about the consensus view of merit. Rather, the superior investor may be the one who's right about the judgments other people will make about the consensus view of merit.

Pinnacle is a company that follows business cycle data, technical market conditions, and valuation, and there is no doubt that the weight of the evidence in those areas helps shape our overall view. However, we also realize that investing is as much art as it is science. Many investors are still searching for a scientific approach to investing that leads itself to quantitative models, thinking that the unemotional data can never do them wrong. We don’t believe you can package what Marks is referencing into a model. For that you need informed intuition, and a good dose of common sense. If anyone has a model that can bottle good out of the box thinking let us know. We won’t hold our breath…

10.2% Prediction for U.S. Market Next Year

Last week someone showed me a USA Today article where they rounded up the usual suspects who weighed in with their 2011 market predictions. I don’t have the article in front of me but the Chief Investment Strategists for Blackrock, Goldman Sachs, and other massive institutional investors fearlessly jumped in with their predictions. What surprised me (I don’t know why this kind of thing should surprise me anymore) was the specificity of the forecasts. Many of them gave their predictions down to the level of tenths of a percent. The more I think of it, if you are willing to go out on a limb and say the Dow Jones Industrial Average is going to gain 10% next year, then why not make it 10.1%? The extra ten basis points makes your forecast more persuasive since it implies greater scientific rigor in coming up with the number. Many of the forecast numbers in the article were exact to the same levels of precision. All I can say is… good for them.

I am at a loss to know what happens at the end of a calendar quarter, and especially at year-end, that compels normally smart and professional investment strategists to behave this way. Surely there is nothing about turning the page on a calendar that has an impact on earnings, margins, employment rates, currencies, and so forth? If there is uncertainty about the future of financial markets, why should it clear up so suddenly for so many analysts at year end, just in time to make their annual forecasts for the next year? I’ve personally never experienced this phenomenon where the month of December suddenly allows for forecasting market performance down to the decimal level, but I want to be clear that I am open to the experience. For the next few weeks I will be making a conscious effort to allow lightening, in the form of scientifically precise knowledge of future events, to strike. If it does, I promise the readers of this blog that you will be the second to know. My associates on the Pinnacle investment team will of course be the first.

Unfortunately, I’m guessing that our forecast for 2011 will evolve during the year, as has our forecasts for all of the previous years we’ve been actively managing portfolios. The main drivers of portfolio performance will be the strength of the US economic recovery, the problems in Europe, and the policy response to outsized growth in China. How these themes will play out during the year is difficult to forecast at the moment. During those times when the forecast is cloudy and the crystal ball isn’t overly clear, we tend to stick to widely diversified portfolios that are invested in a variety of different investment themes. BORING! I guess that’s why I’m unlikely to get a phone call any time soon from USA Today asking for Pinnacle’s 2011 forecast. They wouldn’t appreciate my answer that I’m 47.6% uncertain about the next twelve months of financial market behavior.