Wow, Silver

The last time we wrote about silver was in January and at the time we warned that precious metals may be due for a breather. It turned out to be correct – in the very short term – as silver dropped roughly 13% during the month of January. However, that proved to be an extremely valuable opportunity to add or initiate a position in silver as the price has skyrocketed to $40/oz in two and a half months. That would be a gain of 50%, or an annualized gain of 620%! It has certainly been a very powerful move up but is it time to catch a breather, again?

The chart below shows the price movement of silver (represented by SLV) over the last year and a half. The price has climbed from $15 a share in early February 2010 to over $40 a share yesterday which amounted to a gain of 167%. That move can actually be broken down in to three intermediate trends marked by the white, red and green lines on the chart below. As you move from the white line, to the red line, to the green line the slope of the lines becomes much steeper which indicates that the trend has been accelerating. This can also be called a parabolic rise in the price of silver.

A parabolic rise is certainly fun for an investor invested in that financial asset. However, parabolic rises usually mark the end of outperformance for that asset as investor euphoria settles down and no more buyers are left to drive the share price higher. This may or may not be the case for silver right now but it seems like a dangerous place if you are thinking about buying, especially with QE2 ending in June.

The Proper Investment Time Horizon

I have been studying the Maryland State Pension and Retirement Savings Plan just because I’m interested in how professionals go about investing $36 billion of assets. It’s difficult to evaluate the plan’s asset allocation without considering the investment time horizon that is used to evaluate success. As you might imagine, the plan seems completely uninterested in short-term returns if defined as periods of less than 5 years. In fact, the plan uses actuarial methods that smooth the plan’s returns for very long periods of time. For example, the plan’s unfunded liabilities are smoothed under an actuarial convention called the “corridor method” that amortizes the plan’s pre-2000 unfunded liabilities over 20 years and then each subsequent year liability over distinct 25 year periods. In addition, the value of plan assets is “capped” to be 20% above or below the plan's target actuarial return of 7.75% and can be amortized over five years. As it says in the plan’s annual report, any one year’s investment performance can take up to 15 years to be fully recognized under current plan accounting conventions. Fifteen years is a long time to fully recognize capital gains and losses, and it provides a powerful incentive to not be overly worried about short-term investment performance. We certainly don’t have the same luxury at Pinnacle where we have to mark our client’s investment performance to the market every day.

The Maryland plan sets up a series of performance benchmarks that also promote very long-term thinking. For example, one benchmark is to outperform the 7.75% actuarial return assumption over time. Another is to outperform inflation by 4% over time. Another is for the plan to outperform “the plan’s” performance benchmarks, which careful reading reveals to be individual asset class benchmarks. If there is a single benchmark to evaluate the total portfolio I can’t find it. It is the latter benchmark that is potentially short-term in nature, but it doesn’t incentivize plan managers to be concerned about short-term absolute returns. For example, if the plan’s equities lose 35% and beat the equity benchmark by 3% then they will have accomplished the goal of outperforming, even though they lost 35% on the position. The plan is obviously tilted in every way to succeed over the very long-term and investors will not find any reason to be concerned about short-term performance either in the plan’s asset allocation or performance evaluation.

The question I have is, so what’s wrong with that? The investing we do for Pinnacle clients is also long-term in nature when stated from the perspective of matching investment strategy to our client’s objectives. Retirement planning is a decidedly long-term endeavor, and investing to meet retirement goals should require a long-term perspective as well. Yet Pinnacle clients have access to return information every week and every quarter, as well as every year. The investment team earns part of their bonus based on quarterly performance. We read daily and weekly research, trying to discern how and when trends may change in the very short term. I doubt that we will ever resolve the conundrum of investment time horizon to my satisfaction. Good consumers want performance information in “real time.” I can only be envious of pension plan managers who seem to totally ignore short term market volatility.

Dollar Breaking Down

This big news this week was that the European Central Bank (ECB) raised interest rates on Wednesday. While it was only a 0.25% increase, from a very low level (1% to 1.25%), it has had a big impact on currency markets. The euro has certainly gotten a big boost, and as a result, the dollar has been under renewed pressure, falling through an important technical level. The next critical threshold for the dollar is the low from late 2009, which is only another -1.5% from here. If that fails to hold, then the 2008 lows might come into play.

Why does this matter? Well, a falling dollar will only exacerbate recent inflation pressures. It will drive commodity prices even higher (since they’re priced in dollars), threatening the economic recovery. A lot of blame for the dollar’s weakness has been placed at the feet of the Fed. They currently aren’t even officially considering raising interest rates from their ultra-low level; instead, they’re still furiously pumping credit through their QE2 program.

Critics wonder about the necessity of such stimulus when the economy is supposedly almost two years into a new expansion. The Fed has countered that they’ll be able to successfully remove the excess stimulus when the time is right and prevent inflation from really taking hold. The action in the dollar seems to indicate that the market isn’t buying it.

Chart: Trade-weighted dollar index w/ underlying support levels

Review of Global Central Bank Policy

In this morning’s daily report, Ed Yardeni provided a useful review of Central Bank policy around the world. Since one of the biggest risks to the current bull market is a reversal of policy from being accommodative to being restrictive, I thought it was worthwhile to share some of the information in Yardeni’s report.

The big news in the U.S. is the presumed end of the Fed’s Quantitative Easing (QE2) policy this June. The Fed has been buying securities through their permanent open market operations (POMOs). This money has been finding its way into risk assets, especially the stock market. Investors are worried about what happens when the Fed stops buying. In the meantime, the Fed Funds rate remains at zero and the expectations are that it will remain there “for an extended period.”

The European Central Bank is pursuing a different course. They are expected to raise their lending rate from 1% to 1 ¼%, and investors seem to be anticipating an additional ½% to ¾% raise before year-end. The EU is struggling to “normalize” interest rates even though higher rates will penalize the PIIGS (Portugal, Ireland, Italy, Greece, Spain) by driving the euro higher which is a headwind to growth. The euro has already risen from 1.29 in January to 1.43 this morning.

The Bank of England is on hold at 0.5% and recent economic data is not encouraging.

The Bank of Japan has injected huge amounts of liquidity into the banking system since the natural disasters last month. Their bank reserve balance jumped 53% from 15.9 trillion yen to 24.4 trillion yen.

The People’s Bank of China yesterday raised interest rates to 6.31%. The have raised their bank reserve rate six times since last October, all in attempt to slow inflation that is expected to be 5.1% year over year when it is reported on April 15th. Like other emerging markets, China is struggling with food and energy inflation problems.

Brazil’s central bankers yesterday proclaimed that they will fight inflation next year. While their target inflation rate is 4.5% current inflation is running 6.13% YOY.

The bottom line is that investors who are worried about central banks “normalizing” or raising rates to historically normal levels probably have good reason to worry. Yardeni thinks that the bull market is being driven by higher corporate earnings and that the market will adjust to higher rates and the bull market will continue. However, even he is again warning about the risks of a correction.

Pharmaceuticals Beginning to Show Some Life

Sector rotation is one way we attempt to add value in client portfolios. We rotate within both the equity and fixed income allocations, as we continue to look for good values across asset markets. Currently our equity portfolios have employed a barbell, with cyclical overweight positions in the Energy and Technology sectors, as well as defensive overweight positions in Health Care and Consumer Staples.

For many months the broad Health Care sector has not done well when compared to the broad market, even though many of the industries we own have done quite well (such as Managed Care and Medical Devices). Within the sector, the main industry laggard in Health Care over the last year or so has been the ultra defensive Pharmaceuticals group, which we’ve owned along with the higher flying industries mentioned above. Pharmaceuticals companies are very cheap, have pricing power, and just recently may be showing some signs of turning the corner. In fact, though they are considered a low beta play, it’s interesting that Pharmaceuticals have actually been outperforming the broad market during this rally off the March lows. After a very nasty underperformance period, perhaps Pharmaceuticals are about to look a whole lot healthier.

Life Isn’t Always Linear

Being an Investment Analyst often involves looking at a vast array of indicators that are supposed to be correlated to different degrees with some relevant financial variable. When a given indicator is said to be either positively or negatively correlated to a variable, in most instances this refers to linear correlation. However, two variables may very easily be non-linearly related in which case testing for linear correlation alone will produce misleading results. Responding to this issue, we developed a tool that applies a number of different non-linear transformations to the data in order to test for non-linear relationships between an indicator and a financial variable of interest. In addition, these transformations are applied on different moving averages and percent changes of the raw data, and the correlation is measured not only concurrently but also using different lags from 1 month to 24 months. In the chart below, the black dashed arrow represents a simple linear transformation while the other data points represent the different non-linear transformation that we also consider.

Each time this tool is applied to a single indicator, it produces over 1,500 data series derived from the original one and estimates the correlation of each one of them with the relevant variable. When performing such a massive data mining exercise, we are bound to find some significant correlations simply by chance. If statistical inference doesn’t betray us, for each one hundred correlations that we estimate we would expect, on average, to find at least one of them to be significance at a 99% confidence level. In these instances, it is important to remember that correlation does not necessarily imply causation, and the latter is what we are looking for. A good example is the famous Super Bowl Stock Market Indicator, based on the observation that in 29 out of the 36 years from 1967 to 2003 an NFC victory preceded positive stock market returns while an AFC victory preceded negative stock market returns. Even though it is undisputed that such a correlation existed historically, it would be foolish to expect this phenomenon to repeat itself in the future, unless there is a valid reason to believe that an NFC victory caused the stock market to rise and an AFC victory caused the stock market to fall.

This is where the big brains of Pinnacle’s Investment Team come into play: each time we run into a variable that seems to have a strong predictive power based on empirical tests, it is a team effort to determine whether we believe an underlying causation effect based on sound economic theories actually exists. If the conclusion is negative, then the indicator is discarded as there is no reason to expect the historical correlation to repeat itself in the future. In conclusion, let’s hope that the current NFL lockout gets resolved, otherwise the stock market may not move at all next year.

Coal a Winner on Nuclear Concerns

The ongoing crisis in Japan has cast a shadow on the nuclear industry, and even China has announced plans to look for alternative energy sources. There have been many perceived winners including solar energy and natural gas; however, the coal industry has become a major beneficiary due to current energy infrastructure. The nuclear industry is a major contributor to global electricity generation and this crisis will diminish that contribution. Coal, which already accounts for nearly 45% of electricity supply, is in a good place to make up for the slack left in the nuclear wake.

The coal market has started to anticipate the increased demand as global coal prices have risen since the nuclear crisis. Additionally, the supply side of the equation has been adversely affected due to the flooding in Australia which forced mines to close. This combination is reflected in the great performance in Coal stocks (represented by the KOL ETF).

From the end of June the stocks are up almost 70%. From December to March, as marked by the upper red line and the lower white line, the stocks took a breather in the form of a rectangular consolidation pattern. However, over the last few days the KOL has broken above the red resistance line which signals that the uptrend is likely to continue. Additionally, this breakout occurred on very big volume which is shown at the bottom of the chart. The huge green spike is great confirmation that the breakout is strong and we are happy owners of this position in our aggressive model.