Sequencing

Lately I’ve been reading a lot about sequencing. The term is used in reference to how the Federal Reserve might go about communicating and then changing current monetary policy. The sequencing might go something like this: 1) The Fed ends quantitative easing as scheduled by the end of June but announces that it will continue to reinvest maturing bonds in U.S. Treasury securities, thereby keeping its balance sheet from shrinking, 2) Two months later the Fed announces that it will no longer reinvest bond proceeds and allow its balance sheet to gradually shrink, 3) Two months later the Fed changes the language in its monthly statement so that it no longer implies short-term interest rates won’t change in the foreseeable future, and 4) Sometime in the first quarter of 2012 the Fed raises short-term interest rates for the first of many increases to occur during the year. Of course, no one really knows if this sequence is correct and we suspect that the Fed, like everyone else, will react to economic data as it develops.

We have been having our own discussions about sequencing in the investment team over the past few weeks. Recent events have us pondering the possibility that the economy will slow to the point that it will impact risk markets. The signs are there if you care to see them. They include the commodities market imploding last week, bonds rallying, QE2 inexorably ending in June and market participants wondering if the risk markets are beginning to price this into current prices, the Arab “spring” beginning to look a little “chilly,” the dollar showing signs of rallying, unemployment claims spiking up again recently, and leading economic indicators showing signs of slowing. All of the above may be nothing more than the “wall of worry” that bull markets always climb. After all, earnings continue to come roaring in and this quarter looks like another slam dunk for corporate America. But still…we’ve been thinking about how we might take risk off if necessary.

The sequencing might go something like this. First we are selling our Germany ETF in DA and DUA portfolios and preparing to sell our commodity futures position in all portfolios as soon as this week. Next we rotate to more defensive industries within our cyclical sectors like Energy, Tech, Consumer Discretionary, etc. Next we rotate from cyclicals to defensive sectors like Health Care, Staples, and Utilities. Finally we rotate from defensive equity sectors to cash. A similar sequencing will occur in the fixed income allocations of our portfolios but we haven’t really focused on those discussions just yet. Sequencing seems to be the name of the game of late.

The Strange Case of Two Unloved Secular Stories

I find it interesting that Pinnacle is currently underinvested in two long-term or secular themes. One is the China growth story and by extension, our investment in emerging market ETFs and funds. The second is the commodity bull market story. Notably both themes are related to the other in obvious ways since China is the world’s largest importer of commodities. Also notable is that we think both ideas are largely correct. China will be a leader of global economic growth for years to come and in a world of increasing scarcity commodity prices should continue higher over time. The reasons we are underweight are somewhat complicated.

China is currently fighting a battle with food and energy inflation as well as a real estate bubble. Chinese policymakers have been tightening monetary policy in order to slow the economy and prevent an asset bubble from harming the economy. We have been commenting that Chinese policy is out of sync with much more accommodative U.S. monetary policy with the result being that Chinese and other emerging markets are under performing the U.S. stock market this year. As China and other emerging markets tighten policy and slow economic growth, commodity prices will also have to adjust to slower growth. In addition, the U.S. Federal Reserve is due to stop buying Treasuries and complete their quantitative easing program this June. If less accommodative U.S. monetary policy results in slower U.S. growth that should be a headwind for commodity prices as well. If the Fed ends up raising interest rates early next year that could result in a stronger dollar which might also result in lower commodity prices. In fact, we believe the dollar is currently oversold so any short-term bounce could further weaken commodity prices adding to the devastating price declines last week.

As tactical investors we invest our portfolios in a time frame that is much shorter than the secular or long-term time horizons required for many investment themes to mature. No doubt we will soon find a way to reenter both the emerging markets and the commodity markets since it is clear that there is a long-term story for both that deserves to be invested. But for now, we seem to be content to watch both stories from the sidelines. We have established target prices to sell our commodity position. Hopefully commodity prices will rebound from last week’s disaster and we will get to sell at the top of our target range. We do participate in both themes (China and commodities) indirectly by owning gold, energy stocks, international funds that own companies that do business with China, and U.S. stocks that derive a large percentage of earnings from emerging markets generally and specifically China.

Soft Patch Upon Us

A number of indicators have led us to believe that the economy is probably slowing at the moment. For example, regional manufacturing surveys have been trending down recently, unemployment insurance claims may have broken their previous downtrend, the Economic Cycle Research Institute recently issued a warning based on their Long Leading Index, defensive equity sectors have been outperforming, commodities took a big hit last week, and treasury bonds have been rallying. On balance, it would seem that recent evidence is pointing to an ebbing in global growth.

Some slowing doesn’t have to be catastrophic, and could have the positive side effect of reducing commodity prices (which should help profit margin pressures that were building) and giving the Federal Reserve plenty of reason to remain accommodative, or dare I say an excuse to implement a QE3 program? In other words, this could be the elixir that leads to one last leg higher for the equity market. On the other hand, any time growth begins to slow investors should be on guard for worse than a benign outcome, and we will be keeping our antenna up in case an easing in growth looks like it’s becoming material, and of a more malignant nature.

From a positioning standpoint, we are now focusing on our commodity positions, which don’t seem like a good bet if growth is slowing. In the very short term they are likely oversold after last week and could bounce. If we get it, we think it will be a good chance to sell. We are also taking a look at some of our high beta positions, and will be scrutinizing our bond exposure given a slower growth environment since we are currently underweight duration. We don’t feel it’s time to adopt a maximum defensive posture yet, but some minor adjustments and a close eye on incoming data is the order of the day.

Employment Gains Continue

With recent economic data turning decidedly mixed, raising concerns about the possibility of another economic slowdown similar to the one experienced last spring and summer, it was encouraging to see the monthly employment report released this morning surpass expectations.

Total nonfarm payrolls grew by 244,000 in April, handily beating expectations for a lesser gain of 185,000. Private payrolls turned in an even better performance, expanding by 268,000, which was well ahead of estimates of a 200,000 job increase. Private payrolls are now at their highest level since March of 2006.

While it’s encouraging to see employment continuing to achieve steady, although still somewhat lackluster, progress, we also need to keep a close eye on leading economic indicators, some of which have suddenly stalled a bit. But overall, today’s report was good news, as increased hiring should be a key factor in bolstering consumer spending and extending the current expansion.

Out With Commodities?

Commodities have certainly been on the mind of investors as price gains have been astronomical since a big correction early in 2010. Agriculture stocks were up 70% since then to their recent highs, silver was up just shy of 100%, and even broad commodity indexes were up 37%. These are amazing price moves which have initiated talk of bubbles in the commodity space (which is certainly warranted regarding silver). And perhaps we have begun the inevitable bursting of the bubble as commodity prices have been plunging over the last few days. However, a look into the recent past may put this decline into context.

The chart below is a price chart of DJP (the DJ/UBS Commodity Index ETN) from 12/31/10 to 5/5/11. You can see at the far right that commodity prices have fallen 7.65% in just four trading days. This drop is definitely newsworthy, and could be the harbinger of things to come in commodity prices, but look to the left of the chart. As recently as March, commodities fell 8.09% in five trading days, and from that drop in price preceded to rally 12.02% over the next two months. So this correction is not out of the norm so far and could provide an opportunity to add to current commodity positions. At Pinnacle we are watching the commodity space intently, and having discussions regarding whether to make any adjustments to our commodity positions as I write this entry.

Anecdotally, in 2007, Blackstone Group issued their Initial Public Offering very close to the top of the buyout binge America craved in the 2002-07 bull market. Fast forward to today and Glencore could mark the top of the commodity craze that has led the market higher since 2009. Glencore is the leading integrated producer and marketer of commodities in the world. Only time will tell if the next bear market is about to begin but the similarity is eerie.

Interest Rates & Group Think

Today I had the chance to attend a CFA luncheon in Baltimore with Carl Noble where Jim Grant was the keynote speaker. For anyone not familiar with Jim Grant, he is a very accomplished writer, historian, and value investor, and he writes an excellent newsletter called Grant’s Interest Rate Observer. Jim is also an excellent speaker, and I would encourage anyone that gets the chance to go hear him pontificate about the markets in his very unique style.

As he has been for some time, Jim is bearish on bonds (he thinks yields will rise) and the U.S. dollar, and very bullish on the price of gold. On the topic of yields, we have shared his view that they will likely drift up if the economy stays supported, but have also acknowledged that the view certainly seems consensus at this point, which is a little bit worrisome from a contrarian investing standpoint. As I sat and watched the reaction to Grant’s view on rates, the feeling I got from being in the room was that most audience members agreed with what he was saying. I mean, who can’t see that rates at these levels can’t go much lower, right?

As it turned out, I got the last question of the day and had a chance to ask Jim what a contracting money multiplier and huge bank reserves meant to his view, because the behavior of these metrics might lead some people to believe that the U.S. is currently dealing with Japanese-like deflationary symptoms that could cause interest rates to stay low for a lot longer than most folks think is possible. Jim was undeterred and essentially believes that Japan’s cultural differences were the biggest reason for their lost decade, and he believes and sincerely hopes that we don’t head down the same economic path as Japan.

At the moment we continue to be positioned to benefit from higher rates, if for no other reason that our cyclical view is for continuing economic expansion, and investors had piled into bonds in the Great Recession and may still be unwinding that trade. But I have to admit that I occasionally get the nagging feeling that current "group think" is all for higher rates at the moment, which leaves the herd vulnerable to rates moving lower and staying there longer than most expect.

The Osama Bin Laden Bull Market

For many years I have punctuated many discussions about protecting against a market “melt up” by saying, “What would happen if we came in tomorrow and they captured Bin Laden?” Well, last night we found out that Bid Laden is dead. It is something of a surprise to me that as of 3:45 PM this afternoon the S&P 500 Index is actually down 4 points to a price of 1,361. This is just another example of why I find it impossible to explain market behavior on a day to day basis. Maybe the lack of investor enthusiasm has to do with today’s ISM (Institute of Supply Management) report which came in at 60 (above expectations) but with the prices paid component also above expectations. Prices paid is an indicator of inflation in the pipeline so maybe investors remain spooked about what happens when the Fed stops the QE2 program. I don’t know. I would have thought that getting Bin Laden would have people feeling good about the country and that would have led to a positive “Black Swan” surprise moment for stocks that would take the market up to sharply higher prices on the day. Wrong.

Of course this isn’t the first time I’ve been wrong about how events have played out in the market recently. I freely admit to thinking that the Japanese nuclear disaster would lead to significantly lower stock prices as investors worried about the impact of slower Japanese GDP growth as radioactive water was leaking into the ocean. I could visualize mass selling while radioactive clouds drifted over Tokyo. It turns out that investors were unimpressed by that particular event as well. Stock prices have pretty much headed higher since the tsunami/earthquake/nuclear event on March 12th. In the U.S., stocks fell 3% in two days following the disaster but from March 16th to April 29th they have gained 8.74%. Apparently bad news won’t shake the bullishness from the market, but good news doesn’t seem to be able to move the market to extremes, either.

At a March 12th meeting of Pinnacle’s investment analysts, it was explained to me that Japan was such a small part of the geopolitical puzzle that the unlikely event of a full nuclear meltdown would have little impact on global financial markets. Today we must conclude that Bin Laden’s death is also being discounted as being irrelevant to the health of the global economy. Either he is presumed to not be a relevant force within al Qaeda, or al Qaeda is presumed not to be a relevant force, or….well…I don’t know. At any rate, now I’m going to have to think of a different positive Black Swan event to use as my example for what happens when unexpectedly good news hits the markets.