What Would You Tell a 60-Year Old About to Retire?

A journalist recently asked me this question in an interview. To be honest, I might as well have been asked what the causes were of the Civil War. From the perspective of a trained financial planner and the Chief Investment Officer of a private wealth management firm, the question is, well….difficult. The writer was writing for the Wall Street Journal, and he was looking for some sound investment advice for folks who have been buy and hold, strategic investors for their entire investing life. Now they are faced with the rapidly changing paradigm in the investment community that buying and holding is actually a high risk strategy in expensive markets. As you may have guessed, I flunked the test. My answer wandered all over the place, and I didn’t make it into the article. However, I’ve been thinking about it a lot since then, so let me try again.

Mr. or Mrs. 60-Year Old, don’t spend too much. Americans are used to a certain lifestyle which is apparent in the size of our homes, the amount of traveling we do, our taste in home electronics, our…everything. Spend the money to work with a legitimate financial planner (a Certified Financial Planner, CFP®) and find out what lifestyle you can afford and learn to live within your means. Next, actively manage your portfolio. You can’t afford to buy and hold if the financial markets are going to deliver less than average returns for the next five to ten years. No one can accurately predict the future, but smart people are worried about the amount of debt in the world, and you had better plan for a low return world early in your retirement. Low returns won’t last for the rest of your life, but the portfolio returns you earn early in retirement are disproportionately important to you, so be prepared. Active management can add two or three percent (or more) per year to your returns over time if executed successfully, which could be critical to your success.

If you’ve invested your own money for years and that’s why you’re reading the Wall Street Journal (or fill in the blank financial periodical), you have to invest the time and treasure to become a different kind of investment expert. You can’t be a successful active manager of your money by reading the morning paper and watching CNBC when you come home from work. If you can’t see yourself doing the work, then hire someone to do it for you. Find a professional wealth manager that specializes in building globally diversified, actively managed portfolios. You may have always been a “do it yourselfer” when it comes to investing, but beware. The market is not likely to provide a tailwind to your investment mistakes going forward. You have to know what you are doing in the tough market environment ahead. Good luck.

Credit Default Swaps – like Dr. Jekyll and Mr. Hyde

Credit default swaps (CDS) are an example of a financial instrument that spiraled out of control during the latest financial crisis. CDS were created as a defensive hedging vehicle that allowed the buyers of the swaps to gain insurance protection against credit defaults, and sellers of protection received a nice stream of payments at a time of very low yields in the marketplace. Take this practical idea and add in models that said certain firms could never go out of business (think Lehman Brothers), a very loose regulatory environment with no counterparty accountability, and now introduce it into a banking system that ran casino-like strategies on 25-to-1 leverage. Suddenly, this once innocent product is transformed into the Frankenstein of financial products that threatened to bring down the entire financial system. Indeed, massive losses on CDS were largely to blame for AIG needing a government bailout.

Despite the fact that CDS became one of the “financial weapons of mass destruction” that Warren Buffet warned of, monitoring CDS prices can be useful as an early warning detection system for the credit markets. We routinely monitor the price of protection in the credit default swap market as one measure of overall credit market health, and to try to assess how much default and system risk is being priced into the marketplace. The chart below, from Ned Davis Research, shows the price (in basis points) of buying credit protection on different high yield bond indices. As the line goes up the cost of protecting against default rises to compensate investors for the increased risk of defaults, and when the line goes down it’s just the opposite. After peaking during the height of the bear market, the price of protection has come down markedly and across most risk markets (including investment grade bonds, high yield bonds, emerging market bonds, etc) which we take as a very good sign for credit markets, implying that there is much less system-wide risk than there was a few months ago.

We continue to believe the evidence is building that a recovery is close at hand, but we also acknowledge that conditions are still fragile. Some say system risk has simply been postponed temporarily, and if so we would expect an early warning signal to come from this credit canary. I suppose the good and bad wrapped into one instrument make CDS a little like Dr. Jekyll and Mr. Hyde.

Chartsource: Ned Davis Research

Is Everything Correlated?

Over the past few weeks it has become glaringly obvious to me that correlations between asset classes have become extremely high. Correlation is the statistical number that describes the degree of relationship between two variables. When the correlation is 1 then the two variables perfectly move in the same direction, and when the correlation is -1 then the two variables perfectly move in opposite directions. So, how much have correlations spiked, or moved closer to 1?

I analyzed the correlations from the market bottom on 3/9/2009 through yesterday 7/27/09. I used the S&P 500 Index as the constant for comparison (this is to represent the market) and used five other assets classes as my variables. I started with Russell 2000 Index and found a correlation with the S&P 500 Index of .98 which is a slight spike but the historical number is around .9 so that is not entirely surprising. I then measured the international markets using the MSCI EAFE Index and MSCI Emerging Markets Index and the correlation was .98 and .93 respectively which was also a slight spike from the .85 historical numbers. I then moved to commodities, REITs (Real Estate Investment Trusts) and high yield bonds to gauge asset classes with low historical correlations. Historically, these asset classes have shown a correlation with the S&P 500 of .2 for commodities and REITs and .6 for high yield bonds. However, during this last market rally the correlations have really spiked to .75, .85, and .9 respectively!

With most risk assets at extreme correlations it seems that one must decide to be in the market or out of the market. Diversification is breaking down and places to ‘hide in the market’ have diminished. If you have owned risk assets you have been extremely happy over the last few months since you have probably made a lot of money. But if this does turn and the market heads lower are you prepared for high correlations to the downside?

Here Come the “Tactical Overlays”

The avalanche of press this year about the death of buy and hold investing has surprised even me, and I have been forecasting this change in our industry for just about a decade. Now that financial advisors and professional pension and endowment investors are paying attention, I am watching to see how the industry is going to address this problem. You have an industry that is populated by professionals who have passionately followed the buy and hold dictums of strategic asset allocation for their entire careers, and all of the sudden they need to come up with “the quick fix.” What should they do as pragmatic business people when the status quo about the “right” way to invest has changed, virtually overnight?

When it comes to personal financial advisors, those Certified Financial Planners (CFP®) who are my peers in providing “sophisticated” asset management for affluent investors, I have long predicted that the solution will appear in the form of some kind of technical analysis-driven process. Clearly the least expensive method for active management, in terms of both time and treasure, is to focus on technical trading methods. I can see new institutional level software (i.e., expensive) that will cater to big firms looking to add a “tactical overlay” to their current buy and hold, strategic asset allocation portfolios. In the world of pensions and endowments, my partner, John Hill, recently told me that the consultants to a non-profit board that he sits on recently offered exactly that. The endowment investment committee could remain strategic (buy and hold), or they could purchase the new razzle-dazzle tactical overlay that would change the asset allocation based on their new, proprietary, techno-sizzle methodology. If professional money managers are afraid that their clients are going to demand active management, I think the tactical overlay will be an easy sale.

Of course, the technical solution will not require that the consultant firms that have advised their clients to buy and hold for decades have an actual track record in active management. Or, for RIA’s (Registered Investment Advisors) catering to affluent clients, their new tactical overlay will not require them to actually learn about market fundamentals, do the research, invest in knowledge and people, or be responsible for the asset allocation changes that are integral to active management. They will instantly have a credible, saleable, technologically marvelous, scientific, and relatively cheap, solution to their problem. Since we (Pinnacle Advisory Group, Inc.) are still slogging along reading the research and actually doing the work, a theme that is mentioned several times in my book, I wonder if we somehow got it wrong?

Rally Resumes on Positive Earnings Surprises

The S&P 500 Index has rallied an impressive +11% in just the past two weeks, after declining by -7% from early June through early July. The catalyst behind the resumption of the rally that began in March seems to be some underlying good news in another otherwise dismal earnings season.

According to Bloomberg, through yesterday, 181 (about 36%) of the companies in the S&P 500 Index had reported second quarter earnings. The results aren’t pretty, as earnings have fallen by -26% from the second quarter of 2008 thus far. But, encouragingly, there have been 136 positive surprises (meaning that earnings came in higher than forecast) versus only 43 negative surprises. Even better, as shown on the chart below, 9 out of 10 sectors have more positive than negative surprises (Technology is the lone exception, and there it is just about even – 14 positives to 15 negatives), implying that the phenomenon is broad based. Apparently investors have interpreted this as an indication that analysts have grown too bearish, and they’ve responded to the possibility of better earnings going forward by buying stocks.

An improved earnings outlook for corporate America, along with signs of stabilization in economic data, provides more evidence that the dark clouds hanging over the economy are gradually being driven out to sea.

Growth Watch – Another Notch Up the Ladder for U.S. Leading Indicators

On Monday, the Conference Board’s U.S. Leading Economic Index (LEI) was released, and it was higher for the third straight month: +0.7 in June, +1.3 in May, and +1.0 in April. The index is comprised of 10 different indicators (see chart below), of which 7 rose during June. The biggest gainers were the yield curve, building permits, stocks prices, initial jobless claims, and average weekly manufacturing hours. Surprisingly, real money supply, the single biggest component within the index, contributed negatively for the month.

At Pinnacle we watch numerous barometers of domestic and global growth, such as: several leading economic indicators (including the Conference Board’s U.S. Leading Index, ECRI’s Weekly Leading Index, OECD’s U.S. and global leading indicators, etc.), a host of market-based data (economically sensitive commodity prices, shipping rates, etc.) and conventional economic reports. The combined message from all of these measures recently is pointing towards a resumption of economic growth in our near future.

We are currently positioned at neutral volatility within our portfolio construction since we believe that the world economy has undergone some structural changes that will likely create long-term headwinds and put a lower ceiling on future growth. But we are encouraged that signs are appearing that cyclically the worst may be behind us, and if the recent improvement in leading indicators is painting an accurate picture, the resumption of economic growth may come sooner than the consensus currently thinks…

The Oh-So-Sweet Sleep of the Certain

Recently I had the opportunity to review the investment results of two different money managers who had correctly called the market top in 2007 and by January of 2008 had safely invested 100% of their investment capital in cash. The resulting investment results are, as you can imagine, spectacular. Both firms are quantitative in nature, meaning that they use proprietary technical-analysis-based methods to determine market trends in order to make their investment calls. In one case, the manager has a trade-marked trend identification system that protects their clients from downturns. While I tip my hat to these managers, I continue to view any portfolio construction that is either all-in in terms of stocks and risk assets, or all-out in terms of cash, as a somewhat high risk proposition.

To me, going 100% to cash screams that the investor has 100% conviction that his or her forecast is correct. I just don’t know how anyone can get to that level of certainty. I’ve often said that they must sleep the sweet sleep of the certain, with no doubts about their forecast, their trading system, their proprietary models, their decision making process, and the well documented irrationality of their fellow investors. I’m envious. When Pinnacle portfolios are positioned to be widely divergent with our benchmarks, as they were in January 2008 with our correct bear market forecast, I don’t sleep well at all. Experience has taught me that financial markets are notoriously fickle, and that making large bets about market direction…either direction….takes a certain amount of courage, or a certain amount of hubris. I suppose it is fair to say that we (Pinnacle) are either very wise in recognizing that the irrationality of markets should be approached with the greatest of respect, or we simply lack the courage of our convictions. I believe that the correct assessment is the former.

From a portfolio construction point of view, it turns out that being fully invested in risk assets still allows a portfolio manager a great deal of latitude to “hide in the market” and still manage risk. Being 100% in U.S. stocks but owning staples, health care, and utilities is likely to result in capturing 50% of the market’s volatility in a bear market. If the market rallies and you were wrong in your short-term assessment of market direction, you will still crush cash returns to the upside. On the other hand, going 100% to cash, when cash pays 1%, is truly a high risk proposition from the standpoint of generating total returns. There is no “repair strategy” from there that I’m aware of. Investors must be 100% certain that the market is not about to rally. For our part, we prefer to actively manage portfolios where our equity exposure varies with our forecasts but we don’t end up at either extreme of market timing. It allows us to sleep the oh-so-sweet sleep of the uncertain!