QE2 and Trying to Anticipate Investors Anticipation

The Federal Reserve is slated to end their quantitative easing program (QE2) on June 30th. Lately, there have been a few Federal Reserve Governors voicing their views that perhaps we should end QE2 early due to some of the commodity inflation that has raised the eyebrows of the public recently. Despite the squabbling amongst Fed members, it still seems unlikely that Chairman Bernanke will end this program ahead of schedule. Yes, gas and food prices are up but personally I think Bernanke is more focused on the 8.9% unemployment rate, very low capacity utilization, falling real wages, and a struggling velocity of money. And though it is hard for me to envision helicopter Ben bringing QE2 to port earlier than originally planned, I also have a hard time believing that we’ll get a QE3 unless markets experience another devastating shock that threatens to derail the current bull market.

Assuming the window for QE2 is slowly closing, it is time to begin thinking about what will happen to the economy and markets when QE2 ends. One of many aspects to this issue is how it will affect bond yields. I think conventional wisdom says yields should go up (and bond prices down) when QE2 ends since the dominant buyer of freshly minted bonds will be out of the market. Reinforcing that line of thinking would be the argument that the Fed would only end the bond buying program if the economy was improving, and an improving economy should put pressure on inflation and force bond yields higher. But we must always ask the question, what if the consensus is wrong? For example, perhaps the market focuses less on who is going to buy treasuries and more on the withdrawal of liquidity leading to less robust growth several quarters out. I’m not even sure how much of a surprise that should be given that at the start of QE2 conventional wisdom said that yields would go lower, and they did nothing but climb since the program was enacted on November 10th, 2010. Trying to anticipate what investors will be anticipating is one of the things investors must do, and it is one of the activities the investment team at Pinnacle Advisory Group is constantly engaged in. Rest assured that we’ll be thinking about the many aspects of an end to QE2 as we draw closer to June 30.

Guest Lecturing at Hofstra University

I have been invited to speak to the finance students at the Zarb School of Business at Hofstra University. The engagement is sponsored by GARP, the Global Association of Risk Managers. I’m very grateful to the Pinnacle client who asked me if I would be interested in speaking as well as Ahmet Karagozoglu, Ph.D., and Associate Professor at the School of Finance, who actually extended the formal invitation to speak to his class. This isn’t the first time I’ve been asked to guest lecture to finance students at the MBA level. Professors Russ Wermers and Sarah Kroncke were kind enough to have me speak to their finance students last year at the Smith School of Business at the University of Maryland. Then as now, I am eager to discuss portfolio construction with such fine young students whose knowledge of the financial markets is for the most part shaped by the text books they have read, whatever “color” their excellent professors have added to the story, and I presume whatever experience they have trading their personal on-line accounts. For the record, Professor Kroncke’s students at Maryland actually get to manage real money in the Mayer and Senbet Funds set up by the University Endowment.

While my topic for the lecture is “Managing Portfolio Risk in Natural Disasters, A Playbook for Black Swan Events,” it seems to me that the additional message that I want to share with these students includes an overview of the basic structure of institutional portfolios and how that is likely to impact their future employment. While we manage close to $1 billion in assets nowadays at Pinnacle, the fact is that the assets belong to our individual clients in accounts that are custodied by third parties. The accounts are transparent and liquid. This structure defines what strategies we utilize to maximize returns and minimize risk for our clients. Many of the Hofstra students that I will meet are likely to be employed by bank proprietary trading desks, hedge funds, mutual funds and private equity firms that don’t have similar constraints for portfolio construction. Risk management in these investment communities is based on a different set of rules about how to manage volatility. They will be working at firms that manage huge amounts of capital in pooled accounts that have long-term lockups that don’t allow investors to withdraw their capital for years, and that are completely opaque in the sense that clients can’t see the securities in the fund until the quarterly or annual report. Thus they will be afforded the opportunity to implement all kinds of strategies without the harsh spotlight of clients seeing every trade.

I think I might share the basic rules that we have learned about risk management at Pinnacle, including the potential pitfalls of quantitative investing. I am convinced that the tactical strategies we employ for our clients are so fundamentally sound that they are worth sharing, even if by Wall Street standards they might seem overly simplistic. Evaluating the business cycle, investor psychology, and intrinsic value to find value opportunities is critical to earning excess returns. Avoiding excess leverage, excess derivative usage, and large concentrated stock positions also is critical to avoiding true “Black Swan” events. It might not be sexy, but I’m looking forward to engaging the finance students at Hofstra in a discussion about how to invest in strategies that don’t blow up and have a high probability of creating long-term value for their clients. I can’t wait.

Housing Problems Resurface

There have been several updates on the housing market in the past couple of weeks, and none have been very encouraging. This morning brought the latest reading of the S&P Case/Shiller Home Price Index, and it showed that housing prices are falling anew. The 20-city composite has fallen to its lowest point since May 2009.

It’s certainly not “news” that the housing market is struggling mightily. The stock market has adjusted by punishing home builders and other housing-related stocks. In terms of the economy, housing’s share of GDP has fallen from 6.3% back in 2005 to 2.3% last year, so it has a much smaller impact.

No, the bigger concern is the secondary effects that another leg down in prices may have. Specifically, large financial institutions are still carrying very large inventories of houses, which may create another wave of losses if price declines lead to even more defaults and foreclosures. At the consumer level, a drop in price will increase the ranks of homeowners who owe more on their houses than they’re worth at the same time that gas prices are soaring, potentially creating a big drag on future spending.

The bottom line is that problems in housing aren’t totally yesterday’s news, and we need to keep a close eye on developments there because of potential spillover effects into other important parts of the economy.

Watching Gold Closely

Lately we’ve been watching the price of gold closely. What’s on our mind is that despite extreme havoc in the Middle East, a nuclear disaster in Japan, and a nasty plunge in dollar, the shiny metal has not been able to break convincingly to new highs. Late last week some analysts were noting a key reversal in gold on Thursday when it started up on the day and broke to new highs, but then reversed suddenly intraday and ended the session in the red. That day we did note that there was an increase in margin requirements on silver, which clouded the picture of whether it was showing a very bearish pattern, or just reacting to a short term event.

At the moment we hold 4% gold in our portfolios as a hedge for many things: inflation, banking system risk, geopolitical tensions, terrorism, money printing, potential flight from the dollar, etc. We still believe there are structural risks in the world, and therefore it makes sense not to abandon the asset class completely at this juncture. But we are contemplating bringing down exposure on a tactical basis if it breaks down much further. Why is gold dropping? It could be that the dollar is ready to bounce, it could be that real interest rates are set to rise, or maybe it’s a simple as Warren Buffet saying he doesn’t like it. Any way you slice it, it’s a volatile asset, and we must assess how much of the glittery metal we want to own at any point in time. We’ll be mulling this over and watching the price action closely.

Portugal Government Collapses and the Euro… Goes Up

Overnight, the Portuguese government collapsed following a vote in parliament against a new austerity package aiming to reduce the country’s deficit. Prime Minister Jose Socrates resigned after the vote, as he vowed he would do if this deficit reduction was not approved. He claimed that raising taxes and implementing severe cuts in spending would lead to substantial debt reduction and allow the country to avoid a European bailout. So in essence, the “no” vote has now guaranteed a bailout will come from the European Union summit taking place today and tomorrow at which leaders are discussing the euro-zone debt crisis. The market has a lot of faith in those leaders to quell debt fears as the Euro, currently trading at $1.42, gained against the dollar today.

Traders were quoted as saying the Portugal bailout had been priced into the market already, and all the selling necessary has occurred. Looking at the chart below there doesn’t seem to be much selling in the last few months as the Euro is flirting with 12 month highs. I will be interested in watching this level to see if the Euro breaks to new highs or finds resistance here.

If you ask me, this seems to be more of a statement regarding the dollar than the Euro. The European Central Bank has expressed interest in raising interest rates to counter inflation problems which supports the Euro, and the Federal Reserve is certainly not at that point. If Bernanke’s ultimate goal is to debase the currency then I certainly think he is winning this race. And you know we will continue to hold gold to hedge currency debasement until he releases the throttle.

Chart: Rydex Euro ETF (FXE)

Oil Heats Up as Reactors Cool Down

There’s been a nice rally since the markets appeared to hit a short term selling climax last week on fears of a potential nuclear reactor meltdown in Japan, but we are quickly approaching an important inflection point in this bounce. The S&P 500 has closed in on its 50-day moving average, and many markets have retraced around half of the losses accrued during the panic selloff last week. Markets now appear to be entering the indecision zone that will determine whether the current rally reverses soon or powers forward, leaving the correction in the dust.

While the situation in Japan continues to evolve, recent news has been encouraging as it appears that the nuclear situation is stabilizing. One thing to keep an eye on is the Middle East and energy prices. All the recent focus on Japan has taken some of the focus off the oil markets, and West Texas Intermediate oil has now climbed close to $105 per barrel again in a somewhat stealthy fashion. Whether it’s oil, Japan, commodity price inflation, China raising reserve requirements, or European yields rising, it still seems there are a number of risks circulating around the globe that may keep short term volatility part of our world for just a little while longer. Enjoy the relief while we have it, but don’t get too comfortable since this correction may not be over yet.

The Natural Disaster “Playbook”

Last week I found myself discussing the Natural Disaster Playbook with several clients. This “playbook” is followed by institutional investors with little variation and is employed during unexpected or exogenous events like earthquakes, floods, tsunamis, pandemics, etc. It is also often used for non-natural disasters such as terrorist attacks, assassinations, and any other event that is unexpected and not already discounted by the market. The playbook goes like this: When a natural disaster occurs the reaction of the general public is fear and panic. In such a situation the media is often an enabler of emotional reactions to the event as video is played throughout the 24 hour news cycle. “Experts” are interviewed with dire predictions. In such situations, markets attempt to instantly discount the impact of the tragedy and inevitably panic selling ensues. By definition, the selling overshoots the true fundamental impact of the event creating a buying opportunity for steely-eyed institutional dip buyers. As the smoke clears and the panic subside, it becomes clear that the world isn’t coming to an end and although the event is tragic, in almost every case the global economy continues with little pause. In fact, the odds are that subsequent government spending to recover from the disaster causes GDP to grow faster in the future. Does anyone remember the anthrax scare? How about bird flu, swine flue, and hoof and mouth disease? They all are covered in the playbook.

Buying when there is “blood in the streets” is a proven and time honored method of making money. Institutional investors who buy into disasters are considered to be expert value investors who rise above the panic of the crowd in order to do what they are paid to do, which is to exhibit the counterintuitive behavior of buying when everyone else is selling. The “playbook” includes the unwritten rule that buying a disaster is a low risk strategy from the perspective that clients understand that they wouldn’t do it, so even if it turns out that buying the dip was “wrong,” there is little career risk associated with the strategy as long as it is done in moderation.

There is one hitch to following the playbook, which is the notion of a “black swan” event. These events, by definition, happen very rarely, can’t be discounted in advance by the market, and actually do have dire consequences for investors. Because by definition these events are extremely unlikely to happen, it’s hard to know just what to do about them. The nuclear situation in Japan is a perfect example. The playbook says buy the tsunami and the earthquake, and I suppose we should buy the nuclear meltdown as well. However, if nuclear disasters don’t warrant just a little bit (heaven forbid…not panic) of extra concern, then what does? Until the reactors are under control, I will be in favor of cautiously applying the playbook in the context of unleveraged portfolios that are properly diversified and are positioned close to benchmark risk. Playbook or no playbook, sometimes it is wise to be patient.