There is a Reward for doing Your Homework

Investment Heresy #2: Risk & Return are not ALWAYS positively correlated.

Ten years ago I had lunch with a prospect who was interested in getting a little better return on his investments. He was about 70 years old. He had made fortunes, and lost fortunes, and made them back again. I felt that I had a lot to learn from this man, which is typical of many of the investors who come to me for advice.

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During the mid-1970's, this man made over a million dollars running a small company which developed a medical cream used in fighting cancer cells. Never allowed to sell the product in the U.S., his company developed markets in Latin America and Europe. A small Denver brokerage house took his company public at 10-cents a share. The 400,000 shares for which he'd paid a penny each were suddenly worth $6 in the penny stock market! He sold his last block of shares for $16 a share.

My point is that this man was not unsophisticated about finances. Nevertheless, as he sat in my office, I soon found myself explaining - once again - the basic facts of investment life. Risk and return go hand in hand. Many people forget this rule, which is as fundamental to investing as gravity is to natural science.

Nobody likes risk. Everybody wants a high return. Prospects searching for high return but little risk, like the man I met for lunch in 1997 and the prospects I met last week and the couple I'll likely meet next month, are the norm. Risk and return generally go hand in hand.

But not always.

Investors want portfolio results above the line. They want returns that exceed the normal return for a given level of risk.

A portfolio could end up in position (A) for only a couple of reasons. One good example would be when short-term performance of the portfolio gets ahead of itself. Sometimes investors just get lucky! Experienced investors know that returns are typically "bunched." They are not spread evenly over time. In a given period, some portfolios will, for many reasons mostly having to do with chance, see their portfolio surge in value. When a concentrated portfolio meets a significant investment fad, such as the hype which surrounded "internet" stocks in 1995, performance can surpass all reasonable expectations. In the short run, returns can leap above the risk/reward line. In the long run, however, this position is hard to sustain.

Another reason that a portfolio could end up in position (A) is that its risk might not be properly recognized. For example portfolio (A) might be using options or warrants to take on more risk than most investors realize. Options and warrants, like other forms of financial leverage (borrowing money to purchase additional assets), can increase returns in a bull market, but will also exaggerate the declines of a bear market. Sometimes above-average returns are signals that you are using the wrong average! Properly classified, the return might still be attractive --- but, more importantly, the portfolio might be taking much greater risk than investors realized. Some hedge fund managers are addicted to leverage in the same way that extreme sports fanatics are addicted to adrenalin. But once again, over time the use of leverage can be fatal. Many hedge funds have reported several years of spectacular performance, with increasingly large sums of money, and blow themselves up in the end when the strategy fails and the bankers move in to sell what is left.

Looking for strategies that provide above-normal returns requires an ability to determine how returns are being earned in the first place, as well as a solid understanding of the investment risks inherent in the strategy.

A famous example of out-sized returns:

In 1993, Worth Bruntjen managed a Piper Jaffrey mutual fund that was winning accolades by investing in government securities. In fact, the fund was investing in "government-guaranteed" mortgage-backed securities which were highly sensitive to swings in short-term interest rate levels. As rates declined through 1992 and into 1993, these securities performed very well. The attractive returns drew hordes of investors into this "government bond" fund. Some of the most naive investors believed that the fund was paying out great rates of return but that their principal was not at risk. The fund received high rankings by both journalists and fund rating services. Nobody bothered to look too closely at the reason for these above-average returns.

The fund's real risk/return posture became readily apparent when rates reversed themselves. In late 1993 and throughout 1994, this fund's reliance on speculative mortgage-backed derivatives became quite clear. While rates declined, these securities paid increasingly higher rates of interest, leading to the fund's outperformance. When rates reversed, however, these securities started paying out lower rates of interest. Even worse, the bid side for these hard-to-value mortgage-backed securities plunged. Bids dried up. News about "derivative-related losses" splashed across the top of newspapers (and not just the business section, either).

Piper Jaffrey's fund lost 25% of its value in a matter of months as sharp investors bailed out of the fund. The fund manager sold the most liquid securities first, but that left the manager and the remaining fund owners holding a bunch of hard to sell derivative securities that were falling precipitously in value. This was clearly a case where the portfolio's out-sized returns were achieved by taking some "hidden" risks. Had these additional risks been factored in, the outperformance would not have been so hard to explain, and the debacle during 1994 might not have come as such a surprise.

In 2008 an almost identical scenario unfolded in Memphis, Tennessee when Jim Kelsoe’s formerly top-ranked Regions Bank/Morgan Keegan Select Intermediate Bond fund imploaded under the weight of too many securities backed by sub-prime loans. You may have been wondering who was foolish enough to buy bonds backed by optimistic home owners who, though they may have lied about their income and probably couldn’t afford their home, somehow managed to get someone to loan them the money anyway. And who, ultimately, was lending them the money? Why, it was the investors in Kelsoe’s bond fund! For four years running, from 2003 to 2006, Kelsoe’s investors beat their bond benchmark by 2.5% to almost 3% per year. In the bond arena, that’s a bunch. But there was more risk in those loans to jughead borrowers than Kelsoe realized, and when the market for this garbage dried up, Kelsoe was left with a major part of his portfolio where there was no bid. His fund lost 50% in 2007, and then another 50% in the first part of 2008.

Kelsoe also made his "expertise" available to closed-end fund investors.  In 2009, the brainiacs at Morgan Keegan changed managers at just about the worst time imaginable. The new managers sold nearly all of the holdings into extremely illiquid markets, permanently locking in losses for fund investors, so that they could start with a clean slate.

The homework assignment is not to avoid funds with above-average track records, but rather to do the work necessary to understand how that performance has been achieved.

Next post: Can performance fall below the line?

To start at the beginning of the Investment Heresies eMag, click here

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Alpha, Beta, Recessions and You

Recent investment manager performance is telling. Research shows that managers really set themselves apart from one another during recessions. Moreover, InvestmentNews reports in its November 16 issue, market timing trumps buy-and-hold investing amid big swings in economic activity. “Given that we are currently in a recession,” the author said, “our work suggests that individuals should be looking for a different type of investment manager – one that invests based on macro information.”

Marcin Kacperczyk, Stijn Van Nieuwerburgh, and Laura Veldkamp published a study called, “Attention Allocation Over the Business Cycle” in October 2009 which found, “that the data are consistent with a world in which some investment managers have skill, but that skill is often hard to detect. Recessions are times when differences in performance are magnified and skill is easier to detect.”

During the good times, the macroeconomic environment is stable so “market timing” adds no value. Instead, fund managers tend to cluster around the benchmark index and “stock selection” drives portfolio relative performance. Although stocks, individually, are more volatile than the macroeconomic variables, across a diversified portfolio the different managers tend to see performance cluster around the benchmark returns.

In times of macroeconomic volatility such as a recession, however, the large scale risk, though less volatile than individual stock risk, drives investor performance. The study showed that skilled managers add value by deviating more from the benchmark, focusing more on adjusting the portfolio asset allocation, so portfolio differentiation is much greater, both in portfolio construction and, ultimately, in performance. For this reason, it is easier to spot skilled managers during tough times. Alternatively, it is easier to significantly outperform during a recession, with the skilled managers employing market timing skills that other managers refuse – or are not allowed – to employ.

One way that I might summarize the finding is that in a recession, Beta matters more than Alpha. The sensitivity of the portfolio to the rise or fall of the broad market (i.e. the Beta) matters more than the ability to pick stocks that outperform their benchmark (Alpha). Even more simply, market timing is more important than stock selection in an economic downturn. In the more stable upturn, buy-and-hold is the way to go and portfolio managers should focus attention on stock selection.

The May-Investments portfolio building approach has always recognized this fact, although now we have a fancy sounding study with some really impressive mathematical equations to tell us what we already knew.

We have been implementing a “Flexible Beta” approach for several years now. Our willingness to take on risk varies over the course of the economic cycle. Call it “market timing,” or “tactical asset allocation,” or “staying in the way of what’s working and getting out of the way of what isn’t working,” or whatever you want. When market volatility increases, as it tends to do during a recession, it pays to be more conservative.

On the other hand, when the investing environment becomes favorable again, as it no doubt will at some point, we move to a fully invested position and focus more on industry research to keep us invested in healthy industries that are working well in the market. Though statistically this looks like a high Beta strategy (because it’s outperforming the market, which is also rising), it is focused more on stock selection (Alpha) when constructing a bull market portfolio.
 
Merry Christmas to all!

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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God Test Ye Merry, Gentlemen

From Ben the Chairman of our Fed
A helicopter came;
And loads of money fell into
the hands of banks so lame:
Then GM bonds were trashed to buy
The Union vote to blame.
O tidings of worry and fear,
Ain't it so queer
No hurry to worry and fear

In Wall Street now, in New York streets,
The bonus pool goes on
And bankers all across the land
pull off this spineless con
A bank account pays 1 percent
But businesses get none
O bankers both greedy and mean,
CD rates lean
The old folks eat ramen and green bean.

"Fear not then," said the Angel 'cause,
"The White House has your back,
We won't raise income taxes now
Of funds we do not lack,
The trillions that you're forced to pay
The rich will pay you back."
O tidings of borrow and tax,
Those are the facts
Raise the limit on our debt to the max

Obama came to save the day
With Congress playing ball,
Soon Treasury can't borrow and
The markets hit a wall:
Then China plays the China card
Oh where'd they find the gall.
O tidings of borrow and spend,
when will it end
On good tidings of our lenders we depend

Pelosi gave healthcare to all,
While saving bankers hides,
They bought GM illegally,
then watched as business died;
With Barney Frank and Dodd in charge,
Reality denied.
Civic leaders lying, full of gall,
I'm appalled
Send the politicians home from the mall.

We're praying for a happy end,
Before this song is done,
The stimulus worked briefly
and the spending sure was fun;
We'll pay for that till our kids die
And grandkids too are gone.
O tidings of credit and debt,
Come and get
The problem is that lenders don't forget

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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A Prize For the Most Useless - Part II

William Sharpe


In 1990, William Sharpe won his prize for his contributions to what a generation of business school students have learned to call the Capital Asset Pricing Model (CAPM). In the rarified world of Chartered Financial Analysts, we pronounce it “Cap’em,” like what one gang member might say to another when he wants someone shot.

Like most of what is taught in universities, it was anti-establishment to the extreme and based on theories that sound reasonable in the abstract but don’t fare well in the real world. The CAPM, for example, taught students that all investors have rational expectations. However the parents of those students could testify to the lack of correlation between their children and any sense of rationality at all. They may not talk about it. They may even laugh about it at times. They will go to bat for their kid and threaten to sue the school if it decides to expel a student. But there is very little underlying belief in the concept of a rational college student-consumer. Parents aren’t total idiots.

The CAPM also assumes that investors are solely concerned with level and uncertainty of future wealth. The mere appearance of wealth, in the nightclubs or in later years at high school reunions, is assumed to be unimportant. Risk-free borrowing rates are assumed to be equal, which is true until that first late credit card payment, at which time borrowing rates get very unequal, very quickly. The CAPM assumes perfect information, which isn’t even true after the invention of the internet, and was even less true when Dr. Sharp was dreaming this garbage up. The model assumes no inflation, perfectly efficient markets, and a fixed quantity of assets (whereas in reality the venture capital community exists, primarily it would seem, to create business shells which can be sold into the latest hot stock market sector).

In essence, the completely unrealistic economic theory contrasted wholly and completely with financial reality, which ought to lead one to be suspicious about whatever conclusions are drawn from the high end math incorporated into the study, no matter how elegant the mathematical equations look in the appendix of the study.

Unfortunately, however, the nation’s business schools hopped on the CAPM bandwagon like a day-trader buying into the notion that internet stocks only go up. The study introduced the concept of beta as a measure of stock volatility, but failed to deliver because later studies showed that some low beta stocks may actually offer higher returns to investors, which is exactly opposite of what the CAPM crowd believes. CAPM assumes that the “variance of returns” is an adequate measure of risk, which is a candidate for the biggest lie ever told and deserves an entire chapter or two of its own. The model assumes that given certain and equal return projections, investors will prefer the lower risk strategy but fails to take into account investor fads that drive investors to put money into sexy new products in a pathetic search for excitement. The model assumes no taxes or transactions costs, which in itself is so ludicrous that outside of an election year, not even an economic neophyte would be likely to buy into that hypothesis.

Sharpe’s work stood the investing world on its head. Now the majority of investing models try to encapsulate “risk” into one all-encompassing number, either Beta or a statistic that measures “return variance,” as if the winner of the Super Bowl can be determined by counting the number of first quarter rushing yards throughout the season.

Investors have bought into the notion that markets are “efficient” and that there is no reward for time spent researching one alternative versus another, separating out the boring and profitable from the exciting and overpriced alternatives, as if a flip of the coin has as much chance of picking a winner as does any other method. Ironically, the model which assumes no transaction costs that would limit investors’ ability to shift back and forth between stocks and bonds and other asset classes has decreased investors’ willingness to do that very thing. Investors have come to believe that shifting assets around doesn’t matter, yet it was the assumption that assets would shift around which led to the model’s conclusion that the world is efficient in the first place.

According to the efficient markets hypothesis, no one could have known that we were in a technology bubble in 1999. Outside of Alan Greenspan’s inner sanctum, there was pretty broad agreement among experienced investors that we were in a bubble. You didn’t get a lot of air time on CNBC with such pedestrian observations, but there was no way that the NASDAQ at 5000 was in any sense a “rational” equilibrium. “This time it’s different,” said the market hype, and the efficient market crowd agreed that it must be so. Indexers were among the biggest buyers of tech stocks at the top of the bubble as new names with gargantuan market values were being added to the indexes that index funds emulate. We have the CAPM crowd to thank for much of what happened at the turn of the century, when active management and rational thinking lost favor to the momentum players and the index investors who aided and abetted the thrashing that investors received.

Thanks, Professor Sharpe, for nothing.


Myron Scholes

After Sharpe developed his unrealistic and math-centric view of the world, Dr. Myron Scholes took the formula and put it on steroids. He and Fischer Black left the consulting world to develop the Black-Scholes pricing model, which is still used throughout Wall Street to assign a price to derivative assets for which no real market exists and therefore no actual prices can be found.

The formula works great, so long as it isn’t tested in the real world. For example, Scholes threw in with his Nobel Prize co-winner Robert C. Merton and John Meriwether (best known for his adroit skill at playing Liar’s Poker) to form a hedge fund called Long-Term Capital Management. LTCM’s long-term strategy was to leverage up 50 times (so, using borrowed money, a $1 investment was used to collateralize $49 in borrowing to buy $50 in assets) to invest in short-term derivatives trades. So long as money was coming in so nothing needed to be sold, pricing the assets based on the Black-Scholes model worked well for the partners, who claimed a first year annualized return of 40% which made for a big payday to the fund managers.

In 1998, however, a crisis in Asia and Russia resulted in the need to actually sell some of the portfolio assets to satisfy their bankers annoying request that some of the money be paid back. This resulted in a $4.6 billion loss and the fund failed, becoming one of the most prominent examples of a hedge fund blowing itself up. The Federal Reserve finally engineered a bailout in order to avoid a general financial panic, and the hedge fund partners were forced to look for a new gig, although by that time they’d already made so much money off their investors that they didn’t really need to work anymore if they didn’t want to.

The 2008 financial meltdown provided much more evidence that Scholes formula is to investor success what meth is to student achievement. The short-term high it gave traders at bonus time led to a financial addiction that resulted in the long-term destruction of the corporate host, and a lot of collateral social destruction as well.

An early 2008 casualty of mis-priced derivatives was Bear Stearns. A couple of its hedge funds were the first to implode in 2007. The sub-prime issue surfaced early in the year and by Spring it was evident that there was a big problem around the corner – at least, that’s when the fund managers decided to sell down their own holdings in the fund, though publicly they were pretty certain this was just a bump on the long-term road to riches. By July their fund was upside down and the sub-prime market had locked up, which means that everyone wanted their money back; everything was for sale but the buyers were on strike and so prices were plunging even in spite of theoretical values far north of the bid side of the market.

Mark Twain credited Benjamin Disraeli for the observation that there are liars, damn liars, and statistics. What would Twain have said about the econometricians and the Wall Street firms that hired them to design what they called “structured products?” These structured products had no underlying support except for a bunch of untrustworthy math. In the past few years, Wall Street sliced and diced a bunch of disastrous loans on houses to buyers who couldn’t afford them, and watched in amazement as the AAA-ratings failed to protect investors when the underlying loans began defaulting.

These structured products represented ownership of nothing except for a speculative claim and the promise that another speculator will honor it. They represent Wall Street as a casino and the jingle and crash of financial levers and spilled drinks. Believe it or not, there really are good reasons for Wall Street to exist, but ever since Professor Scholes option pricing model came to town, the quality and tone of research and underwriting have gone downhill. He is not solely responsible for the clatter that reverberates throughout today’s capital markets. He is more like a gun manufacturer who hands out handguns on the city streets and then decries the drive-by shootings that ensue.


Joseph Stiglitz and A. Michael Spence

Joseph Stiglitz and Michael Spence have recently been recognized for doing research which pretty much takes to task everything that Arrow, North, Becker, Sharpe and Scholes represent. Whereas the old guard viewed the economy and markets as rational and efficient, Stiglitz and Spence studies show that

• information is not evenly distributed,
• wage opportunities are far from identical,
• companies have difficulty knowing who is working hard and who is hardly working,
• wage changes are sluggish,
• unemployment levels are sticky, and market failures and
• inefficiencies are the rule rather than the exception.

The traditionalists think that “Amazing Grace” just happened to evolve as a lucky combination of random notes. Stiglitz and Spence, however, could see the difference between random din and an inspired melody.

Unfortunately, the professors political prescriptions require a great deal of government intervention to “fix” these problems, but investors should still take note of the fact that these guys just won a Nobel Prize for teaching us to ignore what the first five guys have been telling us for all these years.

Stiglitz wrote about adverse selection in the insurance industry. If the insurance industry prices a risk at an average price, low risk prospects will be forced to overpay while high risk customers can buy the insurance and continue living their high risk lifestyle. Soon enough the low risk prospects (who can) withdraw from the insurance market altogether, choosing to self-insure. The insurance company is left with medium and high risk customers, and higher than average claims, and enormous financial losses. This forces the insurance companies to raise rates to an above-average level, which causes even more prospects to drop out of the pool. Because of what Stiglitz labeled the problem of adverse selection, the price for insurance is higher than it should be, and not everyone chooses to purchase coverage (though all would benefit from coverage at a fair price).

The right “big government” solution would be to require that everyone buy insurance, and perhaps a “public option” as well. But that sort of solution, as you might imagine, has its own set of drawbacks. (Perhaps you’ve heard…)

Stiglitz developed the notion of information asymmetries where one group (the insurance prospects) know more than another group (the insurance providers) about something (their own proclivity for risk taking). Information asymmetries are not efficient, nor optimal, nor rational nor congruent with traditional economic theory. They do, however, have an advantage in that they do help explain the real world better than traditional economic theory.

In the stock market, adverse selection means that new, hard to value companies where insiders know more than public shareholders are inefficiently priced. Poor quality companies have an incentive to issue shares because average share prices overvalue them, while more profitable companies are undervalued in the public markets. Gradually, as more and more poor quality companies go to the public markets, eventually the public markets become dominated by these “lemons.” When the average investor finally discovers this, the average share prices fall toward the fair value for lemons.

Can you spell “internet bubble?”

In addition to his work on information asymmetry, Professor Spence also furthered research in the area of signaling theory, such as when corporations take expensive actions, like paying dividends in spite of the disadvantageous tax treatment, in order to signal to shareholders with (less) asymmetrical information characteristics how high profitability is at the firm level. In the wake of the sub-prime mess, but before things got so bad that they no longer had a say in the matter, some banks were faced with the diliemma of not being able to afford to pay the dividends that shareholders were accustomed to receiving, but at the same time they couldn’t afford to cut dividends because such a move might get them completely kicked out of the capital markets, and the companies were truly capital starved and would fail if they couldn’t retain access to new funding.

Annuity products are classic examples of “signaling theory” where the insurance company selling the contract offers high first year interest rate “signals,” but in reality clients lock into product for many years and may receive substandard returns during subsequent policy years. Outside the rarified world of econometrics, we call these tactics “bait and switch.” If the stars are in alignment and every step of the fraud has been well documented, we prosecute those guilty of sending illicit signals. That doesn’t happen nearly often enough, however, so mostly we reward such expert signal providers with big profits and a high share price.

Make no mistake, the Ivy League MBA is itself a “signal” of future productivity. The companies who hire these MBA’s don’t really care if they’ve learned anything in class or not. What is most valuable is the fact that these future employees made it through the admissions office filter and the fact that they’ll spend the next two years hanging around other fast-track folks who also made the cut. If you ever wondered why a typical 2007 Harvard MBA had a starting salary and bonus of $141,250 and the local State College MBA is negotiating a foreclosure proceeding, it’s not because of what they learned in the classroom. It’s because of whom they shared the classroom with (please pardon my dangling preposition). To put it in Web2.0 terms, it’s all about the quality of the network.

The network itself has one primary mission. For better or for worse, in whatever way they can, the network is focused on separating you from your money. Some firms hire these MBA’s to go after your “wallet share.” They want to nickel and dime you for every money transaction you make. Others go for the big score – magically transforming your life’s retirement savings into a hedge fund strategy that, if it works, will add to your nestegg and make them incredibly, gloriously, fabulously wealthy. If it doesn’t work and decimates your retirement portfolio, which we might call performance asymmetry, then it’s just off to another job for them, and you’ll have to go back to work as well.

Can you say, “do you want fries with that?”


Caveat Emptor (Buyer Beware)

The strategies we use and the positions we advocate add up to one big wake-up call that your advisor and your daughter’s Professor will call heresy. We’re just asking hard questions and taking action based on the answers we’ve received.

Why is it that many of the most famous “efficient markets” random walk theorists have switched to the “active management” side? Is it just because the pay is better, or is it because they’ve realized that the “collective thinking” of the market is sometimes crazy, often foolish, and rarely profitable? Other than John Bogle, whom I love as a kindred frugal soul, why don’t we find any indexers in the money manager Hall of Fame? Indeed, why are big institutional managers moving away from indexing strategies toward active management (via hedge funds) approaches. They may combine an indexing core with a hedge fund “satellite,” but at the end of the day the total portfolio when you combine the neutral-weighted core with the long and short positions in the hedge fund is a traditional actively managed total portfolio. The only thing that has really changed is how the managers are compensated.

For all the work that has been done in the economic arena, investors are left with the sickening feeling that they’ve come full circle and paid full fare for the roller coaster ride. First, markets were efficient. Now they’re not, again. Give back the prize, guys, we’re no further ahead than we were 50 years ago.

Investors, throw away the textbook. It isn’t going to help you know how to invest your money. If nothing else, tossing the text shortens your summer reading list significantly, which might leave a spot on the list for a good murder mystery.

The good news is that with a little homework, almost anyone can design an investment management approach that takes the best of Wall Street (it’s hard to find, but it’s there) and combines it with a little technology and a pinch of professional advice to enable you to invest wisely for your future.

Before you can do that, however, there are a few myths which we need to unlearn.

Next post: There is a reward for doing your homework


To read "A Prize For the Most Useless - Part I" string, click here

To start at the beginning of the Investment Heresies eMag, click here

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Does Chinese Money Matter?

I once wrote an "Ode to Chairman Volcker" which observed that money matters, especially regarding inflation and interest rates.

Economic activity has been perking up in the latter part of 2009, partially as a result of pent-up demand and partly as a result of monetary stimulus a year ago.  However, U.S. stimulus efforts seem to be flagging.  Money growth in the U.S. has slowed markedly.

In China, however, money growth has taken off like a rocket.  There will surely be consequences.  In the short run, Asian economic activity may be sustainable - at least until inflation takes off in the emerging markets and force the hand of the Chinese government to take measured steps to slow the growth in money supply, at which point the boom may come crashing down. 

This is just another interesting fact to add into the global investing mix --- as if it weren't already interesting enough!

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Dubai Debt Crisis

Dubai World is sort of a government backed Donald Trump of the Petrodollar set. You may have seen images of Dubai’s various real estate projects in e-mails making the rounds. Burj Dubai is the world’s tallest man-made structure in the world, at least for now, and Ski Dubai is the largest indoor snow park in the world (attached to the Mall of the Emirates, one of the largest shopping centers in the world).

Dubai World is one of the largest borrowers in the world, at least relative to its home country. However, in a world of trillion dollar bailouts and healthcare plans, Dubai World’s problems are rather small on a global scale. In addition, it sounds like Abu Dhabi’s sovereign wealth fund – which has assets of over $400 billion – will likely extend a helping hand. Finally, there are real assets underlying the debt…and some of it is pretty spectacular, at that.  Just Google Dubai images and see what you get.

Another bright spot, for U.S. investors at least, is that most of the U.S. banks were so busy manufacturing profits through the trading back and forth of sub-prime loans and credit default swap contracts that they somehow overlooked this opportunity to make some bad loans in Dubai. It appears, this time, that it is Citibank's traditional, slower moving European counterparts who will be restructuring their loan portfolios.

The Dubai shock reminds Wall Street that the de-leveraging process is not over as quickly as the markets would like. Bank Credit Analyst suggests that, “Treasury bonds, gold and the dollar could benefit from the mini market rout.” But BCA “does not expect that these negative shocks will derail the cyclical bull market in global risk assets.”

I am less of an optimist than BCA. There are reasons to be uber-cautious, but Dubai’s follies should not be given more weight than they’re worth..

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Making Hay in a Strong Market

While the market is going up, we want to be invested. In a “trading market” that rises and falls but goes nowhere over time, there are times to be in and times to be less-in, and it is extremely important to make hay while the sun shines. The sun is shining on the stock market, whether I think it makes sense or not.

In general, though I’m glad that optimism has replaced fear, I see little reason to be giddy. I still believe that we are headed into another recession sooner rather than later. A couple of November 2 Barrons articles highlight the sad truth behind recent economic statistics. Alan Abelson passes on an observation that the recent quarter’s spike up in economic activity was fueled by an unusual depletion of savings, rather than income. “In the past quarter century, there have been only four other instances when savings have fallen so much in a single quarter….Put another way, all of the quarterly gain in GDP ‘was funded by a rundown in the savings rate that occurs less than 5% of the time’.”

Abelson also passes on an observation by John Williams, proprietor of Shadow Government Statistics, that “every recession in the last four decades has had at least one positive quarter-to-quarter GDP reading, only to be followed by a renewed downturn… (Williams thinks that) it’s a fair bet that historic pattern will be repeated in the current quarter.”

Then, in the Market Watch segment of the same paper, Stephanie Pomboy’s Oct. 29th newsletter is excerpted wherein she notes that inventory liquidation was the second strongest on record, which added a full 1% to GDP. The cash-for-clunkers and home-buyer-tax-credit added another 1.5%, which leaves only 1% of sustainable underlying growth. Furthermore, she notes, “not only did companies NOT rebuild inventories, but capital expenditures logged its fifth straight quarterly contraction. Clearly, current inventory levels are low – which is a good thing. But it’s hard to see an economic rebound resulting from current business activity. It could be much worse, but neither is it likely to be strong enough to offset the hemorrhaging of consumer spending that drives the bulk of economic activity.

Earnings for companies in the S&P 500 Index have rebounded to approximately $60 from nearly $100 at the peak. While Wall Street analysts are projecting an earnings recovery back nearly to prior peak levels, the difficulties facing this economy and the pressures on profits, in particular, leave me wondering whether we won’t be lucky if profits don’t flatline soon around the $60 level.

In spite of my concerns, the market has rallied more – and this rally has lasted longer – than any of the rallies that markets enjoyed during the 1929 through 1932 period. Either the markets are trying to signal a recovery ahead of the statistics, which we hope is the case, or the Fed is holding savings rates so low that money can’t help but flow back into the stock and bond markets, which is inflating values.

There is an old saying on Wall Street, “Don’t fight the Fed.” A closely related and slightly altered axiom is that the Federal Reserve can spend your tax dollars irrationally longer than you can remain in a high tax bracket, even in spite of a higher and higher tax burden falling on increasingly less wealthy taxpayers.

The Fed is pumping billions of dollars into the system. Unfortunately, more of it is getting to the market than is getting into the economy. Banking system excess reserves (dollars that the banks hold “in reserve” instead of putting it out into the economy) just recently passed the trillion dollar mark. Whether the banks want to be lending or not isn’t clear. What is clear is that the real economy is not yet enjoying an “easy money” environment.

No longer bankable are used modular homes, loans where the appraisal is too low, or even too high. Jumbo loans are just beginning to become thinkable. Spec homes are non-starters with your local banker (which is probably a good thing) but credit card rates are soaring, pushing consumer default levels ever higher. Normally, low rates signal a monetary easing. This time around, low rates signal a defacto tax on savers in order to prevent the FDIC from having to make good on its unfunded promises to the American people. Profits in the financial services sector are rebounding, but the sad truth is that there are more foreclosures and defaults just around the corner, so 2009 earnings have all the credibility of the not very credible 2007 reports.

As negative as this rant sounds, I do believe that we have turned the corner and avoided financial catastrophe. Whether or not that is enough to make the stock market a great buy and hold investment, however, is another thing. Economic stability, and in the long-run eventually a recovery, is great news. For company profits and stock investors, however, I believe that the recovery will not be as robust as Wall Street analysts have forecast.

I still maintain that liquidity in the financial system is sufficient to fund the Treasury’s current trillion dollar deficits. I even think that there is enough money on the sidelines to absorb the upcoming onslaught of foreclosed real estate as property as it shifts from “renters” (dwellers who should never have been given a “no money down” mortgage upon which they have defaulted) to real investors.

However, with the government sector, the real estate sector, and the stock market all clamoring for liquidity, something has to give. The problem with deficits is that they don’t flex. Debt is forever. Similarly, disposal of the excess real estate inventory is going to happen. It may not be a fun time, but at some price properties are going to shift from the banks into the hands of private investors. The question is, with all this forced borrowing and liquidation occurring, will there also be enough money in the system to support stock valuations at 17X or 18X earnings.

Personally, I have my doubts.

So how do you invest in this environment? Be creative, for one thing. Atypical investments in client portfolios currently include an inverse bond fund, inflation plays, a bit of cash, and junk bond funds instead of consumer stocks. Remember, sometimes it’s what you don’t own that is most important!

Second, stay on top of current trends. For most of the year, energy investments have been a suitable substitute for gold. During the past few weeks, however, that has begun to change. We recently sold or trimmed our natural gas investments and added gold back into the portfolio.

We often say that our job is to stay in the way of where the market is working, and get out of the way of where it’s not working. Gold is a good example. We’ve owned it some, this year, but in August (we regret) sold out. Since then, it has attracted an even larger following, including the central banks of China and India. Could gold keep going up to $2,000 per ounce? You bet. It’s possible given the currency uncertainties out there. If it does, clients would have expected us to be taking advantage of that move. For us to not own gold, given that economic fundamentals and current market activity both suggest it can keep going higher, would leave clients wondering if we do what we say we do. We swapped out of gas into gold when gas stopped working as an effective hedge against future inflation.

Lastly, we are trying to keep our exposure to traditional U.S. stocks in areas where valuations are reasonable, even given the current economic environment. Industries which have stable fundamentals in spite of the recession are favored over more cyclical companies. Property casualty companies went down significantly alongside the implosion in the banking sector, yet pricing trends in the insurance industry are fairly stable and the insurance company executives have generally done a much better job of managing their huge asset base.

Pharmaceutical companies, also recently added, seem to have negotiated a deal with Congress that leaves them with the ability to continue their current business model and perhaps even sell more drugs to more patients in the new healthcare regime. Given that the valuations on these companies appear to be extremely attractive, it made sense to add these companies back into the portfolio once the market stopped punishing them for being part of the highly politicized healthcare delivery system.

The $64,000 question, of course, is when will the dour economic realities drive the market back down? That’s where a crystal ball would be helpful. Lacking that, we keep in mind the fact that we began talking about the “upcoming” real estate recession in October 2006, yet the market didn’t peak until a year later, and commodity oriented investments kept working even into early 2008. Reality bites. And sometimes it’s late.

Make hay when the sun shines and keep an eye on the exits. By all means, keep up your guard. That is our current strategy, and maybe it’s a good description of our overall investment mission.

I’ll try to post more often, about fewer topics (per post), in the future. Have a great Thanksgiving celebration.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Wall Street versus Main Street (redux)

What is good for Wall Street is not always good for the real economy. While dime-a-dozen million dollar Wall Street bankers exhort just rewards for hard work, the reality of the most sought after Wall Street deals is that they are “heads we win, tails you lose” sorts of affairs.

Hedge Fund managers speculate with worker pensions. If the investments work, the hedge fund trader makes a small fortune off a lot of people, which all adds up to unfathomable riches. If the investments fail, the hedge fund closes its door and investors are left to pick up the pieces. Hopefully, there are pieces left.

Citigroup’s derivatives traders used FDIC insured and government subsidized capital to speculate on indexes moving this way or that, collecting multimillion-dollar salaries for their guesswork, but when the guesses went wrong the industry pleaded “too big to fail” and required a taxpayer bailout in order to remain solvent. Now that the liquidity crisis is past, the trading desks have returned to putting on one-sided trades for which they will either receive spectacular financial rewards, or the bank will be back at the till.

Which brings to mind the old expression, “fool me once, shame on you – fool me twice, shame on me.”

This week, we entered the height of earnings season. Because of the stunning market rally off of March lows, the talking heads are feeling bullish. Most seem to expect a typical economic recovery, in spite of the facts. Instead, to me it looks like the earnings have improved, but “recovery” is still a long way off.

Several financial stocks reported earnings this week. The big Wall Street firms reported very strong profits, because their trading desks have been busy gouging customers in the midst of one of the strongest back-to-back market rallies in history. Furthermore, it’s not just stocks that have done well, but the bond desks are making a mint as well. These profits, however, have virtually no predictive power of future earnings potential.

On the other hand, in core competency areas (away from the shiny new market rally), loan loss provisions continue to climb – which is an indication that consumers are still feeling pressured, even if Wall Street has already “moved on” past the economic debacle it helped cause a year ago.

After the “cash for clunkers” activity this summer, consumers are settling back into a more cautious outlook. The ABC News Consumer Comfort Index fell two points to -50, which is the lowest level its been in three months and is only four points higher than the record low it set last January. Mutual fund flows $7 flowing toward bond funds for every $1 that investors put into stocks.

This market is not caused by a horde of investors flooding into the market, afraid of being left behind. The rally is simply caused by an absence of selling. A year ago, investors were bailing out at any price, and prices fell to the point where new buyers could be lured into the market due to cheap valuations. Today, the massive dumping of stocks is (for now) a thing of the past. Prices have stabilized, sure, but we’re not seeing much net new money being invested in the market. Investors, like consumers, are cautious. Only headline writers and politicians think that the coast is clear.

Consumers drive this economy. While the industrial side of the economy is benefitting enormously from the declining value of the dollar and a rebound in China for technology and basic materials, it is hard to imagine the broad U.S. economy, or market, from doing well until U.S. consumers have found a way to reduce their debt burden. Parts of the market may do well, but consumer spending makes up about 70% of economic activity, so if consumers are feeling strained, it is hard to imagine the rest of the economy somehow pulling off a typical economic rebound.

Savers' balance sheets are being ravaged by the low interest rates that Wall Street is paying on savings accounts.  The Obama administration wants to give certain seniors a $250 stipend to help them through tough times.  Why not raise short-term rates so that all savers can earn a decent return on their life savings.  It's not like the bankers are actually loaning anybody money with the artificially low savings rates.  The Fed needs to restore some normalcy to the economic environment.  Paying savers a reasonable return on their investments, though it might hurt Wall Street earnings prospects, would go a long way toward helping main street retirees recover.

As a result of the difficulties we see, we remain pretty selective in what the portfolio owns. Our commodity investments have done well as oil prices recover to the $80 level. Our technology stocks are enjoying true earnings growth. Our high yield bonds look increasingly sound as the companies that stand behind the debt de-leverage balance sheets and investors in the bonds collect high coupon payments as we wait to see whether a real economic recovery is around the corner or not.

We have invested some internationally, where consumers are not as tapped out and where politicians target economic growth rather than redistribution. And we have a bit of cash, too. We have too much cash on some days – and too little on others.

We would like nothing more than to put last year’s crisis behind us. At this point, however, it seems more like the eye of the hurricane than blue skies, forever.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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That's A Plus

A year ago we began peering into the abyss.

Our mutual fund model, and by extension the typical client account, went into the plunge with six equity positions, a junk bond fund, and 30 percent of the portfolio in other types of fixed income funds. We implement a Flexible Beta discipline that varies clients’ risk profile based on current market conditions. Clients had some money on the sidelines, but it was almost impossible to avoid the bloodletting.

We try to get money on the sidelines during high risk markets for two reasons. First, we want to reduce clients’ risk exposure during these times, rather than sit tight and just encourage clients to “hang in there.”

The second reason we want to have money on the sidelines is so that we can take advantage of the buying opportunities that result from the market decline. We have often said that bear markets are easier to accept if you have money available to buy into the opportunity.

So, twelve months later, what did we buy and how did it work out?

First, as a point of reference, the broad market (as represented by the S&P 500 Total Return Index) is down about -6.9 percent.

About 360 days ago, we bought energy services stocks through a mutual fund. We bought them too early. If we’d purchased them 330 days ago, I’d be a lot happier. But in the model portfolio the position has a small gain (not quite 8 percent) and hopefully clients will see their holdings up slightly over cost, also.

Then, around November 1, the model purchased a fund that owns preferred stocks. At the time, bank stocks were actually outperforming the market, but we had been avoiding the stocks for many months and, frankly, I still didn’t trust the bank CEO’s who were saying that the worst was behind us. On the other hand, I think that the media was exaggerating the likelihood of massive bank failures and preferred stocks, which were dirt cheap so long as the institutions didn’t go bankrupt, looked interesting. It was another example where the work we do in individual securities helped uncover investment ideas that our fund-owning clients could use as well.

We sold those positions in July for roughly a 17% gain. The proceeds from that sale are still in cash.

The junk bond position we’d originally owned had fallen almost as much as the stock market had dropped. We were astonished at the bargains available in that sector last December so we decided not to sell that fund, assuming again that any sort of “muddle through” recovery would leave junk bond investors with dramatic capital gains on top of a nearly 20 percent current income return.

In fact, we were so enamored of the stock-like potential return on high yield bonds that we bought more of them on December 31, as a New Year’s present to ourselves and clients. That purchase, with 20/20 hindsight, was well timed. The model portfolio shows a nearly 63 percent gain in that position.

Note to clients - we consider those to be part of our "stock portfolio" at the moment.  They clearly performed more like stocks than bonds in last year's downturn.

These three purchases have helped the model portfolio weather the tumultuous economic environment. While the market has fallen -6.9 percent during the 12-month period ending September 30, 2009, the mutual fund model portfolio is up 9.9 percent over the same period. Clients need to check your statements to confirm that you are really up year-over-year while the market continued its slide.  Model returns and client returns do not always match, and I can't be more specific without catching hell from the regulators.

Now, granted, for a 9.9 percent return, I’m not certain that I wouldn’t rather have sat out the whole near-Depression scare and watched from the sidelines. But a plus is better than a minus. That’s all I’m saying.

Year-to-date, the model portfolio is up +30.65%. The market is up +19.3%. For pundits who say that we must be taking on extra risk to be beating the market, the burden is on naysayers to explain how these portfolios did better during a period of extraordinary turmoil while most risk-takers, worldwide, were being blown out of the water.  We believe in flexible beta.  The amount of risk that investors take on should vary across the market cycle.

Since inception, the chart below tells the story.

It's always easier to explain the past than plan for the future.  We'll get back to trying to give our best guess about the future in upcoming posts.

In trying times, such as these, we all learn to be thankful for the good things.  Right now, I am unbelievable grateful for the last year's client returns.  They had a plus in front of them.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Energy Fuels Local Stock Rally

The May-Investments Index of Western Colorado Stocks surged higher in September, gaining +6.6 percent as energy exploration and services stocks powered higher. The widely followed S&P 500 stock index rose +3.7 percent during the month (total return including dividends).


Arch Coal (ACI) ended the month at $22.13, up +27.8 percent from a month earlier. Arch Coal was up over 35% two weeks into the quarter, on mixed analyst reports. Doug May, President of May-Investments, noted that “An analyst at Brean Murray initiated the stock with a sell recommendation on September 8, but two days later Mad Money TV show host, James Cramer, said that Congress has bought into the clean coal story in spite of the fact that natural gas is a much better energy alternative.” The entire energy complex was very strong during the month.

Kroger (KR) led a lackluster retail food group lower, falling -4.4 percent during the month of September and was the worst performer in the index. “Kroger cut its forecast for 2009 as the stock market rally has not yet convinced shoppers to loosen up their purse strings,” May said.

Year-to-date, May-Investments Index of Western Colorado Stocks is up +20.6 percent through the end of the third quarter while the overall market has gained +19.3 percent over the same time period. The index focuses on large companies whose operations have a significant impact in the local economy, including major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Markets), StarTek, CRH (United Companies), and the Union Pacific Railroad.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Enjoying the Rally, but not Relaxed

Investors should relax and stop worrying. That’s my job.

I continue to be more worried about preserving wealth than I am about missing the next market upleg. This weekend’s Barron’s reading was a mixed bag.

The good news was an article, “Trampled in the Rush to Riskier Stocks” by Andrew Bary, that featured stocks in the property & casualty insurance sector, which is a new area of investment in many client portfolios. The article noted that most of the P&C stocks command little or no premium to their accounting (book) value, are currently profitable, and have an opportunity to take business away from the wounded giant, AIG. The hurricane season has been kinder and gentler than in years past. The Price/Earnings ratio of the nine stocks profiled in the article range from 5.9X earnings to 10.1X earnings. If earnings power is maintained and the P/E multiples remain stable, these companies would provide an earnings yield of 9.9% to 16.9%. If earnings power grows, as the analyst in the article expects, or if P/E ratios improve from today’s low levels, investors would benefit even more.

We watched the downward spiral in financial stocks from the sidelines. We are no longer convinced that the sidelines is the best place to be when we look at stocks in the insurance industry, but as always we’ll monitor that view and modify it if necessary.

More of concern was the Lipper fund data which continues to show money coming out of equity mutual funds, in contrast to the surge in July and August that coincided with the big run-up in stock prices.

The Federal Reserve released new data on excess reserves, which is money that is hiding in the banking system but not finding its way out into the real economy, where it could help alleviate some of the financial pressures we are still experiencing. The Wall Street bailout, where public dollars are used to buy up illiquid securities to bail out big banks who were caught in the squeeze, has worked pretty well. Unfortunately, even nine months after excess reserves first surged, the money hasn’t yet made its way out into the real economy. Excess reserves jumped from $823 billion up to about $855 billion, near its all-time high. Regardless of today’s low short-term interest rates, it’s hard to conclude that we’ve got an “easy money” policy if the money sits on the sidelines and is unavailable for job creation and capital investment.

The best news, of course, is that the market has wanted to go up in spite of these fundamental concerns. The Vanguard S&P 500 Index Fund, for example, is +17.8% year-to-date through last Friday, September 25th. Though it was hard to justify higher prices in the fearful days of February and early March, now the S&P 500 sits 57% higher than at its nadir in early March.

Clearly, the volatility inspired by widespread fear in the last months of 2008 and the early days of 2009 created a significant opportunity for profit. Similarly, however, the upside volatility we’ve enjoyed as a function of relief spreading throughout the economy has magnified the risks of decline. Just as we did not put all our money to work at the bottom, I am absolutely certain we won’t be able to define and get out at “the top.” What we will do, however, is carry our bias toward wealth preservation and experience in managing our way through volatile markets into the period ahead..

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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A New Week

Last week in Barron’s Mike Hogan noted that the politicians are finally getting around to considering natural gas as a cleaner burning fuel, suitable to large auto and truck fleets, that might be capable of actually making a dent in our foreign oil dependency sometime this side of the next quarter century. Most energy alternatives are so far out in the development stage that they provide little near-term impact. It would be nice if we could develop the solar and other renewable options, but few barrels of oil will be left on the shores of Saudi Arabia, at least during the next decade, if we limit ourselves to clean green options.

Natural gas, though, is cost effective and available and, with just a little technological sprucing up, could drastically reduce our dependence on areas of the globe which tend not to raise their hands when volunteers for the USA fan club are solicited (unless, of course, the term “citizenship” is dangled as an incentive).

Harry Reid and Obama’s Chief of Staff, Rahm Emanuel, are among those pushing for a political initiative favoring natural gas. How it was left out of the hundreds of pages of middle-of-the-night negotiating for the Cap and Trade bill, is a great question. The Colorado delegation might want to spin up an answer for the next election cycle. For Western Colorado, natural gas stocks, and our current portfolio, however, it’s a plus.

Natural gas and crude oil are diverging in an unprecedented way. Natural gas prices are setting new lows, making this clean substitute for crude ever more cost effective. It reduces the value of reserves, which is a negative for the gas exploration stocks, but it creates an ever greater incentive to lean toward gas as a clean fuel for the future.

I was less enthusiastic when I checked the recent money supply statistics in the tiny print of the Market Laboratory section of the paper. Excess reserves, which is money held in the banking system instead of being available to business and consumer borrowers, rose again – back up to nearly $800 billion. Thus, the money which came screaming out of the stock market, last Fall, and now sits earning practically nothing in certificates of deposit, is not yet finding its way back out into the real economy.

Were it not for the credit crunch, credit-worthy borrowers would abound. As it stands, since no money is going into the real economy and therefore attempts by the Federal Reserve to stimulate the economy using monetary policy isn’t stimulating anything, almost any loan looks like a mistake waiting to happen. It’s a classic “Catch 22,” but without the biting humor that Joseph Heller wrote into his characters.

Finally, money flows into equity funds went negative last week. The last six weeks have been good to stocks, and positive flows into the market helped explain the surge. In many sectors, valuations look stretched. I can find insurance stocks and healthcare stocks whose earnings prospects remains strong, but whose stock prices are a lot lower than a year ago. For the broad market, though, earnings power has fallen at least as much as the stock market itself. We’re rotating into some new sectors, but if the same guy who was telling you to “sell” in March is now telling you to throw caution to the wind and “buy” today, it’s probably time to upgrade your choice of market pundits. Risk is always at least partly a function of price, and today’s market is 50% more risky than when the market that was causing us all to sweat bullets last March.

Clearly the economy is stabilizing, as we said it would. It’s not clear that it’s getting ready to shift into high gear. Or even that it will be able to sustain the momentum it’s got. It’s in low gear, crawling forward through difficult terrain, and valuations ought to reflect this reality.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Timing versus Tuning

We recently sold gold from the mutual fund portfolio. We’ve presented the gold thesis before. Trouble issuing trillions of treasuries could cause foreign investors to doubt the viability of the U.S. dollar as a reserve currency, sending the value of the dollar down versus substitute measures and exchanges of value, such as gold. There are other reasons that gold may go up or down in value, but our thesis focuses on problems in the bond market and a decline in the value of the dollar.

It’s a splendid thesis, except that it hasn’t been working lately. In fact, we had four investments in the model portfolio that make up our “inflation trade,” and for the past several weeks they have all been struggling to keep up with the soaring spirits of stock investors across the globe.

If we are right about our thesis, we should have time to get back in and profit from a move up in gold. Our discipline, however, does not look kindly upon sitting and waiting for the markets to prove us right. In addition to forming our own independent view of the economic factors impacting the market, we’ve also learned that in the long run it usually pays to listen to the market as well. This market, lately, has not been rewarding speculators of impending inflation, either because our worries are ill conceived – or perhaps because we’re too early. In either case, it typically (but not always) pays to move to the sideline and wait and consider alternative points of view.

We are active money managers, trying to take advantage of volatility associated with things going up, but we also try to take volatility (Beta) out of the portfolio when things are looking weak. We do “time” the market, but not quite in the way people think.

Although we are occasionally forgetful enough of our own imperfections to try to catch a falling market at the bottom, or sell it at the top, our track record in these endeavors is far from perfect. I bought into a plunging market after 9/11 in 2001 and was rewarded for it, but I also bought energy a month too early during last year’s panic.

We’ve had prospects ask us why we didn’t liquidate “at the top,” and the easy answer is because we don’t know where the top (or bottom) was. We would like to. It would certainly simplify things. But we’re not trying to catch tops and bottoms with our discipline. When we try to sell a top (or buy the bottom), it is usually contrary to what our discipline recommends. Our discipline encourages “letting the winners run” and “staying out of the way of sectors that aren’t working.”

Instead of trying to catch tops and bottoms, we are usually trying to rotate into sectors that are doing well, both fundamentally (i.e. looking at the relevant economic factors) and relative to the broad market index. At the end of June, pretty much the entire portfolio had the wind at its back. Unfortunately, during the past several weeks, we’ve noticed a shift as the inflation trade takes a pause and rebounding sectors like financial stocks and automotive stocks shoot dramatically higher. We're not as "in synch" with the market as before.

When we talk about “listening” to the market; we force ourselves toward sectors that are going up faster than the market, benefiting from upside volatility. But today’s market is telling us to back away from the inflation trade, at least for now. We don’t mind having four out of ten positions all positioned for inflation, if/when they are working. But having four positions lag, together, tends to get old. No matter how well thought out our thesis, we’re going to want to reduce the commitment to that area, at least until things turn around and the investment starts working better.

In this way, we fine tune the portfolio. We gradually build large commitments to areas that are working, and gradually sell them as the trend changes. We would rather pick the exact top and sell it all, but those bold actions require a more precise knowledge of the future than we possess.

Often, our portfolio tweaks come as a result of listening to the market. That is why we sold gold. Gold was not working as well as the broad market, nor as well as our energy-oriented commodity investments.

Much of the thesis behind owning gold assumed problems in the treasury market, yet our inverse treasury fund (which is also part of the “inflation trade”) is also struggling to remain in the portfolio. If the inverse treasury fund investment doesn’t pay off, then it’s hard to expect the gold investment to pay off. The inverse treasury fund is the horse that pulls the gold cart higher. If the treasury market doesn’t hiccup, we don’t necessarily expect the foreign currency markets to puke on the dollar. (Perhaps that explanation is a bit more graphic than readers can stomach.)

Minyanville’s Todd Harrison calls this expectation a “seismic currency adjustment.” We think it will happen – we just don’t know how soon.

What also stands out is how our lack of financial sector exposure is starting to cause us to miss out. We missed out on a lot of bad stuff in that sector over the past two years, but as financials rally off of extremely depressed levels from last March, we’re more inclined to want to get a piece of that upside volatility. Our junk bond and preferred stock funds have been worthy substitutes, thus far, but the upside in those sectors is getting to be limited, mostly by the fact that they’ve worked so well and bond prices have gone back up, much closer to "par value" on the bonds in these portfolios.

We will continue to fine tune the portfolio in order to seek the sort of (upside) volatility that investors prefer. We will gladly put gold back into the portfolio when the market confirms our fears, as I think it will.

We continue to own junk bonds as proxies for high dividend stocks. We still hold to the “muddle through” scenario and fear that today’s market is reflecting something more profitable. Though certain sectors (today it was new housing starts) are improving, the new home sales number is still at levels that reflect previous recession levels.

I don’t know if we’re at a “top” or not. If I knew it, and we were, I would gladly go all to cash, but I’ve not been blessed with such perfect knowledge. I think that there is still risk in this market, and that investors need to be prepared to sell. I think that it is more important to remember that the market is up 50% from March, rather than to focus on how far below 2007 highs we are. I do think that profits will return, but until they do I think investors need to be wary of great ideas if they aren’t working out. We will continue to “tune” the portfolio, thus, whether we are at a “top” or not.

Douglas B. May, CFA, is President of May-Investments, LLC and author of GJretire.

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Debt-Addicted Economy Exits Rehab

My primary “big picture” analysts are both predicting that the economic recession ended on June 30. Pent-up consumer demand, government spending, and a relaxation on the business community’s embargo on inventory re-stocking are working together to move the needle positive on economic growth for the next few quarters.

I am extremely cautious however I don’t want to be dogmatic about things. Facts trumpet ideologies and the facts include a stabilization of the economic downturn and trillions upon trillions of government stimulants helping to fuel this modest upturn in spending. The government has taken over banks, auto companies, and now it is trying to take over the role of consumer spending. A few quarters of economic growth, which the econometricians will likely label a recovery, wouldn’t surprise me as the economy gasps for breath after a six-month hiatus in which pocketbooks were locked down tighter than a Jack Benny comedy routine.

So after a few months of counseling (Nancy Pelosi to CEO’s, “don’t fly private jets”) and an injection of stimulants (like the original “Cash For Clunkers” program that bailed out overleveraged and overpaid financiers at Goldman Sachs, AIG, Morgan Stanley and others), our debt-addled economy has been pronounced “cured” because the stimulant cupboard is bare and we really can’t afford to re-fill it. The economy is being re-released into the community with hopes that it won’t re-appear as a multiple offender.

Unfortunately, this debt-addled economy is far from cured. It is still addicted to smack but the bank regulators have screwed the lid down on the banking system. The inmates are still in charge of the asylum on Wall Street, sucking the blood out of corporate America as it lines up to refinance upcoming debt maturities.

The markets may have rallied, but the markets are a manic-depressive with such incredibly bad judgment that companies that didn’t even make sense when scribbled on a napkin were able to obtain billions in financing just a few years back. As the financial system was spiraling out of control in October 2007, Wall Street’s financial sector analysts were writing reports about bargain hunting. Believe me, just because the markets are flashing that “the coast is clear” is no reason for optimism.

Instead, I see long-term interest rates that have risen about 2% in the midst of the most severe economic weakness since 1929 due, I believe, to the trillions of treasury bonds that need to be sold (to somebody) in order to finance the current rehab program. I see a Federal Reserve that talks the talk of easing, but a gaggle of bank regulators who are knee-capping real estate investors when they try to roll over bank loans. I see corporate America trying to preserve profit margins by laying off consumers, and then wondering why revenues are gliding lower.

I fail to take comfort in lower job losses because the job growth that is required for a real recovery to ensue are unlikely in this world where a potential employer health mandate has businesses too frightened to even think about adding to their labor pool.

To be fair, everything is in place for a typical economic recovery. We have stimulus “out the wazoo” (can’t you picture the old E-Trade commercials circa 2000?) and low inventory levels and pent-up demand. Normally, this is enough. But this time we also have a debt problem so oversized that our creditors don’t dare call their loans because it would send us both into bankruptcy. Financing stimulants “crowds out” job-creating private investment. In other words, scarce investment dollars that are desperately needed to finance capital investment and job growth are set to be confiscated by the government to pay for a SuperSizing of the government's role in American life. A weakening U.S. currency threatens to create inflationary pressures that would rob consumers of purchasing power.

The bottom line is that I believe that the economic recovery which may well have started on July 1 will be short-lived. The market has rallied from the March bottom. The rally looks to fully reflect today’s rosy economic forecasts, but what it really cares about is “what’s next.” I think investors need to look forward toward a double-dip recession when the economy falls off the spending wagon early next year.

"Helicopter Ben" Bernanke threw the Federal Reserve’s medicine cabinet at the economy during the past few months. However, an ancient Chinese proverb says that it is easy to get a thousand prescriptions but hard to get one single remedy. We now have a hefty pharmaceutical bill to pay off, and I’m afraid we’re still waiting for the remedy.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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I'd Rather Be Wrong (and Up)

I predicted a down year at our Economic Forecast seminar in January, and that the economy would stabilize and remain in a recession for all or most of the year.

Our industry analysts from Bank Credit Analysts, and the top down research provided by Ned Davis Research, is concluding that we are about to come out of the recession in mid-Summer, much earlier than I’d anticipated. I hope they are right. I’d much rather be wrong, and have markets rally, than be right about my more pressimistic forecast.

We still have a long way to go before this year closes out.

The leading economic indicators have risen, three months in a row. It appears that the Chinese stimulus program is working, even if the U.S. package isn’t exactly setting the world on fire. Furthermore, it is possible that U.S. stimulus spending is still coming down the pike, and it is massive. Machinery stocks seem to be benefiting from an increase in global economic activity. Car showrooms aren’t going to remain empty much longer.

Wells Fargo’s chief strategist, Jim Paulsen, remains much more optimistic than most and believes that the low value of the U.S. dollar will lead to a dramatic increase in U.S. exports. Clearly, most industries with business end-markets are holding up better than industries that sell directly to consumers.

I still think we’re just muddling through. I continue to worry about the impact of higher interest rates on future business activity. I still believe that caution is the key word.

In the meantime, we have enjoyed the rebound in commodities and more rational pricing in the high yield bond market. We have emphasized technology companies, and the degree to which tech stocks outperformed most other sectors during the first half of the year has been striking.

I hope I’m wrong. I hope that today’s market trends remain in place for the rest of the year. If so, we’ll end up with a great year. At the end of the day, though, I just don’t think it’s going to be that….easy.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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All Clear Indicator Update

On December 19, when asking if the “Market (is) set to turn up?” we identified a half dozen items to watch to gauge if the bank panic would continue spiraling down. We revisited the list on March 30, concluding that the market is “still bottoming” but seeing tremendous improvement in some of those half dozen indicators.

Today, we've seen significant improvement in most of the indicators and we are enjoying the commodity strength, tech sector rally, and are especially pleased with how our muddle through investments in high yield bonds and preferred stocks have performed. Though the majority of our indicators demonstrate that our situation is vastly improved over where we were six months ago, we still see reason for caution, rather than optimism, and the unique nature of our current portfolio reflects this view.

The high yield bond rally came and is providing some much needed liquidity, at least to some firms. Many financial companies, including banks, insurance companies, and real estate companies, have been able to issue common stock to de-leverage companies and reduce default risk in the junk bond sector. Other companies have been able to roll over existing debt, and even issue new high yield bonds at high, but still reasonable interest rates, in order to forestall a cash crunch later in the year or in 2010.

True, the auto bailout trampled bondholder rights for holders of GM and Chrysler debt, but in general the existence of an option to raise money in the high yield bond market has saved many companies, and is probably one of the key reasons we are breathing much easier now than we were last Christmas. Santa really did come – in the shape of the bond underwriting units of Goldman Sachs and J.P. Morgan.

A rally in oil prices also signals strength in the global economy. Oil prices below $40, to us, signaled a global depression. That oil prices have stabilized suggests that the sub-$40 prices were more a result of hedge funds dumping futures and energy stocks, rather than an indication of a disastrous economy going forward. On the other hand, higher oil prices also hurt the consumer, so it is a mixed blessing that we’ve seen prices rally.

The rising prices may also signal a weaker dollar in the months and years ahead. Gold has also rallied. If worldwide economic activity increases, energy demand would likely increase and the energy rally would probably continue. However, if the dollar plunges, energy prices might remain firm even if a global recession ensues. Oil is priced in dollars. If the value of the dollar declines, the global energy community will need to raise the price of the commodity, all other things being equal.

In other words, we’re glad oil prices rallied, but we don’t think that it is a sure sign of future economic strength.

In December, we were hoping that the government’s new TARP program would enable banks to start lending again. That hasn’t happened.

The bank panic led to the wheels locking up on what some have called the “shadow banking” sector. There were many non-bank lenders who were funding all types of speculative, and some even not so speculative ventures. These shadow bankers, be they hedge funds, independent loan companies, independent mortgage companies, car finance companies and credit card companies, no longer make sub-prime loans (assuming they are still in business at all).

Traditional banks have not filled the lending void. The big bank TARP recipients are mostly sitting on capital, rather than trying to meet the demand for credit. In many cases, they have no choice. Bank regulators have clamped down hard on real estate lending. Most banks find themselves already over the limit of what the Fed would like to see. Also, given the recession, it's hard to argue against the need that banks feel to be especially prudent with depositor funds.

A recent company presentation by a local mining company proves that, thus far, even a well researched enterprise with reasonable proven resources and a profitable manufacturing process – even at today’s depressed cobalt prices – is not a fit enterprise to receive $250 million in financing. Yet, anyway. The company is limping forward, improving its reserve study but trying not to spend too much of its cash, waiting for the banking system to normalize so it can raise capital to proceed.

With capital, it is a very viable company. Unfortunately, it continues to struggle, today.

In a typical economic recovery, it is the price of money (i.e. the level of interest rates) which determines whether or not companies can borrow money to move forward. For my entire investing career (now a quarter of a century in the making), all the Fed had to do to get the economy moving again was lower interest rates. By re-pricing money, lower, borrowing increased, consumers refinanced high rate mortgages, and the economy rebounded.

This time it’s different. I know, I know – those are the four most dangerous words in investing. But, literally, this cycle is different. It’s different because over the past 25 years, rates fell so low that it was almost impossible to go much lower. It’s also different because even at low interest rates, the fear in the banking system is so great that while there is demand for money from the business sector, the bank vaults are still locked tight.

We’ve followed the level of “excess reserves” sitting over at the Fed, which represents dollars that the banks could be lending, but don’t. It is the banks’ vault, and that is where the money sits. It needs to be out in the economy, but we’re still waiting. Hopefully, when a gazillion stimulus dollars (please, don’t even get me started on that topic) hits the economy, the bankers will stand willing to finance the projects. Until then, we’re still waiting for this key indicator to improve.

Outside our borders, in a few places, efforts to provide liquidity are working. The mining company officials are focused on seeking development partners in China, which seems to be one of the few parts of the world which has money. It may take awhile for some of that global liquidity to slosh back onto our shores.

A much better sign is that bond markets are working again. High quality companies can still issue bonds. The prices aren’t ultra-cheap, but these companies do have the ability to raise money. Some forecasters are favoring large companies over small companies, simply because the big (high quality) companies can borrow money and move forward, while smaller companies are dependent on the banking system, which doesn’t seem to be open for business. I’d rather see all companies have access to capital, when appropriate, but at least we’re much better off as compared to December, when no company, anywhere, was in a position to borrow money to fund job creation.

In December, we also hoped to see market volatility decline, and it has. We’re not quite back to normal, but we can see normal from here, and it’s a darn sight prettier than the scene looking back. “Lack of volatility” is sort of like good health. You don’t really notice it, until it goes away. Then, it becomes the only thing that matters.

This leaves the final indicator: economic fundamentals. How are things going? This week, the leading economic indicators were up, but don’t let those numbers fool you. The strongest indicators were “market based” indicators. The stock market has rallied a lot since March. Interest rates, especially in the corporate and high yield markets, have declined. These market based indicators are positive. However, they are bouncing up off of extremely low levels in March, back when foolish talking heads from both the Left Coast and the Washington D.C. Beltway were talking about nationalizing our banking system. Just because we’ve discarded a stupid idea, and the markets have rallied, does not mean that we’re ready for the real economic fundamentals to rebound.

As we’ve written before, money matters. Interest rates matter. If they go up, as the U.S. struggles to finance its huge deficits, that is going to cut into consumer spending and postpone a housing sector rebound, because mortgage rates will go up as well. Higher rates will threaten a rebound in business investment, too. Right now, the best hope we have for a rebound is that business inventory levels are pretty low. If businesses re-stock, and sales and job growth increase as a result, we might be able to lift ourselves up out of the mire. If rates skyrocket, however, the cost of holding inventory will go up, companies won’t be able to afford to re-stock, and there goes our business rebound.

In addition to reasonably priced money lending rates, businesses need to be able to earn profits in order to justify expansion and job growth. I believe that the markets are forecasting an earnings rebound based on the very tenuous assumption that a rebound always follows a recession, and this recession is already longer than typical.

A muddle through economic rebound, based solely on cyclicality, probably lies ahead. A substantial rebound in profits, however, is much more a matter of faith. In the May 18 issue of Barron’s, Alan Abelson observes that first-quarter earnings on the S&P 500 Index came in “a tad over $10.” The current earnings scenario has earnings for the entire year coming in at around $40, down nearly 60% from peak levels. Typically, earnings fall about 10% in a recession, and rise 11% in the rebound. The 2000 recession was very severe for companies, resulting in a 20% decline in profits, and a similar rebound (fueled by an irrational and very generous banking system).

How realistic is an earnings rebound, of 150%, back to previous levels?

I wonder if the next economic rebound will result in a more “typical” rebound in corporate profits – perhaps a 10% to 20% increase to around $50 for the Index. If so, with the S&P 500 closing at 921.23 today, that gives the market a current Price/Earnings multiple of almost 18.5X earnings. If that’s what happens, the market rally is probably already over. A sustained increase from here might be hard to imagine.

A muddle through recovery is a pretty good scenario, from an economic point of view. It is not as encouraging, if you’re primarily concerned with where the stock market goes from here.

The answer, we believe, is to move away from a “typical” stock market portfolio. We are using more alternatives (gold, an inverse bond fund, commodities) and more high current income securities (junk bonds and preferred stocks) than ever before. If, in fact, “this time is different,” then that observation should apply to your portfolio as well.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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