Consuelo Mack interviews Steve Leuthold

On May 15, Consuelo Mack interviewed Steve Leuthold, manager of the Leuthold Asset Allocation Fund. He was joined by Steve Romick from the FPA Crescent Fund, who is another excellent manager. In the interview, they discuss the prospects for stocks, looking forward, given the dismal decade we've just completed.

Click here to see the interview. In case the web page changes, the segment is dated 5/15 and is titled "Nowhere to go but up."

For the record, through yesterday (May 28th), the Leuthold Asset Allocation Fund is up +5.73% year-to-date.

Leuthold states that the current "trade" is to buy stocks and to short treasuries.

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

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Spotlight On Interest Rates

Our long-shot prediction at the January Economic Update on Inauguration Day was that a U.S. Treasury auction would fail at some point during the year. Since then, the size of the bailouts has increased, the amount of money being raised by the Treasury has soared, and the prediction has evolved from a long-shot to a market-wide worry.

This week, the market successfully raised $101 billion. We only have another couple of trillion dollars to go before our worries subside. On Thursday and Friday of this week, the bond market rallied once it was clear that the auction hadn’t failed. Worries about the ability of the U.S. to borrow enough money to finance the current round of bailouts and promises are causing the value of the dollar to fall, the price of gold and other commodities to rise, and it is generally forcing interest rates higher. Though the economy needs lower interest rates to jump start consumer spending, I have to agree with Mick Jagger that, “you can’t always get what you waaaant.”

Our mutual fund model has been under-invested in stocks for about 18 months. We still own more (high yield) bonds than is typically the case, and our preferred stocks are more bond-like than stock-like. This week we sold our final remaining money market position to invest in a fund whose returns are based on the long-term Treasury bond.

Unlike a normal bond fund, however, the fund we chose should rise in value on days that interest rates increase. The fund, by “shorting” U.S. government bonds, rises in value when the price of government bonds decrease, which occurs when interest rates go up. Like our gold bet, to some degree it is an investment that will do well particularly if current political and monetary policies run into difficulty. It is not an approach which I enjoy taking. However, I believe that current events will prove it to be a wise allocation of capital in a difficult time.

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

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Unusual Investments for Unusual Times

We continue to believe that the “muddle through” investing scenario that we forecast in January is on target.

The Dow Jones Industrial Average hovers around 8,500. Despite the sense of volatility that we all still have, the market has remained fairly stable since last November – with one notable exception. The exception was when several political heavyweights began considering whether or not to nationalize major portions of our banking industry. The market recognized this potential travesty by spiraling down to a low point where the market traded at roughly down 25 percent before the folks at the Treasury realized that maybe it wasn’t such a good idea. As soon as Katie Couric and the political talking heads moved on to other subjects (e.g. how wonderful was our new President’s first 100 days), the market recovered.

There have been signs of improvement, though I still read them as signs that the downward spiral has come to an end. This week the Conference Board’s Leading Economic Indicators were released. The latest number was positive. While half of the indicators have stabilized (in recession), the relationship of short-term interest rates to long-term interest rates (i.e. the “yield curve”) and monetary policy (the amount of cash that the Treasury is shoveling out the door) were both positive. A third indicator, the U.S. stock market, was also a positive – although I think that just reflects the fact that the politicians stopped talking like imbeciles, which isn’t exactly proof of better things to come.

The real economy, as reflected in the average manufacturing workweek and “vendor performance,” which attempts to measure the timeliness of vendor deliveries, were both very negative. Would indicators do you trust these days? Washington policies? Or how the heartland is responding to them?

For my money, I remain a bit cautious. Corporate profits have all but disappeared. They are down 90 percent. The real question, of course, is how long this environment will last. At current profit levels, stock valuations are extremely rich. I do believe that we’ll see a significant recovery in profits from current levels, to how much and how quickly, neither I nor anyone else have a clue.

Stock market investors remain fully exposed to this earnings risk. Our portfolio, with its emphasis on high yield bonds, is mostly betting that today’s companies are here to stay. Betting on the broad stock market, it would seem, requires more – a significant upturn in the profit picture for corporate America. I’m not sure that I’m ready to bet on that. Not yet.

One thing that is working is what we call our “inflation trade.” Year-to-date, energy stocks have been very strong, and gold is moving up again. The value of the dollar is falling. Long-term interest rates are moving higher. Next week the Treasury Department will put over $100 billion of treasury securities up for auction.

Like it or not, the U.S. government has chosen to inflate our way out of the 2008 banking panic. One could argue that they had no choice. In any event, the portfolios that will work in a stagflationary quagmire aren’t your typical S&P 500 stocks.

If the current portfolio looks a bit unusual, it is because we live in unusual times.

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

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April Portfolio Stands Pat

Our discipline of reviewing portfolio strategy progresses at a less frenetic pace. Markets have resumed a somewhat more normal tone. We used to review holdings each month, at the end of the month. In mid-July of 2008, however, market volatility started increasing and we had numerous occasions to make mid-month changes to portfolio strategy. Though we are not resuming the process of only making changes on the first day of the month, a practice tied to our old newsletter publishing dates as much as anything else, we do appreciate the less frenzied pace of today’s market activity.

At the height of the 2008 bank panic, we also found that our normal discipline of looking back 6 months made little sense. What happened prior to the mid-September bankruptcy of Lehman Brothers mattered little in late December or early 2009. Prior to September 15, we had a poorly functioning but extremely large “shadow banking system.” After that day, it ceased to function altogether. We had to change our look-back date for identifying new trends to November 1. It didn’t remove all of the volatility because November 2008 was also a pivotal month. However, by November the markets were all fully aware of the significance of the bank upheaval. Rational responses were beginning to appear in the market trends. The September and October panic reflected mostly fear and illiquidity in the hedge fund arena, both of which interfered with the signals that the market was trying to send.

The April 30 portfolio rebalance reflects the first time in 8 months that we’ve been able to apply our normal evaluation process to the portfolio. We were pleased to see that by and large, the portfolio is in great shape. We try to own “what’s working in the market,” and for the most part the current portfolio reflects those holdings. As a result, we are not making any immediate changes to the current portfolio holdings.

As always, we will continue to review the strategy – on an ongoing basis instead of the old strategy of just rebalancing at month-end – and continue to dynamically adjust our asset allocation to attempt to stay in the sweet spot of current market trends.

For the comparison, below, as of month end (April 30, 2008) the broad market, as represented by the Vanguard 500 Index Fund, had fallen -2.5% year-to-date. A recent study by Standard & Poors confirms what has been found in numerous previous studies, that the low-cost index funds tend to outperform roughly ¾ of their actively managed peer group. In other words, investors can often attain top quartile performance, simply by buying an index fund, and index fund investors, through April 30, are down -2.5% thus far in 2009.

Clients, and regular readers, have heard me break today’s portfolio down into three types of investments. First, we continue to invest defensively with roughly 40% of the portfolio (4 positions) in cash and high yielding preferred stocks or junk bonds. Even money market funds have outperformed the stock market thus far in 2009. Generally speaking, junk bonds have done much better. For example, two funds which our clients are quite familiar with, the American Funds High Income Trust (AHTFX) and the Fidelity Advisor High Income Advantage Trust (FAHYX) are up +11.7% and +16.5% year-to-date, respectively. Preferred stocks, which are dominated by bank issuers, have generally lagged the market over this time frame.

I read many articles about investors who are concerned that a sluggish economy will retard economic growth for an extended period of time, and who are leaning toward high dividend yielding stocks so they will get “paid to wait.” A typical high dividend yielding common stock probably has a 6% yield. In contrast, a high yield bond or preferred stock may provide investors with two- or three-times that level of income (12% to 18% yields). While some worry about the potential for defaults in the junk bond arena, it seems to me that if a wave of bankruptcies does overwhelm the junk bond investors, then common stock investors are likely to get overwhelmed even more.

The junk bonds seem well suited to our view that this economy will “muddle through” for awhile, and in aggregate we are pleased that they are outperforming common stocks, which we view as much riskier investments.

Second, we continue to prepare investors for a wave of inflation which we view as the inevitable result of current monetary and fiscal policy. These, too, look to be squarely in the middle of current market trends. For example, the Fidelity Energy Services Fund (FSESX) focuses on drillers and has gained +20.7% year-to-date through April 30. The Fidelity Natural Gas Select Fund (FSNGX) focuses on exploration companies and has gained +17.4% year-to-date.

We also recently added exposure to gold mining companies. An example of a fund in this sector is the Franklin Gold and Precious Metals Fund (FKRCX), which is up +7.7% year-to-date. However, clients should note that our gold company purchases came late in the first quarter and are generally below cost at this time. Still, all three of these investments represent a hedge against future commodity inflation, and insurance against a currency crisis that would probably send the dollar plunging. All of these investments seem to be in line with current market trends.

We also have about 30% of the portfolios invested in more traditional stocks, primarily in the technology area (including biotechnology). For example, the Fidelity Select IT Services Fund (FBSOX) is +11.0% through April 30, and the Fidelity Select Computer Software Fund (FSCSX) is up even more, +13.3% at month-end. These show that technology has been a pretty decent place to be invested thus far in 2009.

We also own positions in healthcare. The individual stock portfolios tend to own more traditional pharmaceutical companies. The fund portfolios are more weighted to biotech companies. It wouldn’t seem to matter much. Thanks to the President’s budget proposals, political risk is weighing heavily on these sectors. The Fidelity Select Pharmaceutical Fund (FPHAX) is down -7.3% year-to-date, lagging the broad market, and the Fidelity Select Biotech Fund (FBIOX) is down a nearly identical -7.1% year-to-date. These are cash rich sectors with generally healthy fundamentals and valuations as low as, and now getting lower than, the rock bottom levels achieved during the Hilarycare scare of 1993. They should be a rallying point for the market, but instead they are a test case to see just how anti-business Washington D.C. has become.

Biotech is fighting to retain its place in the portfolio. Emerging market investments are doing well, and are not yet represented in the portfolio. Our current energy investments are also struggling over a 6-month look-back, but what we call our “inflation trade” is coming on strong so we decided to postpone any decision to move out of them into Latin America or Asia. Many portfolios also have a final tranche currently sitting in money market funds available for investment. We would like nothing more than to wake up and get an “all clear” signal. We could invest that money, and significantly ramp up our portfolio risk profile.

Whether we get that signal will hinge on several things. How long will the recession last? I believe that the economy has stabilized, in recession, which means that a new bull market probably isn't right around the corner. There are good things happening out there. Inventories are fairly lean. Housing inventories are starting to decline. The bond markets are working much better. However, I could list an equally daunting list of concerns, first and foremost of which concerns the ability of the U.S. Treasury to borrow trillions of dollars from increasingly anxious foreign lenders.

I’ll tell you whether we’ve seen the bottom if you’ll tell me whether or not we’re going to experience a failed Treasury auction in the near future.

We’re happy that the portfolio, today, is well enough positioned that we didn’t have to make any changes this month. We thought there would be a lot more work to do, once markets stabilized. We’re also glad that we are far enough past the crisis that we can once again apply our normal discipline, in a less anxious setting.

To clients, thank you for your business during this trying stretch. I don’t know how many times I called on people, to offer reassurance, and was blessed with kind words and encouragement from the very people I was hoping to help. Your stalwart trust is appreciated more than you know.

Happy Spring!

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

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