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.

Go to Investments main page.

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.

Go to Investments main page.