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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