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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