Red Flags Everywhere

I started the year forecasting a double dip recession and a down year for stocks. Instead, the economy has shown remarkable progress and stocks came out of the chutes with a strong first quarter and then moved up a lot more in April.

At this point, it is clear that my January expectations weren’t right. What is less clear is whether or not I’ll eventually be proven wrong.

The recent correction doesn’t worry me. The market was way “overbought” in April, so much so that we welcomed the correction. A market that grows to the sky far into overvalued territory has nowhere to go but down. With the market now have fallen more than 10 percent from its recent high, the market has fallen into “oversold” territory and in normal markets I would be buying into this weakness.

When I look at individual stocks in the custom wealth management portfolio, more than half of them look to be extremely “oversold.” Typically, it makes sense to buy on weakness, especially when the market is well off its top. In fact, our portfolios have money on the sidelines for just such an occasion as this. It would typically require a major market downturn, which just doesn’t happen very often, for it to make sense to continue sitting on the sidelines. What makes us think that such a downturn might be upon us?

First, China has stopped stimulating. Probably as a result, emerging market stocks and most commodity stocks have been among the weakest asset classes in which to invest. Whether or not the China bubble has popped is a question that I’ll leave to others to debate. For the moment, I’m just pleased not to be watching those holdings sinking lower in my portfolio.

Second, Greece matters. Whether Greece signaled the end of the Euro or, as it turned out, the need for a trillion dollars in unfunded stimulus, the end result is that global investors who have been forced to seek an alternative reserve currency now know that the Euro is no longer a viable reserve currency. In fact, the Euro looks so bad that many currency speculators have been forced to retreat back into U.S. assets. The worry stems from the fiscal straight jacket that Germany and the Club Med countries have been forced to wear. The cutbacks in government largess will almost certainly force Europe into a severe recession. Greece matters. Money matters. Money is no longer easy, in Greece, in Spain, in Ireland, in California, and in many more socialist regimes. Europe, California, and maybe China look to be headed for a double dip recession. How can the U.S. not follow?

Third, the U.S. economy remains shaky. Has the recession ended? Has the economy recovered? Alas, those are two very different questions.

If you define the “end of recession” as “having recovered,” we are nowhere near recovery. Money is still tight, in spite of last year’s stimulus package and near-zero interest rates. The government has wiped out savers’ incomes in order to finance deficits as far as the eye can see. Banks aren’t lending. Consumer credit is shrinking. Retiree incomes have plummeted. The employment situation remains a disaster. Recovery remains a long way off.

However, a “recovery” is more accurately defined as an end to declining economic activity. When “growth” resumes, from whatever level, the recovery has started. By this measure, the recovery began on July 1 of 2009. We remain at a level of economic activity that is well below what we experienced in 2006 and 2007. The current level is the “new normal” that pundits talk about. We have recovery, and high unemployment. We have a better manufacturing environment along with bankers who are making things worse by calling in loans of borrowers who are current with their payments. Retail sales and corporate profits are definitely stronger than I had anticipated, however construction hasn’t recovered so much (but it’s no longer dropping like a stone). This “new normal” is an uncomfortable status quo, even if things are improving slightly from day to day.

Will the U.S. economy double dip back into recession? You tell me. Unemployment claims are once again nearing the 500,000 per week level. States and municipalities have been forced to recognize the financial reality that businesses have faced since late-2008. The Federal Government threw a trillion dollars of kerosene onto the U.S. economic fire but it has burned off and it doesn’t look like the logs have reignited yet. With China and Europe now set to rain on our parade, the May-Investments double-dip fears suddenly have a bit more company.

Fourth, the market is not valued cheaply enough to offset these red flags. In March 2009, with the market off more than 50% from its peak, a lot of bad news was already baked into that market. Even after today’s 4 percent sell-off, however, this market is still up 50 percent from the March lows. Based on current earnings instead of projected/anticipated earnings, the market sells for nearly a 16X multiple. That is not the low end of the range.  "Valuation" is not a reason to ignore the red flags.  In March 2009, brave investors could at least take solace in knowing that they were at least buying on the cheap.

Fifth, and very importantly, market “volatility” is extremely high. The “VIX Index” has soared in recent weeks. Typically, it takes a major sell-off or news event to stabilize the market. Europe’s trillion dollar bailout of Greece didn’t calm the waters. So what will?

Maybe Europe will come out with a more robust fix for the Club Med sovereigns than the trillion dollar fixer-upper that has already been announced, but I doubt it.  Maybe some U.S. economic statistics will be surprisingly strong, as has been the case most of this Spring, and turn investors attention away from problems overseas.  Perhaps corporate earnings will continue rebounding as strong as current forecasts project.

However, to me the most likely "catalyst" for the VIX to peak and then reverse direction is a market sell-off that takes stocks back down to attractive levels. I’ve said before that I think that “fair value” for this market is around 9,000 on the Dow (still a 10 percent fall from today’s close). In fact, the market typically falls below fair value before it stabilizes.

I don’t think that the market needs to revisit the March 2009 lows, when it fell below 7,000. Another 10 percent drop, however, wouldn’t surprise me. That is why we’re not buying more stocks today, despite stocks having fallen into an “oversold” condition. If this is the double-dip I’ve been expecting, then there is no point in buying too early.

Hopefully I’ll be wrong. However, given the number of red flags waiving, we are glad to have been “defensive” in our holdings (glad to have some cash on the sidelines) and we are actively considering whether there is still time to move more to the sidelines to reduce our Beta (exposure to portfolio volatility) even more. If the economy is starting its double dip, and the stock market is entering a new bear market, then adding a “bear market fund” might help us preserve wealth better while the market adjusts to this “new normal” in which we find ourselves.

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

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1,000 Points of Fright

The Dow Jones Industrial Average fell nearly 1,000 points intra-day today, but recovered to “only” lose 348 points (or 3.2%) on the day. Exchange officials are investigating whether some erroneous trades posted that set off the selling panic. The only certainty is that market volatility soared, which (in and of itself) is a bad sign.

Was it a computer glitch? Or was that instant evaporation of wealth for real?

The data feeds are clearly suspect. At one point, a small cap exchange traded fund appeared to have fallen 60% during the midst of the debacle. An hour or so later, the trading chart showed no such plunge. The data that people had, mid-day, seemed to have errors. When traders can’t “see” what’s really happening, bids dry up. That is an excellent way to foster a selling stampede. Smart money stepped to the sidelines until eventually bottom-fishers started buying in. The good news is that you can make an argument that if the market were to fall to around 9,875, then new buyers would likely step back in and provide “support.” They did today, anyway.

After buyers came back in, the market rebounded about 650 points to close at 10,520 on the Dow. The computer glitches and massive trading programs (sells, initially, and eventually buys) make today’s panic hard to interpret. Was it an anomaly? Or did it reflect the fact that “Greece” is the word?

One number that can be believed, today, is the VIX (the Volatility Index). We have been watching it creep up in the past few weeks to levels that used to signal panic. A couple of years back, the placid market resulted in VIX numbers in the low teens. In a more typical market, the VIX index is probably 18 to 20. In 2008, the VIX kept climbing to new highs and finally peaked somewhere over 80 amidst the worst crash in 70 years.

A couple of days ago, the VIX had snuck up to the 30 level amidst worrisome headlines in Europe. Today’s 1,000 point fall resulted in the VIX level climbing above 40, to a level never seen before – prior to 2008’s rout.

Today’s market is selling at fairly high levels, versus corporate earnings power and when compared to the March 2009 lows, but don’t let today’s high prices fool you. There is still a lot of fear left in this market. Today’s action proved it.

So what? Volatility in an up market is a good thing, right?

True, but more typically “volatility” is unleashed during a sell-off. Markets climb higher, bit by bit. But markets “plunge” down. If you know that volatility is high, it’s a much better bet that the market is selling off. That’s why the term “volatile” is now virtually synonymous with “falling.” Brokers will almost never admit that the market had a bad day. They can’t bring themselves to say that stocks went “lower” today. Instead, they just observe that stocks were “volatile.” They don’t fear that stocks are going to go lower. They’re afraid that “volatility” will continue.

With a VIX of 40, there is reason for caution. With a VIX of 40 and valuations that we believe are above normal, that is even more true. A high VIX and rock bottom prices may signal a fantastic buying opportunity. But a high VIX and high valuations suggest little upside, significant downside, and a ticking time bomb in your back pocket.

As you can tell, today’s activity doesn’t exactly call for a celebration. We continue to be cautious in our portfolio construction. Our mutual fund model fell -2.24% today, and the individual stock model portfolio fell -2.21% today, as compared to the S&P 500 decline of -3.24%. Eight out of ten fund holdings outperformed the market, though even gold and junk bond funds fell during the day. We have one position in “cash,” which outperforms everything else on a day like this, simply by standing still.

We are already positioned defensively. However, we could position ourselves even more defensively than this, especially if we once again feel the need to add a “bear market” fund that is designed to increase in value when the market declines.

If the market declines significantly, we could sell our high yield bonds and cash, and perhaps gold, to reinvest in stocks at much more attractive levels. However, if this market is to keep falling, we will likely try to position ourselves even more defensively on the way down.

Our Flexible Beta strategy tries to reduce risk in “volatile” markets. We have already taken a substantial amount of risk off of the table. That is why we captured only about 2/3 of today’s move lower. It might be possible to get even more defensive, however, and today’s spike in the VIX index would likely support such a move.

In general, today’s market activity supports our thesis that we’re at the high end of a trading range. We still believe that the economy has stabilized, still in recession. I have been more befuddled by the first quarter’s 5% surge in stock prices than I am by today’s fiasco. An overvalued market will find a reason to come down. It might be Greece. It might be that a computer glitch triggers program trading that causes things to get out of control. It might be that everyone knows that the market is overvalued but we’re in the midst of a melt-up as mutual fund investors spend down their cash in the face of a rising market. Eventually, however, something triggers the market to revert toward “fair value.”

Today’s panic is no reason for panic. On the other hand, for a thousand different reasons, I hope it doesn’t happen again tomorrow.

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

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Baker Hughes Buys Into List of Local Stocks

The May-Investments Index of Western Colorado Stocks increased +2.69 percent in April while the widely followed S&P 500 stock index rose +1.58 percent during the month (total return including dividends). Arch Coal (ACI) was the best performing stock in the index (+18.2 percent) while Wellpoint (WLP), which fell -16.4 percent during the month, was the biggest laggard.
Baker Hughes completed its acquisition of BJ Services and replaces BJS in the index. Baker Hughes has been working to expand its presence in the Middle East and Russia. By adding BJ Service’s pressure pumping products to the Baker Hughes product portfolio, now it can compete more effectively for international contracts that require a more comprehensive range of capabilities. The merger received Department of Justice approval late in the month and closed on April 28.

Arch Coal reported a first quarter earnings miss, but the company raised its 2010 earning guidance based on forecasted improvements in its domestic steam coal markets. Wellpoint shares declined after the health plan company cancelled its proposed massive rate increase in California. When Wellpoint announced the rate increases, some as high as 39 percent, the move almost single-handedly revived the moribund Obamacare legislation. Now we find that the rate increases didn’t stick, after all, but the legislation did.

Year-to-date, the May-Investments Index of Western Colorado Stocks is up +9.3 percent through the end of April while the overall market has gained +7.1 percent over the same time period. The index began tracking the performance of local stocks in December 2006 and is up +0.6 percent since it launched, while the S&P 500 has declined -10.0% during the same period of time. 
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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"Inverse Treasury" Fund gets sold - for now

We sold our inverse Treasury holdings after Friday's good economic news was accompanied by falling interest rates, instead of causing rates to increase - as would normally be expected.

The investment has been on the verge of being sold for months. Though long-term rates have been fairly stable since the purchase of this fund in mid-2009, the fund itself has not been able to demonstrate that same investment stability. Instead, it has seemed to experience much higher holdling costs than the fund's stated expense ratio would seem to suggest. We believe that the cost of maintaining the fund's short position in Treasury bonds must have caused the drag, which we've estimated to be as high as 1 percent per month.

In most investments, if the underlying investment idea is neither moving up nor down, the fund stays pretty even. With this inverse Treasury fund, which uses futures investments to maintain its investment position, there is a steady "leak" from portfolio value that makes it an unacceptable long-term investment vehicle. This is likely true of most "inverse" funds, which suggests that inverse funds should most often be used tactically - in the worst of a sell-off - rather than strategically, waiting for a "sell-off" to happen.

Our investment in the fund was predicated by a concern that the nation's huge borrowing needs would result in higher borrowing costs in the ever more frequent Treasury auctions. Instead, banks have stepped up and appear to be buying up the new issuance. In addition, millions of dollars flowing into bond mutual funds have also funded the purchase of treasuries at the auctions. This morning's Ned Davis research included a note that in April, alone, $486 million was added to the iShare long-term Treasury ETF, increasing assets in that fund by over 21 percent.

With this amount of money flowing into treasuries, a short-treasury position could remain out of favor for awhile. Add to that, difficulties in the European credit markets and increased market volatility that are raising the stature of the dollar as a "safe" reserve currency, another factor which tends to keep interest rates lower, the notion that we will experience a run on the dollar, and that market pressures will force interest rates higher, seems to run contrary to current market trends.

Our concerns about the U.S. government borrowing requirements may be right, ultimately, but it's not at all clear that this is a near-term problem. Further, given the amount of "leakage" we've experienced, where high transaction costs transfer wealth from our pockets into those of the futures traders, we could no longer justify holding a position which hasn't been an "outperformer" for several months.

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

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