Rising Portfolio Cash Speaks to Market Concerns

Don’t ask market gurus for their opinion; ask to see their portfolios.  Bullish advisors that sit in cash have little credibility.  Fully invested advisors with “cautiously optimistic” opinions don’t strike me as being very cautious.  At May-Investments, with most “red money” (growth oriented) portfolios now sporting cash positions of 20% to 30%, our concerns about recent market activity have shown up in portfolio holdings.

 

In the short run, there are numerous technical indicators that have forced us to a more cautious stance.  In the long run, there are still many reasons to be optimistic – but recent events are suggesting that the possibility of a bad surprise has increased.  Rather than cross our fingers and hope that things don’t get worse, in the past few weeks we have shifted portfolio holdings to cut back on the amount of risk to which portfolios are exposed.

 

• While stocks (the S&P 500, at least) are still up 3.8% year-to-date through the end of trading today, the market direction has shifted enough that momentum investors are heading for the exits.
• Investor interest in the stock market is flagging, which shows up in very low trading volume. 
• Moreover, on days with greater activity, the market trend is often lower – suggesting that when trading volume returns, it won’t lead to an upsurge in the market. 
• Money flow indicators, which have been positive for most of 2012’s rally, appear ready to go negative. 
• Defensive sectors, by and large, are outperforming the broad market while commodities, technology, financials, and cyclical stocks lead the market lower. 
• Investors Business Daily’s “Market Pulse” indicator switched to “market in correction” on May 4, which is when May-Investments began reducing our stock weighting in some portfolios as well.

Perhaps the action which has us most concerned has been the very dramatic sell-off in the commodities sector, reminiscent of July 2008.  While newspaper headlines focus on the political and banking situation in Europe, a more compelling explanation to me is that the situation in China continues to deteriorate.  The chaos in Europe, while unprecedented, really shouldn’t be surprising to anyone.  The banks over there need to be recapitalized, which means that this week’s takeover of a bank in Spain is just the first step in a long line of dramatic steps that result from the sovereign debt problems over there.  Maybe the market is just responding to the unfolding of the inevitable, but what worries me more than Europe is that the bad news out of China keeps coming.

 

Our hope, as the year began, is that the U.S. and China would avoid the recession which had already begun in Europe.  If China continues sinking into recession as well, it is very hard to imagine the U.S. avoiding a similar fate.  That, to me, is the real news that the market is digesting.  Throw in a little uncertainly about our own political incompetence, and it’s not too hard to imagine that a correction (or worse) might be just around the corner.

 

As always, however, it is important to look at both sides of the coin.  There are a number of long term factors which still favor continued growth, unless China does continue toward an implosion of its own.

 

First, our portfolios have very little direct exposure to the problems in Europe, and haven’t for over a year.  The U.S. market, generally, has performed much better than the international markets and client portfolios have been focused on domestic stocks.  Most of our international exposure comes through our gold and precious metals holdings. 

 

Second, as in 2008, having a significant amount of cash on the sidelines gives us significant buying power should a market correction unfold.  We have always said that corrections feel a whole lot worse when investors are fully invested.  If there is money available for investment at “the bottom,” then a correction becomes an opportunity which can be a silver lining to the otherwise cloudy sell-off.

 

Third, the May-Investments U.S. Leading Indicator Index remains pretty strong.  It flattened out for a few months, but the preliminary numbers for the month of April show continued growth in U.S. economic activity.

 

Fourth, regulators have had some time to prepare for the financial crunch sweeping across Europe.  Even in the midst of this week’s angst, Spain was able to sell bonds at auction.  Banks, using money borrowed from the European Central Bank, can buy bonds at 6% and pay just 1% on the borrowed funds.  True, as in the U.S., this funny money is being created out of thin air, but the plan hatched late in 2011 does provide liquidity to the system.  It is my guess that the U.S. will soon be asked to tap into the Federal Reserve balance sheet for a trillion dollars or so.  We will lend money to the European Central Bank, which will lend it, in turn, to banks on the continent.  Japan and other countries may also make funds available.  This rescue has been at least a year in the making, and the printing presses aren’t even close to running out of ink.  (It helps that all of this fiat money is being created digitally, on electronic balance sheets on both sides of the pond.)

 

Fifth, May-Investments new custom wealth management approach has been working well.  Last fall, we tweaked some disciplines around our portfolios’ “flexible middle” to make the decision to move to cash more objective, less stressful, more gradual and less disruptive to the portfolio.  Beginning in early May and continuing step-by-step as the warning signs began to accumulate, we gradually reduced our risk exposure to the point where now we have a significant stash of dry powder in the event the sell-off continues.  The sales were made more quickly.  The main problem with 2011 was a delay in August as we wanted to get past the budget impasse – a decision which meant that we weren’t reducing risk until too late during the sell-off.  The process was more objective and less subjective.  It will also be easier to reverse, if and when markets begin to recover.  Thus far, the portfolio tweaks made late last year have worked very well.

Sixth, market valuations remain very attractive.  Note that these valuations are a function of forward earnings estimates, which are themselves a function of what the U.S. economy does during the remainder of 2012 and into 2013.  At this point, however, the domestic indicators remain strong, so corporate profits may stay the course.  If the U.S. indicators start going down, it will make sense to take even more risk out of the portfolio.  In 2008, the economic indicators lead the market decline.  This time, the market is weakening in advance of any decline in U.S. economic fundamentals.

 

The technical indicators that are waving red flags are too numerous to ignore.  It is possible that we could be whipsawed again, as happened in 2011 when we reduced our equities at the height of the European crisis but, when solutions finally began to appear, the markets surged higher and our portfolios missed out on the recovery.  We will be quick to buy back in if things settle down (because of the numerous long-term positives mentioned above), but it is easier for us to risk the opportunity cost of a market recovery than it is to think about the losses that could accrue to investors if these red flags are right, this time.

We remain long-term optimists, but the news coming out of China also can’t be ignored.  We are reminded of John Maynard Keynes response to criticism for changing his mind, who replied, “when the facts change, I change my mind.  What do you do, sir?”  The slowdown in China is morphing toward something worse, which would put the U.S. recovery at great risk.

 

If, as I hope, the European markets settle down and China starts showing signs of stabilizing, the market would likely go back into rally mode and we will put the cash to work.  At the moment, however, we are concerned that the market has enough downside from here that it makes sense to reduce the amount of capital at risk in the long-term portfolios.

 

It almost goes without saying, but we’ll say it anyway, it’s also appropriate to be absolutely certain that only long-term money is invested in the “red money” portfolios.  At this point, from the market’s high water mark, the S&P 500 Index is down less than 9%.  At this point, volatility has not spiked and the downturn is well within the range of normal market ups and downs.  No one should consider it “too late to sell.”  Investors should be certain that long-term portfolios have only long-term money invested in them.

And remember that this, too, shall pass.  But buckle up.

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

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Get Out The (Proxy) Vote

Citigroup made headlines in April when its shareholders rejected the company’s “say on pay” proxy initiative in response to C.E.O. Vikram Pandit’s $14 million pay package.  Only 45% of the proxies voted to “approve” the TARP-recipient’s compensation practices.  In addition to the shocking pay package for a company that requires ongoing government support just to stay in business, both of the major institutional proxy consultants recommended shareholders vote against the proposal.  Proxy voters are speaking their minds, so to speak, and companies are beginning to take notice.

The culture of capitalism fits well with the spirit of democracy where, in both systems, people and ideas compete for the approval of those governed.  Shareholder elections take place each year when companies send out proxies soliciting votes from individual shareholder/owners.  In fact, capitalism would probably work better if more investors took these referendums seriously, as May-Investments does on clients’ behalf.

May-Investments may be in the minority of investment advisor firms that vote proxies on behalf of clients.  Key proxy issues include approving executive compensation and authorizing future incentive plans, whether the company should require an independent Chairman of the Board, and electing directors for the upcoming year.

May-Investments reviews each company election independently to determine how we will vote client shares.  Given the outsized compensation packages that most boards approve for their executives, May-Investments believes that most boards are abdicating their fiduciary responsibility to shareholders, and that most executive teams are more skilled at absconding with company assets than they are at managing the enterprise.  In our view, C.E.O.’s  that have failed to grow earnings for a period of years, and whose company stock price has failed to rise along with earnings power, do not deserve the multi-year multi-million dollar pay packages which are the industry norm.  To generalize, we tend to vote against approval for overly generous pay packages and we typically vote against the directors that have approved such corporate largess after confirming that these board members are often paid in excess of a quarter-million dollars in exchange, it seems, for playing the part of C.E.O. sycophant.

While the Occupy Wall Street movement might delight in our voting “against” the 1%, we would prefer to think that our clients are more Ayn Randian in our demands that owner representatives be more parsimonious with shareholder resources.  Ayn Rand likes to see success rewarded.  But first, there must be success.  We vote not the politics of envy, but we do desire accountability.

Apple's board of directors approved a pay package for new C.E.O., Tim Cook, of $900,000 cash and a $378 million stock grant, just for taking the job.  Seriously?  They tried to give him a sufficiently large equity position to persuade him to focus on the task at hand.  In reality, even if Apple's stock plummets 75 percent, they will have paid him nearly $100 million to preside over the Titanic.  Not a bad gig, if you can get it, but what was the Apple board thinking?

In the relatively few instances where corporations have delivered on promises of earnings growth and shares have appreciated to reflect that performance, we will give managers and boards the benefit of the doubt and approve very generous pay packages.  In most cases, however, managements are being paid too much and our vote reflects our displeasure with how salaried employees are raiding the nesteggs of passive retiree-shareholders.

Increasingly, shareholders are proposing their own election items.  Frequently, shareholders will propose an independent Chairman, forcing management to relinquish key responsibilities to someone better able to represent outside shareholders.  Despite management’s recommendation that shareholders reject these proposals, we typically concur that anything to give shareholders better representation is an idea worthy of support.  Shareholder proposals to install better controls on executive compensation are also likely to receive support, unless the company has been able to grow earnings and shareholder value materially during previous years.

While not everyone will agree with our willingness to vote against management on these issues, we think it is necessary to look out for clients’ best interest.  I can think of very few clients who would disagree with my view that most managements are drastically overpaid.  As a fiduciary, voting client shares on their behalf, I believe that our vote should reflect this point of view.  Further, for capitalism to reach its potential, boards should be holding managements accountable.

During proxy season, many magazines publish articles ranking the most- and least-overpaid corporate chieftans.  We hope that you’ll appreciate that you are not sitting out this election.  Hopefully the directors at Citigroup and other companies will accept the responsibility with which they’ve been blessed.  We are looking to invest in profitable companies at attractive prices.  It is also important to send the message to boards that compensation packages should enrich managers for achieving success instead of enriching every Tim, Vik & Mary who manages to land the job.  After all, as Apple's board may yet learn, past performance may not necessarily be an indication of future success.

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

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