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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Enjoying the Rally, but not Relaxed

Investors should relax and stop worrying. That’s my job.

I continue to be more worried about preserving wealth than I am about missing the next market upleg. This weekend’s Barron’s reading was a mixed bag.

The good news was an article, “Trampled in the Rush to Riskier Stocks” by Andrew Bary, that featured stocks in the property & casualty insurance sector, which is a new area of investment in many client portfolios. The article noted that most of the P&C stocks command little or no premium to their accounting (book) value, are currently profitable, and have an opportunity to take business away from the wounded giant, AIG. The hurricane season has been kinder and gentler than in years past. The Price/Earnings ratio of the nine stocks profiled in the article range from 5.9X earnings to 10.1X earnings. If earnings power is maintained and the P/E multiples remain stable, these companies would provide an earnings yield of 9.9% to 16.9%. If earnings power grows, as the analyst in the article expects, or if P/E ratios improve from today’s low levels, investors would benefit even more.

We watched the downward spiral in financial stocks from the sidelines. We are no longer convinced that the sidelines is the best place to be when we look at stocks in the insurance industry, but as always we’ll monitor that view and modify it if necessary.

More of concern was the Lipper fund data which continues to show money coming out of equity mutual funds, in contrast to the surge in July and August that coincided with the big run-up in stock prices.

The Federal Reserve released new data on excess reserves, which is money that is hiding in the banking system but not finding its way out into the real economy, where it could help alleviate some of the financial pressures we are still experiencing. The Wall Street bailout, where public dollars are used to buy up illiquid securities to bail out big banks who were caught in the squeeze, has worked pretty well. Unfortunately, even nine months after excess reserves first surged, the money hasn’t yet made its way out into the real economy. Excess reserves jumped from $823 billion up to about $855 billion, near its all-time high. Regardless of today’s low short-term interest rates, it’s hard to conclude that we’ve got an “easy money” policy if the money sits on the sidelines and is unavailable for job creation and capital investment.

The best news, of course, is that the market has wanted to go up in spite of these fundamental concerns. The Vanguard S&P 500 Index Fund, for example, is +17.8% year-to-date through last Friday, September 25th. Though it was hard to justify higher prices in the fearful days of February and early March, now the S&P 500 sits 57% higher than at its nadir in early March.

Clearly, the volatility inspired by widespread fear in the last months of 2008 and the early days of 2009 created a significant opportunity for profit. Similarly, however, the upside volatility we’ve enjoyed as a function of relief spreading throughout the economy has magnified the risks of decline. Just as we did not put all our money to work at the bottom, I am absolutely certain we won’t be able to define and get out at “the top.” What we will do, however, is carry our bias toward wealth preservation and experience in managing our way through volatile markets into the period ahead..

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

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A New Week

Last week in Barron’s Mike Hogan noted that the politicians are finally getting around to considering natural gas as a cleaner burning fuel, suitable to large auto and truck fleets, that might be capable of actually making a dent in our foreign oil dependency sometime this side of the next quarter century. Most energy alternatives are so far out in the development stage that they provide little near-term impact. It would be nice if we could develop the solar and other renewable options, but few barrels of oil will be left on the shores of Saudi Arabia, at least during the next decade, if we limit ourselves to clean green options.

Natural gas, though, is cost effective and available and, with just a little technological sprucing up, could drastically reduce our dependence on areas of the globe which tend not to raise their hands when volunteers for the USA fan club are solicited (unless, of course, the term “citizenship” is dangled as an incentive).

Harry Reid and Obama’s Chief of Staff, Rahm Emanuel, are among those pushing for a political initiative favoring natural gas. How it was left out of the hundreds of pages of middle-of-the-night negotiating for the Cap and Trade bill, is a great question. The Colorado delegation might want to spin up an answer for the next election cycle. For Western Colorado, natural gas stocks, and our current portfolio, however, it’s a plus.

Natural gas and crude oil are diverging in an unprecedented way. Natural gas prices are setting new lows, making this clean substitute for crude ever more cost effective. It reduces the value of reserves, which is a negative for the gas exploration stocks, but it creates an ever greater incentive to lean toward gas as a clean fuel for the future.

I was less enthusiastic when I checked the recent money supply statistics in the tiny print of the Market Laboratory section of the paper. Excess reserves, which is money held in the banking system instead of being available to business and consumer borrowers, rose again – back up to nearly $800 billion. Thus, the money which came screaming out of the stock market, last Fall, and now sits earning practically nothing in certificates of deposit, is not yet finding its way back out into the real economy.

Were it not for the credit crunch, credit-worthy borrowers would abound. As it stands, since no money is going into the real economy and therefore attempts by the Federal Reserve to stimulate the economy using monetary policy isn’t stimulating anything, almost any loan looks like a mistake waiting to happen. It’s a classic “Catch 22,” but without the biting humor that Joseph Heller wrote into his characters.

Finally, money flows into equity funds went negative last week. The last six weeks have been good to stocks, and positive flows into the market helped explain the surge. In many sectors, valuations look stretched. I can find insurance stocks and healthcare stocks whose earnings prospects remains strong, but whose stock prices are a lot lower than a year ago. For the broad market, though, earnings power has fallen at least as much as the stock market itself. We’re rotating into some new sectors, but if the same guy who was telling you to “sell” in March is now telling you to throw caution to the wind and “buy” today, it’s probably time to upgrade your choice of market pundits. Risk is always at least partly a function of price, and today’s market is 50% more risky than when the market that was causing us all to sweat bullets last March.

Clearly the economy is stabilizing, as we said it would. It’s not clear that it’s getting ready to shift into high gear. Or even that it will be able to sustain the momentum it’s got. It’s in low gear, crawling forward through difficult terrain, and valuations ought to reflect this reality.

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

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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.

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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.

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I'd Rather Be Wrong (and Up)

I predicted a down year at our Economic Forecast seminar in January, and that the economy would stabilize and remain in a recession for all or most of the year.

Our industry analysts from Bank Credit Analysts, and the top down research provided by Ned Davis Research, is concluding that we are about to come out of the recession in mid-Summer, much earlier than I’d anticipated. I hope they are right. I’d much rather be wrong, and have markets rally, than be right about my more pressimistic forecast.

We still have a long way to go before this year closes out.

The leading economic indicators have risen, three months in a row. It appears that the Chinese stimulus program is working, even if the U.S. package isn’t exactly setting the world on fire. Furthermore, it is possible that U.S. stimulus spending is still coming down the pike, and it is massive. Machinery stocks seem to be benefiting from an increase in global economic activity. Car showrooms aren’t going to remain empty much longer.

Wells Fargo’s chief strategist, Jim Paulsen, remains much more optimistic than most and believes that the low value of the U.S. dollar will lead to a dramatic increase in U.S. exports. Clearly, most industries with business end-markets are holding up better than industries that sell directly to consumers.

I still think we’re just muddling through. I continue to worry about the impact of higher interest rates on future business activity. I still believe that caution is the key word.

In the meantime, we have enjoyed the rebound in commodities and more rational pricing in the high yield bond market. We have emphasized technology companies, and the degree to which tech stocks outperformed most other sectors during the first half of the year has been striking.

I hope I’m wrong. I hope that today’s market trends remain in place for the rest of the year. If so, we’ll end up with a great year. At the end of the day, though, I just don’t think it’s going to be that….easy.

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

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