The Style Box Paradox

Zeno’s dichotomy paradox refers to a philosophical conundrum where someone wishing to get from point A to point B must first move halfway before completing the journey. However, since they always have to complete half the journey first, and the half-journeys can go on ad infinitum, the Greek philosopher was forced to conclude that they would never arrive at the destination but would forever be stuck at various halfway points. It’s a great theory, but it just doesn’t make sense in the real world. People get to their intended destination all the time.

In investing, the theoreticians often study portfolios in the context of investment style boxes. Some portfolios are characterized as small cap value while others are classified as large cap growth. Classifying portfolios in this way is helpful in understanding fund performance looking backward over a discreet time period. However, classifying portfolios by style box classification is not particularly helpful while building portfolios. In the real world, bottom up investors shouldn’t care that much what style box the stock falls in. A more helpful way to classify stocks when constructing the portfolio is by industry and sector. At May-Investments, our portfolio building process has always emphasized sector rather than style box classification. We might look for a consumer stock with good earnings growth prospects that sells for a reasonable valuation, but we really don’t care how the stock is classified by the style box methodology.

A recent Fidelity Investments study explains that, “beyond company-specific factors, sector exposure has been the most influential driver of equity market returns.” While passive indexers mimic their marketing masters who repeat ad nauseam the myth that stock selection doesn’t matter and that a static asset allocation makes up 85% of investor return, in reality the studies showed that asset allocation is so important that it shouldn’t be held static, and that stock picking and sector selection actually matter a lot. While these facts inconvenience the passive indexing crowd, that doesn’t change them.

Style box investing, while great for performance attribution, helps little during the portfolio construction process. It’s a great theory, but it just doesn’t make sense in the real world. The Fidelity study notes that managing sector exposure is key because, “of the distinct risk and performance characteristics of the 10 major sectors.” While a specific stock’s style box attributes fluctuate constantly as ever-changing financial characteristics evolve, companies’ sector and industry attributes remain fairly constant. Moreover, these consistent performance drivers have a wider dispersion between the best and worst performing categories. “Equity sectors tend to have significant performance dispersion relative to each other, which is a key attribute for any alpha-seeking equity allocation strategy,” Fidelity observes. In other words, for investors trying to focus their portfolio on the best performing investments, more can be gained by focusing on sectors where the difference between the best and the worst is significantly wider than is the case with styles.

Another key difference is that different sectors have lower correlations to one another. This makes it easier to diversify risk than can be done using a style box orientation. “During the 2000s, the average correlation of sectors versus one another was 0.52, while the same average correlation among style box benchmarks over the same period was 0.76.” The higher the correlation, the higher the risk that all types of styles will rise and (more importantly) fall at the same time. Fidelity goes on to note that portfolios created with equity sectors “are more efficient – providing higher return and lower risk – than those created using style box components.”

Vanguard Fund founder, John Bogle, has made quite a stir lately criticizing the exchange traded fund industry for creating industry specific ETFs and branding the investors who use them as some form of wild speculator. Bogle, of course, made his fame and living off of passive investing. To his credit, he developed a firm based on low-cost investing strategies. To maintain that his approach is the only legitimate strategy is a bit arrogant, however. The lowest price car in the U.S. is the Nissan Versa S Sedan, priced at $12,780. The car comes with a manual transmission, a less fuel efficient engine, 2 wheel drive, bad ground clearance, a hardtop and very few bells and whistles. Are we all fools for not buying the lowest priced car, as Bogleheads suggest? Or are there other reasons to prefer a different way of viewing the world?

Anyone interested in getting a copy of the Fidelity Investment Insights white paper (Equity Sectors: Essential Building Blocks for Portfolio Construction) can e-mail us and we will be glad to forward a copy of the study.

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

Japan ETF Trade

The Japanese stock market has been on a tear since Prime Minister Shinzo Abe initiated his own version of Quantitative Easing (printing money) which appears to be QE100X (quantitative easing “on steroids”).  Money has to flow somewhere, it seems, and these days the money seems to flow directly into the stock market.  In response to the rapid printing press strategy, the value of the yen promptly and materially declined in value.  Japan’s twenty-year bear market seemed finally to come to an end, and it did (for a few months).

As we mentioned in our Tuesday Noon Classes in April, our strategy calls for moving money toward asset classes that are working.  The strong and seemingly sustained strength in the Japanese market led to our initiating positions at the beginning of May.

The Japanese market kept rallying into mid-May, and then the short-lived rally came to an end.  The Nikkei 225 turned down and never really looked back, entering bear market territory this week.  At the moment, to generalize, we have small losses in our positions and are frankly not in the mood to take a big loss. 

The Japanese market ran up fast in furious in 2013.  The iShares Japanese Index ETF (ticker symbol EWJ) is still up about 11% year-to-date, in spite of the market currently being in “bear” territory.  The Japanese market is another QE-driven asset class with an ETF that is quickly attracting widespread hedge fund interest, somewhat reminiscent of gold in 2011.  The main difference is that gold wasn’t just coming out of a 20-year doldrum when it ramped up.

For the most part, I have viewed the recent sell-off as somewhat appropriate given how fast the Japanese stocks moved up earlier in the year.  Some “consolidation” would actually be a good thing.  Stocks don’t go “straight up,” typically.  Those that do go parabolic usually do so just before crashing back down again.  A little correction would have been welcomed.  At the beginning of the week, it seemed more like a time to add to positions, rather than a time to bail out.

Then came Wednesday night.

On Wednesday night, the Japanese market fell about -6.5%, overnight.  As you can imagine, this created a bit of consternation as I watched the sell-off unfold that night.  Moreover, the yen (currency) was also moving a lot.

When we bought the iShare (EWJ), we chose the exchange traded fund security that demonstrated the best liquidity characteristics.  There are other ETFs available that try to eliminate the impact of currency adjustments by hedging away currency moves.  We weren’t buying EWJ in order to speculate on the yen, one way or the other.  We have, however, seen futures-based ETFs disappoint investors as the constant and costly futures trading result in those securities underperforming our expectations.  We chose EWJ in order to avoid the currency issue, prioritizing liquidity and low expense ratios over currency strategies.

Instead, this week it became clear that one way or another, currency is going to be part of the equation.  To be honest, not understanding the currency impact as well as I should have, when I saw the dollar/yen relationship moving –1.5% on Wednesday night, the pessimist in me pretty much assumed that the currency was moving against us as well.  On Thursday morning, I came in to the office expecting to see EWJ moving down –8% (just days after doubling up on some of those holdings).

So, imagine my surprise when EWJ closed UP over 2% that day.

This caused me to do a couple of things.  First, I jumped for joy.  The security we owned performed 10% better (in a day) than I had expected.  Luck was on my side.

However, it also meant that I really didn’t understand how this ETF was working, not nearly as well as I needed to.  If it meant that I could be 10% lucky on one day, I could just as easily get a 10% disappointment on (literally) the next day.  That was unacceptable.  So the first thing I did was cut our position in half until I could get a better understanding of what was driving the performance of this security.  In theory, it’s really not that tough.  ETFs are usually pretty straightforward instruments.  The Nikkei 225 Index goes up or down, and this ETF should follow.  But at the end of Thursday, I had all sorts of questions.

Why is the Nikkei suddenly so volatile?  Moving –6.5% in a day is not the norm for a healthy market.  How could the U.S. market response to the previous night’s plunge be so different?  EWJ opened up, and just kept getting stronger.  It never reflected the sell-off at all.

There are four fundamental factors that I needed to monitor in order to come up with the answer.  First, the action on the Nikkei stock exchange is the primary influence on returns.  Second, the movement of the currency is significant – more significant than I had originally wanted to believe.  Moreover, in my shock at the –6.5% decline in the market, I had assumed that the currency was also moving against me.  In fact, the yen was increasing in value on Wednesday night, which reduced the dollar-denominated loss to a –5% market move.

Third, ETFs trade at a premium or discount to their net asset value and this, too, was having a bigger impact than I had expected.  ETFs normally trade pretty close to net asset value, by design.  If the computer-generated valuation of the stocks in the index is $10, then the ETF might trade at a discount of $9.98 or a premium of $10.02, but in general discounts and premiums aren’t material.  One of the reasons that we prefer exchange traded funds (ETFs) to closed-end funds, which also trade at discounts and premiums to net asset value, is that market makers can generally keep the gap to a minimum.

On Wednesday night, before the Japanese market opened, EWJ was trading at a pretty hefty 2.5% discount to net asset value.  As a result, the first –2.5% decline in the value of the Nikkei 225 was already “baked in” to the price of EWJ.  Now, instead of having to explain a 5% variance, I’m down to only a 2.5% variance in what happened to EWJ as compared to my expectations.

Finally, at the end of the day on Thursday, EWJ was trading at a 4% PREMIUM to the Nikkei 225.  As the trading day continued, it is quite possible that money was flowing INTO the EWJ exchange traded fund.  As buyers came in to “buy the dip” in the Japanese market, the demand for EWJ shares was so strong that they actually began to trade up versus the security’s intrinsic value (the “net asset value”).  Also, the U.S. market was trading up during Thursday, and certain large Japanese stocks like Honda and Toyota trade on the American exchanges, so the intrinsic value of the Japanese market was moving up even though the Japanese market wasn’t open at the time.

The bottom line is that our positions in EWJ are still slightly below cost.  If EWJ goes down much more, we will cut our losses and sell out.

Second, the volatility the yen is having an enormous impact on the valuation of our EWJ investment.  We really wanted to ignore the currency impact on this investment.  That was naïve.  Just because we don’t want to be currency speculators, and use a security that doesn’t focus on currency hedging, doesn’t mean that we will be able to.  Once again, the political ramifications of easy money policies are creating enormous uncertainty in the markets.  There’s just no way around it, these days.

Third, the market makers aren’t doing a particularly good job of closing the gap between the price of EWJ and its net asset value.  This is a pretty new problem.  Normally, gap issues only impact investors during times of crisis.  In normal trading times, the gap is relatively immaterial.  Right now, that’s not the case.  Hopefully it’s just an unusual time for this particular ETF, rather than a sign of big underlying liquidity issues across all of the international markets.  Still, we’re going to have to treat EWJ almost like a closed-end fund, limiting buying opportunities to times when there is a significant discount, and taking advantage by selling into premiums, as we did on Thursday.

Lastly, I have a sense that the underlying fundamentals in Japan are not what’s driving the market.  The Nikkei was said to dive because U.S. quantitative easing policies are about to “taper” off.  Why would U.S. monetary policy cause a –6.5% mini-crash in Japan?  That doesn’t make much sense.  Unless, of course, what’s driving the Japanese markets higher are U.S.-based investors, using EWJ as the preferred speculative tool.

In watching markets, this week, it did not appear that EWJ (the U.S. trading tool) was following the Japanese market.  It appeared the EWJ was LEADING the Japanese markets.  It seemed, at times, like the entire Japanese market was responding to what EWJ was doing over here.  The tail seemed to be wagging the dog.

If that’s true (and I’m not at all sure that it is), then it would appear to be somewhat like when all of those U.S. investors bought gold ETFs in 2011, which drove the real markets higher as the financial demand for gold overwhelmed the actual supply in the physical markets.  Could it be that financial demand for the Japanese market, through hedge funds buying ETFs, is the source of Japan’s rally?  If the fundamentals in Japan aren’t improving, and the source of the Nikkei rally, then that’s a big deal and makes me much less willing to own shares of EWJ in the portfolio.

In any case, this week’s buy-then-subsequent-sale of EWJ shares is not something that I ever want to do again.  Because the Japanese market mini-crash wasn’t being reflected in the U.S. traded shares of EWJ, mostly because the ETF swung overnight from a 2.5% discount to a 4% premium, we took advantage of the gift and reduced the size of our exposure.

Soon we’ll have to decide if we’re going to completely eliminate it, or not.  If Abenomics works and this finally helps Japan begin to climb out of its twenty year recession, then we’ll get back in and just pay more attention to the yen and the gap between the ETF and its net asset value.

On the other hand, if we decide that the fundamentals in Japan aren’t driving the Japanese market, but rather it’s just U.S. speculators pushing that market around, then I’m not as inclined to stick around.  If trading in U.S. markets determines what the Japanese market does the next day, then something’s wrong.  If Japanese news causes its market to rise and fall, on its own, and then the U.S. ETF simply reflects these changes, then that’s an asset class in which I will consider investing.

Right now, it’s not clear what’s the driving force with this investment.  If trading activity doesn’t start making sense, and I mean soon, then we’ll just exit the rest of our position.

You know what they say about markets and poker.  If you don’t know who the patsy sitting at the table is, then it’s time to fold your cards and go home.

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

ETF Swap in Mutual Fund Accounts

The portfolios recently sold shares in the iShares MSCI EAFE Index fund (EFA), which invests in companies in the Morgan Stanley Capital International Europe, Australasia, and Far East markets.  With the proceeds, we purchased the iShares Dow Jones International Select Dividend fund (IDV).

Swapping from EFA to IDV is a bit more arcane than our normal portfolio move and we wanted to explain the (very simple) rationale behind the switch.

Fidelity Investments has had a small number of exchange traded funds which trade no-commission, much like the no-transaction-fee mutual funds which we typically use.  EFA has been on that list, but very few other ETFs (including IDV) were included as NTF exchange traded funds.

About a month ago, Fidelity inked an agreement with Blackrock, the company that sponsors iShares, to broaden the number of exchange traded funds that trade without commission on the Fidelity platform.  Importantly for us, there were several ETFs which we do normally use to track alternative asset classes that are now included.

We are believers in actively managed mutual funds, but at times the advantages of ETFs are large enough that they make sense instead.  One of the disadvantages, particularly with the international mutual funds, is that we are locked in for a minimum 90-day holding period.  If clients need those funds for any reason, or if the market starts breaking down and we would like to get out, which definitely happened in the 2008 crash, the ETFs have the advantage of less onerous minimum period holding fees.  Instead of charging 2% of principal for selling a mutual fund early, as is the case with our Matthews Tiger Fund (MAPTX), with the ETF selling before 30 days costs us, at most, $17.95 per trade.  If the markets are indeed starting to crash, $17.95 is nothing.

So, as a result of the new deal between Blackrock and Fidelity, the EFA iShare was being removed from the No-Transaction Fee platform (I have no idea why), and IDV is being added to the NTF platform.  We had until April 30 to get out of EFA, commission-free.  I’ve been holding on, trying to determine whether the international fund can hold its position in the portfolio, but thus far it has been doing fairly well and we simply are running out of time to make the swap on a transaction-fee basis.

Small changes in trading fees don’t often trigger portfolio changes, but it did in this case.  Every $17.95 helps. 

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

Market Uptrend Under Pressure

Today the Investors Business Daily changed its market scorecard to “uptrend under pressure.”  IBD has been whipsawed as many times as we have, in recent years, but it still makes sense to pay attention to what the overall market is doing.  Stocks and commodities “go up like an escalator and down like an elevator.”  Trying to avoid a big drop doesn’t make sense, and then doesn’t make sense again, and then doesn’t make sense, until suddenly it’s the only thing that does make sense.  Trying to reduce risk in highly risky markets is at the core of our “Flexible Beta” strategy, so we haven’t stopped paying attention when the markets raise warning flags.

IBD’s scorecard isn’t the only thing that makes us worry about whether 2013 will be as good of a year as we’d been expecting.  A quick study of which asset classes and sectors are doing well, and the most recent update of our May-Investments Leading Economic Indicator, also gives us pause for thought.

Bonds and defensive stocks, especially utilities, often do best during tough times.  Bonds recently took a breather from selling off and yesterday the moving average convergence-divergence (MACD) signal just turned positive.  That’s a concern because bonds are not cheap.  The primary reason for them to do well is if the economy is heading for a downturn.  Ditto for utility stocks.

International stocks also seem to be moving from strength to weakness.  Unemployment in the Eurozone hit a record 12 percent in February.  While rates in Greece and Spain are above 26 percent, the recession is evidenced throughout the continent.  In Greece and Spain, half of the young adults under the age of 25 are unemployed.

Commodity stocks have been hit hard, too.  Gold stocks are selling at prices equivalent to where they sold at the height of the financial panic in the Spring of 2009.  Flows out of gold bullion exchange traded funds are down 20 percent in recent months.  Investor sentiment is extremely negative.  While normally this is a contrarian sell signal, it hasn’t signaled a turnaround thus far.  We don’t think that people have to get excited about gold stocks for them to do much better.  We just need to see an end to the “dumping” of shares.  After all, the last time that gold shares sold at current levels, in 2009, the price of gold was about $900, well below today’s price of $1,550.

At the beginning of each month, we update our Leading Economic Indicator inputs.  Of the ten variables that make up our LEI, about half are updated at the beginning of each month.  When we input the most recent data, it appears that our LEI chart is turning down again.  The pattern looks very similar to 2007-8.  (Note, however, that the market conditions are quite different than in 2007, so my overall level of concern is not the same.) 

Our technology sector indicator, as well as the Institute for Supply Management (ISM) “New Orders” index, both turned negative for the first time in several months.  We’ve been thinking that 2013 would be a year of modest continued growth, but the factors that often point to which direction the economy is headed are beginning to tell a different story.  Unfortunately, the story being told is consistent with weakness that is beginning to develop in the stock market.

May-Investments response to increased risk is to reduce our holdings of stocks owned in exchange traded funds to quickly and cost effectively reduce overall stock exposure.  Because the U.S. market retains its “most favored” status among global investors, most U.S. sector ETFs have yet to hit what we consider to be “sell” signals.  This is a good thing, partly because we are still in sectors that enjoy relatively better performance than the rest.  Our positions in financials, healthcare, and consumer cyclicals are still doing better than average.  If this market trend turns down, however, we don’t expect them to somehow avoid the trend.

Most portfolios still have about 10 percent invested in cash equivalents.  We have said before that we’re not sure if that 10 percent represents our last investment “in” to the market as it recovers, or the first 10 percent to come “out” of the market in the next downturn.  After spending the first quarter of 2013 looking for what to buy with that money, this past week we’ve been forced to turn our attention to the fact that maybe we ought to be looking at what we next need to sell, instead.

We’ve been on an escalator for four years now.  The current bull market is already longer-than-average, if not “long in the tooth.”  Investors need to remember that sometimes markets feel more like an elevator (down) than an escalator (up).  We certainly haven’t forgotten.

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

Bear Market Hits Gold Stocks

After the interest rate bubble pushed bond prices to all-time highs, the Dow Jones Industrial Average has surged into new high territory as well.  In contrast, the stocks of companies that mine gold and other commodities are in the midst of a full-fledged bear market.  More importantly, May-Investment clients own positions in these companies and clients are asking why we aren’t “getting out of the way” of this asset class that really isn’t working, at the moment.

Many May-Investments clients have owned gold and precious metals investments, through mutual funds, exchange traded funds, or individual stock positions since March of 2009.  While positions may have been sold and repurchased in the interim, generally speaking we have been owners of gold for the past four years.  We have even more reasons to own these companies now than we had originally.

In 2009, gold stocks were going up and the government was running the printing presses on overtime, igniting concerns about dollar-devaluation.  Since then, the price of gold has increased, earnings throughout the sector have generally increased, and the psychology has shifted from positive to greedy and now to extremely negative.  From a valuation perspective, too, it is much easier to make the case for gold, today, than it was in 2009 (when just about everything was cheap).  Today, gold is like a relic from 2009; while some other asset classes have doubled off the lows, gold mining stocks languish back at 2009 prices.

One thing that is abundantly clear now, however, that wasn’t as apparent in 2009 was that gold doesn’t respond well to our normal trading rules.  In August of 2009, we sold our position for a modest gain because gold was lagging other parts of the market, which were rallying quite a bit.  Only three months later, gold more than caught up and we bought back in, at a much higher price, at which point gold once again took a breather.  While momentum hasn’t worked all that well, anywhere, in the past couple of years, it has been particularly dangerous to gold investors.

In the summer of 2012, it was clear that our discipline was telling us to sell gold again.  We hung on, and in the third quarter of the year gold soared higher, moving so quickly that gold moved from the bottom performing asset class to the top spot for the quarter, up more than 30 percent in only three months.  As it turned out, rather than a “buy” signal – this would have been a “sell” signal for gold.  Since then, the gold Exchange Traded Fund is down nearly 30 percent.  Had we sold in June and bought back in, in October, we would be much worse off.  Trading gold, using our traditional trading rules, would have been a very costly mistake.

Instead, we are forced to make a longer term decision about keeping gold, or selling it.

One of the original reasons for buying gold miners still applies.  More than ever, the U.S. government continues to print money so aggressively that it is hard to imagine it not resulting in currency devaluation.  Throughout history, many governments have tried to print their way out of a financial crisis, convinced that ownership of a printing press is a license to overspend, but none yet has managed to avoid paying consequences for unrestrained monetary growth.  Moreover, in 2009 it was mainly the U.S. government that was experimenting with this new theory of “Quantitative Easing.”  Now, Europe and Japan have jumped on the easy money bandwagon, too.

After this new bear market in gold stocks, the gold mining companies now sell for about the same price as they did amidst the Great Recession of 2009.  The price of gold, itself, which is the source of revenue for companies that are in the business of converting gold reserves into precious, shiny metal, is actually worth about 70 percent more than it was in 2009.  While no longer selling at its peak, the metal itself is worth significantly more than it was when we first bought into gold mining companies.

Not surprisingly, given the rise in the value of what is stored in the basement of gold mining companies, the companies themselves are far more profitable than they were back in 2009.  Earnings in the sector, generally, have tripled since early 2009, when we first invested in these companies.  In spite of this, their stock prices have done a round trip back to 2009 levels.

Compare this with the stock market, generally, which has appreciated significantly since 2009 and now sells for roughly 15-times corporate earnings power.  Gold miners, however, are currently valued at only about 10.6-times earnings.  Comparing gold companies to the broad stock market, the gold stocks sell at a cheaper valuation and are about as uncorrelated to stocks as anything else out there, making it a good diversifying investment for a growth portfolio.

Another popular asset class is inflation-protected Treasury bonds, which promise to pay investors a certain rate of interest in addition to ratcheting up bond principal to keep up with inflation.  In the long run, gold is also likely to keep pace with inflationary pressures.  However, according to the Baseline gold miners industry index the gold stock sector is comprised of stocks paying an average dividend yield of about 3.5% per year, while 10-year TIPS bond yields are negative (about -0.61% at the most recent Fed auction).

Inflation protection and yield are things that everyone seems to want, unless it comes in the form of a gold miner stock, in which case the current bear market psychology trumps every other investment attribute.

The speculative fever in 2011 popped when the U.S. economy failed to succumb to political gridlock and resumed its growth pattern.  The number of speculators in the gold futures market is down significantly from the excitement that accompanied gold’s spike to $1,900.  The net positions of large futures speculators have been cut by 45 percent, while short interest in the gold futures market have increased as speculators reverse the bullish bets made only 18 months ago.

In the meantime, real demand for gold seems to be holding up.  Ned Davis Research group believes that central bank buying by the People’s Bank of China accounts for a lot of this demand for real gold.  About the same time that China’s central bank stopped investing in U.S. Treasury securities, demand for gold spiked higher.  Their thought is that, “the desire to own physical gold (strong hands) remains solid, in contrast to paper gold (weak hands).”

Essentially, by March of 2012 my gold investment feels as contrarian as my skepticism about tech stocks in 1999, my concern about a real estate bubble in 2006, and my interest in junk bonds at their nadir in 2009.  We’re in the midst of a vicious bear market for gold companies.  And if a bottom can be called based on the degree of pain experienced by “long and wrong” bulls, the bottom has got to be close.

A recent “Seeking Alpha” article expresses a technical case for gold and gold stocks making a technical bottom.  Please be aware that the author’s views do not necessarily represent May-Investments view, but many readers of this blog will find this article of interest.  Furthermore, that author talks about specific investment securities which are typically not owned by May-Investments clients.  We don’t typically like to blog about specific securities, but found the article of interest in how it discusses the possibility that gold is at a bear market nadir.

So is this a great time to add to our existing positions?  That’s the problem with bear markets.  They are particularly vicious in their last days, which makes bottom fishing tough.  The ferocity of this sell-off remind me a little bit of 2008, when one of the first indications of big problems around the corner was a nightmarish sell-off in international stocks and commodities.  It might be that the commodity bear market is just an indicator that it’s a good time to sell, everything else.  Hopefully not.

The recent sell-off also correlates to a short-term boost in the value of the U.S. dollar, particularly versus the yen and the Eurodollar.  Maybe the sell-off in gold just means that the other currencies involved in Quantitative Easing are blowing themselves up?  Whatever the case, the weakness in gold accounts for a great deal of my grumpiness, of late, particularly as other parts of the portfolio surge to new highs. 

At this point, we’ve re-experienced a bear market in gold and gold mining stocks, and to some degree in commodity stocks, generally.  It is important to recognize the grinding pit in the stomach that accompanies a bear market, because often times that is the signal that it’s time to buy.  If so, it’s time to buy the gold mining stocks.  My main regret, of course, is that they are already in the portfolio.  So it seems like a poor time to cut bait and run.

It took less than 6 years for the bear market in U.S. stocks to round-trip back up to 2007 highs.  My guess is that we’ll see new highs in the gold mining stocks long before 2019.  The reason that gold doesn’t trade well is because it is so volatile.  For the past 18 months, we have experienced the downside of volatility.  Looking forward, I think it’s high time we once again enjoyed the upside volatility that gold and other commodities can deliver.

If the stock market is right, and it is signaling continued economic expansion, then we ought to be cycling on into the late stages of economic recovery, which is identifiable by rising interest rates and higher commodity prices.  If so, better times for gold could be right around the corner.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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2013 Outlook: New Normal not too bad

The May-Investments economic forecast for the year ahead is based on a continuation of the 2012 trend toward “normalcy.”  That we’re living in a “new normal” only means that the future will look a bit different than the past, but that’s not “new” and it isn’t necessarily anything about which we should worry.  As market volatility, valuations, and investment spending return to more normal levels, the outcome for stock investors could be quite satisfactory.

The lone “red flag” that is on the horizon is the May-Investments Leading Economic Indicator, which weakened in the fall, and dipped again right at year-end, perhaps in conjunction with the fears surrounding the “fiscal cliff.”  The tax increases, in and of themselves, are not as worrisome as the fears that surrounded the debate.  Investors feared a 40 percent tax on dividends, but it didn’t happen.  People feared an increase in the capital gains tax above 15 percent, but the vast majority of filers will pay the old rate.  Most of the tax increase was limited to “fat cats,” who will see their tax rates jump pretty significantly by the time you factor in the total impact from increased tax rates, capital gains taxes, phasing out of deductions, and additional Obamacare tax burdens.  All told, however, the $60 billion raised isn’t that significant.  In fact, about a week later, roughly that same amount of additional spending was pushed through Congress for Hurricane Sandy relief.

The “new normal” in Washington looks a lot like the spending binge we’ve been on for the last two decades.  In the long run, this spending is an issue.  In the short run, however, the market has little reason to fear contractionary fiscal policy.

It is true that there are some “new” facets to this upcoming “normal,” but it merely represents the ever-present “change” that provides both a hurdle and an opportunity to investors.  While not chosen thematically, companies in the May-Investments core portfolio are well positioned to benefit from many of the same changes about which many conservative Western Colorado voters complain.  Dodd-Frank, which is limiting borrower choice and forcing small lenders out of the market, should lead to market share gains for the mega-lender we recently purchased.  The same natural gas glut that is keeping a lid on local economic growth is a boon for energy companies we own in Pennsylvania and North Dakota.  Solar subsidies and the political push for renewables may be inflating the budget deficit, but they also create opportunities for vendors that sell solar components to major utility companies and for electronics vendors whose components hook these systems up to the grid.

While investors have complained about empty product pipelines at the major pharmaceutical companies, hurt by drug approval processes that take ever longer, our biotech companies are focusing on developing and cashing out on the launch of new products purchased by the big companies for distribution in their marketing system.  While stock guys complain that no one cares about equities anymore, annuity vendors are growing nicely by providing “income for life” solutions for the millions of baby boomers transitioning from the accumulation phase to retirement’s distribution phase of investing.

During the 12 months following the 2011 Economic Forecast, the stock market provided many investors with double digit returns, largely for the reasons that we had anticipated.  Corporate earnings grew a bit, but much of the appreciation came from an increase in the market Price/Earnings multiple from 12.8-times earnings (in January of 2012) to 14.3-times in 2013.  In 2013, it wouldn’t shock us if the P/E ratio continued to improve, on top of another small increase in corporate earnings, which could again provide investors with another nice year of appreciation in equities.  In the meantime, cash equivalents provide little return and bonds could force losses on investors if interest rates rise much.

2012’s 4th Quarter Gross Domestic Product (GDP) growth will be reported in about a week and we believe that our year-ago forecast for 2 percent real GDP growth will be on target.  It is likely that consumer spending will be a little weaker than anticipated – largely due to the year-end spending pause as consumers weighed the impact of the fiscal cliff – but foreign trade and U.S. government spending are both likely to be a little stronger than expected.  For 2013, we are forecasting slow growth, but slightly faster than a year ago.  The 2013 forecast for 2.5% growth in GDP factors in slightly slower consumer spending, resulting from tax increases impacting both very high and very low wage consumers, but offsetting this would be greater business confidence now that the divisive and tumultuous 2012 political campaign is behind us.  Companies have the financial resources to increase their rate of investment and we believe that they will do so as 2013 continues our slow move back toward normalcy.

Of course, “normal” does not mean a problem-free, peaceful, predictable status quo.  Uncertainty, after all, is normal.  For us, we think it means that markets will continue to move beyond crisis mode, price volatility will stay low, asset class correlations will diverge so we move away from the politically driven risk-on/risk-off trading environment of 2008-2012.  In a normal environment, there are both winners and losers and it is no longer just a question of “fully invested” or “in cash.”

Normalcy is a figment of our faulty memory.  Markets climb a wall of worry.  Once things have appreciated, the anxieties experienced on the way up are mostly forgotten.  If we are right and 2013 takes us one step closer to normal, it doesn’t mean that our political problems will be resolved, that our economic concerns will melt away, or that robust global growth is just around the corner.  However, it is an improvement from the dark days of the Great Recession, not too long ago, and we were happy to again be able to provide a positive outlook at our annual forecasting event.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Election Final Results Being Tabulated

The popular vote is in, the Electoral College will confirm the decision, and today it was time for the market to weigh in on the decision.  Gold was up, interest rates, oil prices, and stocks (generally) were down, and I’m still searching for an unbiased and informed observer to help me make sense of what we can expect to see next.  Anyone who is unbiased is almost certainly uninformed, and anyone with a clue is already dug in deep with an entrenched opinion.

So, I am forced to pull myself together and come in from the fiscal cliff in order to sort things out.

First, I don’t think that the President’s re-election was already “priced in” to the market.  I think that the next few days will be about the market re-pricing the long-term outlook for stocks.  The blue investors think that we will be much better off in the short-run.  The red investors think that, as Joe Biden said, “facts matter” and choices have consequences, and that the long-term consequences of fiscal irresponsibility will be negative.  As with so many things about this election, I think that they’re both right.

In the next few days, I think that the long-term costs of living in a banana republic, running up deficits that may exceed $20 trillion before the President’s term is up, will come back to haunt us.  I think that it is possible that Wednesday’s 313-point drop might not be the last down day we see, in the near-term.  Hopefully that won’t happen, but I think that markets do try to price in stocks’ long-run earnings power and that the market’s judgment might be harsh.

On the other hand, I think that the near-term results might lead to a reasonably profitable 2013.

First, the market is already reasonably valued, so any material short-term sell-off should be limited by the fact that stocks will be getting cheap.  Second, one way or the other we will get past the daunting “fiscal cliff” headlines, and the media will be more than happy to pronounce the problem solved and celebrate the President’s achievement.  I think that the President will get pretty much what he wants in negotiations – not because he has a mandate from the voters, but because I believe that he is quite willing to ignore the handcuffs imposed by the debt ceiling altogether.

In years past, President Clinton was willing to consider the option of “just ignoring” the debt ceiling limitations.  The President could just keep cutting checks.  There isn’t a lot of recourse for using Executive Privilege as an excuse to ignore the rules that have bound others to responsible behavior.  In the fall of 2011, President Clinton even went on record recommending that President Obama use this strategy.  With re-election looming, the White House went a different direction.  That time.  Now that President Obama has secured another four years, I think that this president is perfectly willing to make the problem go away simply by ignoring it.

Furthermore, I think that the markets would love it.

The last thing that the markets want is for today’s slow-growth 2% Gross Domestic Product growth to take a 4% haircut, as many analysts predict would happen if we run off the fiscal cliff.  If the President negotiates modest and imaginary spending cuts, or just ignores the debt ceiling completely, I think that the market would sigh in relief and the headlines would treat the President kindly.  Conservatives would throw a fit.  But strict constitutionalists are now just part of the 49%.

In the short run, Obamacare might reduce healthcare costs by paying doctors and vendors less, keeping a lid on inflation in that part of the economy.  With worldwide economic growth contracting, inflation really isn’t a near-term problem.  Ongoing fiscal stimulus will propel some parts of the economy forward, and deficits higher, providing a traditional short-term stimulus to economic activity. 

Third, tax increases are coming.  Obamacare-related increases have been coming down the pike for months.  Businesses are already paying much higher unemployment taxes.  Big government is going to require big taxes, for all.  However, the economic costs of these tax increases may not be immediate, so 2013 might not feel the squeeze.  Those bills will be paid later.

Also, the President’s re-election means that short-term interest rates are here to stay.  The art of Fiscal Repression, mastered by Ben Bernanke in his economic thesis as a way to enrich Tim Geitner’s banking friends at the expense of retirees from coast to coast, is here to stay.  This government can't afford to pay 4% interest rates on $16 trillion in debt.  Financing deficits at 1% interest rates will hopefully keep the whole deck of cards standing upright.  While the costs are hidden from view, the headline risk of "rising interest rates" is gone, at least until the bond market vigilantes say otherwise.

A late-2012 market sell-off might position the market well for a 2013 rally.

The long-run costs could be years out.  That’s the good news.  I’ll defer from listing those negative consequences, which have been filling up e-mail boxes for most of the past 6 months.

As your mailboxes will indicate, as trading confirms are being sent out, you will find that our equity portfolios have been raising cash.  We started selling a few weeks before election day, and we have sold a bit more after the election as well.  These trades were not made in anticipation of the election.  They were made as a result of general market weakness.  As a result of them, for better or worse, we now have a fair amount of cash on the sidelines.  If the market does sell-off in the near-term, we have dry powder available to reinvest at more attractive levels, if we get them.

At present, the May-Investments Leading Economic Indicators have flattened out, after declining from July through September.  If the indicators resume their downtrend, I will be more likely to keep more cash on the sidelines, for longer.  If growth resumes or markets start to recover, we will be glad to take a look at investing in sectors that are acting well.  At present, there are very few sectors whose “uptrend” hasn’t turned down.  One of the few sectors that was acting well – coal stocks – sharply reversed post-election.  We talk about getting out of the way of what’s not working, and right now very little is working well in the stock market, and we have become quite conservative, particularly given that we are still pretty close to market highs as I write this.  If the market really does turn down, these sales will be very well timed.

If the market stabilizes, we will be happy to get back in to enjoy an upward trend.

We have raised a significant chunk of cash, not because of my forecast or view of the election results, but because the market turned around, just a few days before our “all is well” third quarter client letter was dropped in the mailbox.  The problem, I guess, is that “flat markets” really aren’t flat.  They are jagged and dangerous, with small increases matched by quick and ruthless declines.

My “forecast” is for a quick sell-off, which sets the stage for a decent market in 2013.  Rather than structuring the portfolio so it aligns with my opinion, however, we are managing our risk exposure based on the way Mr. Market is treating investors.  In the past weeks, the trends have been turning down.  As a result, we have reduced the amount of risk we are willing to take.

Hopefully this correction, if that’s what we’re having, will – like the election robocalls - be over soon.  While the market weighs in, however, we’ve moved some cash to the sidelines.

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

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Fed To Punish Savers For Three More Years

Last week, after completing a set of grueling meetings in Jackson Hole, the honchos at the Federal Reserve announced to the market a new round of money printing and extended its policy of denying savers a fair return on their savings.  They worded the announcement slightly differently, but that’s the gist of things.  Faced with deteriorating economic statistics, the Fed decided to continue its current policy of “financial repression” at least until mid-2015.

Critics of this latest round of Quantitative Easing (QE3) accuse the Fed of bowing to political pressure from the White House in advance of the upcoming election in pursuit of policies that debase the dollar and have not helped reduce unemployment or restimulate business investment.  Contrasting current policies with the polar opposite policies successfully implemented by Paul Volcker in 1979,  Obama critic Larry Kudlow wrote, “It’s like history is repeating itself, but in reverse.”

I do believe that the QE3 announcement is confirmation to what the May-Investments Leading Indicators Index is showing; economic fundamentals are deteriorating rapidly and the Fed is worried.  While the critics charge that QE3 will be no more successful than the first two attempts, I believe the evidence on Quantitative Easing is unclear.  While it is clear that interest rates can’t go any lower, so the normal Fed tools aren’t working, it’s hard to know where we would be absent this digital printing press, which is working overtime.  It is entirely possible that absent “Helicopter Ben’s” herculean efforts to spread money we don’t have to random companies throughout the financial sector, we might already be in a Depression.

One reason that Bernanke is doing just the opposite of Volcker is that the 1979 Fed was fighting rising and persistent inflation.  Today’s Fed is petrified of deflation, inflation’s polar opposite.  No wonder it is using a different set of tools.  Rather than blaming the White House, it is fair to say that there is real uncertainty, and honest differences of opinion, about the efficacy of current Fed policies.
 
The real problem is that something other than low interest rates is holding back confidence and business investment.  Indeed, the current policy of keeping interest rates unrealistically low, which boosts bank profitability at the expense of retirees, just forces the elderly, foundations, and other savers to take more risk than they’d like with their nest eggs.  This policy of “financial repression” punishes retirees who had hoped to live off of their savings when they are too old to work.  It is a cold-hearted subsidy of U.S. government borrowing that is forcing people to put off retirement, take more risk than is appropriate, cut back on day-to-day spending, and forces more dependence on Social Insurance programs.  Is it any wonder that confidence is waning?

Most readers don’t spend a lot of time thinking about U.S. government fiscal and monetary policy.  These subjects seem like dry, “intellectual” pursuits with little bearing on daily concerns.  For May-Investments, however, these political economic policies, known in economics jargon as “macroeconomics,” have clear consequences and we see the impact on our friends and neighbors on a regular basis. 

Households forced to choose between lowering their standard of living because their bank savings no longer pay a decent return, or taking on additional risk, are moving out the risk spectrum into securities that have hard to interpret risk associated with them.  When these investments decline in value, as they almost certainly will, scared investors will lock in losses as the frightened herd heads for the door.  While millions blame “the banks” for today’s ills, in reality it is government policies, bureaucrats at the Treasury, and economists at the Federal Reserve who are largely responsible.  True, bankers are the beneficiaries – but it is current macroeconomic policy which is largely to blame.  When we look at this economy and try to assess what “excesses” might lead to a new recession, the clear and obvious candidate is the bond market, which has been pumped up by Federal Reserve policies that have inflated the value of income paying securities.

Markets are a mess, and it is the hyper-regulated banking sector that is mostly to blame.

The politicians in Washington D.C. are focused on arguing about social issues and tiny steps that don’t begin to solve the country’s economic problems.  “Nero fiddles while Rome burns.”  The Fed’s policies of financial repression are doing more harm than good.  QE3 is, at best, a narcotic designed to get us through the next few months.  No matter what your party affiliation, May-Investments urges readers to make your vote count, pay special attention to voting for candidates whose top priority is getting the economy working again, and remember that “all ties go to the challenger.”  Both parties are guilty.  Incumbents really aren’t going to turn the ship around.  If we want a better future, we have to do things differently.  If we want this brain damage to stop, we need to stop letting the folks in power beat our heads against the wall.  If we don’t want the punishment that the Fed has laid out for us, then rather than continue to mask the symptoms, we need to take whatever macroeconomic medicine will lead to a cure.

Vote early.  Vote often.  Make it count.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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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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Market Climbs 1Q Wall of Worry

In spite of an abundance of investor concerns, the first quarter of 2012 was very kind to investors. The S&P 500 index rose +12.6% during the first quarter, with the financial and tech sectors leading the way (up more than 20% each). We think the rally can continue through the year as long as economic fundamentals don’t collapse, and at this point the leading indicators forecast continued strength ahead.

Many investors have come to loathe the stock market. This dissatisfaction is primarily a result of the collapse in stock prices between the tech bubble, in March of 2000, and the bottom of the financial panic, in 2009. For the past three years, the Vanguard 500 Index (VFINX) has risen 23.8% per year. At the end of March, annualized 10-year VFINX returns are +4.02%, and 15-year returns are +5.86% per year. While the long-term returns haven’t met common financial planning forecasts of 10% annually for equity returns, they don’t seem to justify the current antipathy toward stocks, either.

We believe that the “lost decade” in stocks is primarily a result of the bubble valuations of 2000. More than the uncertainties in Europe, more than the 2006 real estate bubble and subsequent financial panic, and even more than the fiscal ineptitude by our politicians in Washington, the current investor dissatisfaction results from irrational exuberance 12 years ago.

Back in 2000, the market sold at roughly 30-times earnings. $1 of earnings, selling for $30, represents a 3.3% return on investment. Helping investors is the fact that corporate earnings tend to adjust for inflation, over time. Corporate earnings have generally doubled since 2000. Hurting stocks, however, has been the subsequent P/E Ratio adjustment, from a nosebleed 30-times earnings to a much more rational 14-times earnings, currently. With corporate earnings at roughly $2, and a 14 multiple, that would put the current value at about $28.

Thus, roughly, since 2000 companies lost $5 in valuation but earned about $15 from operations, for a total return of $10 on a $30 investment (or approximately 3.3% per year).

Investor returns, then, are comprised of one part Return-On-Investment, one part Inflation-Adjustment, and one part P/E Ratio adjustment. Moreover, a simplistic forecast of a 3.3% return to stock investors made in 2000, based simply on the earnings yield of a market selling at a 30X multiple, would have proven to be fairly prescient.

A simplistic forecast for equity returns, based on today’s 14X multiple, would be that stocks can return 7% annually over the next decade.

Based on the three-part variable analysis, and assuming that today’s 14X multiple stays constant, a forecast of 7% inflation-adjusted return seems reasonable. If inflation decreases purchasing power by 3% per year, it suggests a total return to stock investors of 7% + 3%, or a nominal 10% rate of return. In a world where 30-year government bonds yield a nominal return of only 3.33% (i.e. unadjusted for inflation), it is easy to see why money may still flow toward equities, even after the first quarter market rally.

During the past decade, the stock market didn’t return a nice, steady 4 percent per year, of course. It was a gut wrenching ride with two full-on bear markets through which investors suffered. Going forward, I would expect that volatility to continue. But, who knows? More importantly, investors need to note that cash offers virtually no return and bonds offer little return and material price risk. Stocks, by comparison, offer reasonable profit potential in spite of the probability of a rough ride at certain points in the cycle.

There are a number of specific risks that I believe investors should take very seriously. Profit margins are close to all-time highs. There is a risk to corporate profits from shrinking margins. Eventually the Federal Reserve will choose to, or be forced to, allow interest rates to rise to natural market levels. When this happens, savers who have been forced to invest in stocks because of the paltry rates available on bonds will likely pull their money back into fixed income instruments. This would likely, at least temporarily, hurt stocks. In the long run, however, these factors will likely just depress stocks for a short while.

In the long run, I haven’t heard many sound arguments as to why stocks cannot provide long-term returns that exceed the returns available to savers and bond investors. Investors need to be prepared for a rough ride in order to achieve these returns, however.

In the short run, I believe that the market can continue to climb the wall of worry. In fact, today’s fear and pessimism is perhaps the most comforting factor of all.

In the medium-term, I expect more rough sledding ahead. When interest rates rise to the point where money starts flowing out of stocks and back into bonds – i.e. when interest rates rise from confiscatory levels and the Fed abandons its current policy of financial repression – the stock markets may experience a pretty sharp drop. Although we will certainly try to position portfolios appropriately, timing markets is a difficult endeavor.

In the long-run, I agree with Jeremy Grantham and other prognosticators who note that while stock markets may not turn in record-setting long-run rates of return, stock investors will likely fair better than bond investors and savers in the years to come, especially when measuring returns after inflation.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Asset Allocation Folklore Revisited

When people thought the sun revolved around the world (geocentrism), the quality of navigational advice was sketchy at best, and might have been downright dangerous at times. For the past twenty years, the quality of investing advice has been tainted by the idea that the one-time selection of investors’ stock/bond portfolio mix accounts for 93.6 percent of the ultimate portfolio return. The idea that investors should try to “time the market” is considered heresy. This flawed perspective has been perpetuated by the marketing department of financial behemoths, widely read financial periodicals, and (more than likely) your broker, regardless of his or her employer. Unfortunately, this common asset allocation myth is causing investors to make bad decisions regarding their financial future and threatening the financial house of investors across the globe.

Wall Street has taught most financial advisors that it is a waste of time to manage their degree of exposure to risky assets. Finally, however, in his February 2010 Financial Analysts Journal article, asset allocation guru Roger Ibbotson observes that “the idea that “asset allocation policy” explains more than 90 percent of performance has become accepted folklore... The time has come for folklore to be replaced with reality. Asset allocation is very important, but nowhere near 90 percent” as claimed by traditional industry thinking.

Indeed, asset allocation is extremely important – but the famous Brinson, Hood and Beehower article, “Determinants of Portfolio Performance” published in 1986, never concluded that a static policy is therefore best.

But as a result of the traditional interpretation of that 1986 study, nearly all financial advisors place clients in a static (never changing) mix of stocks, bonds and/or cash. In nearly every market environment, and in all economic conditions, investor allocations to the magical mix stay constant. As a result, clients pay advisors significant fees but get no real advice in return about when to increase or decrease exposure to stocks, the asset class most likely to cause investors to lose money. In addition, clients underutilize stocks because many are unwilling to accept so much portfolio volatility through good times and bad.

Upside volatility is great, but downside volatility is what investors remember. In fact, the entire industry gets accused of doing nothing for their money, when part of what financial advisors deliver is general financial planning advice, but advisors price it in the value-added clothing of a true investment manager. Consequently, consumers neither seek nor get either financial planning advice (which they probably need) or investment allocation advice (which they want, but can’t find an advisor willing to provide this guidance).

Many advisors have replaced actively managed portfolios with an indexing approach, but indexing leaves clients vulnerable to market volatility because they are forced to “buy and hold” through all types of markets. Investors who cut back on equities may have to reduce return expectations and, therefore, their standard of living in retirement, and reducing equity exposure leaves investors more vulnerable to inflation at a time when inflation is creeping higher and shadow inflation statistics suggest that the real level of inflation is much worse than is officially reported.

May-Investments solution is to allow “Beta” (the fancy statistical name for portfolio volatility) to vary so that in high risk markets, clients aren’t completely exposed to a huge market decline. If “asset allocation policy” is the most important determinant of portfolio return (and it is), then a flexible Beta approach allows a portfolio’s allocation to stocks, bonds or cash to vary according to the current economic environment and market opportunity set investors face.

A flexible approach allows risk to be reduced during the most dangerous times. In addition, cash can be set aside so that it is available to repurchase stocks when either risk is reduced, or stock prices become more attractive. By timing markets (imperfectly, but as well as we can), we can transform volatility from merely being a statistical proxy for market risk into the generator of opportunity for future returns. Buy low, sell high. Isn’t that the idea?

Galileo was considered a heretic for supporting heliocentrism, and most traditionalists in the financial services industry view our approach with equal disdain. Galileo spent the last nine years of his life living under house arrest, condemned by Pope Urban VIII’s inquisition of being “vehemently suspect of heresy.” There is no substantiation to the rumor that he recanted at his trial by muttering the rebellious phrase, ‘I could agree with you – but then we would both be wrong.’
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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MPT Is Still Just A Theory

Most investors are basing their investment strategy on an oversimplified theory of investing that is better suited to writing dissertations than it is to managing an investment portfolio.

The tools most advisors use to build portfolios are based on Modern Portfolio Theory (MPT), which is the idea of creating a portfolio that balances risk and return using a computer-generated distribution of holdings designed to maximize return achieved per amount of risk taken. MPT works in theory, only because of the unrealistic assumptions made in constructing the theory.

MPT assumes that the future unfolds in a random fashion. In reality, future returns are much more likely to fall – from high valuation levels and when economic fundamentals weaken – and rise when the opposite is true. In statistical jargon, the distribution of returns are not in a normal bell-shaped curve. Returns are skewed by price levels and economic fundamentals. As a result of MPT, most investors keep the same (static) portfolio construction through good times and bad, rather than ramping up risk and return during the good times, and taking less risk when the outlook is less favorable. Taking the same amount of risk, in both good times and bad, reduces optimal return during good times and produces more painful losses in down markets. Ideally, portfolio Beta (the sensitivity to market risk) should be flexible, depending on where you are in the market and economic cycles.

MPT also assumes that probabilities don’t change and that investors don’t make mistakes. While not all investors admit their mistakes, or learn from them, all experienced investors have made them. MPT assumes that everyone has good data, can reasonably calculate the probability of future events, in a rational and error-free decision process. These assumptions pretty much rule out anyone and everyone who has experience investing in the market.

Finally, MPT is typically a backward-looking method. In theory, it should look forward. In practice, however, it uses historical returns as an input. So even in a world where long-term bonds pay only about 2.2 percent and are likely to decline in price in the future, your advisor’s computer will likely estimate a 5 percent return on bonds looking into the future. The entire investment industry, it seems, is dependent on a classic garbage-in/garbage-out process for constructing portfolios.

To do a better job, computers need accurate future return numbers as input, but crystal balls are in short supply. At the very least, “efficient frontier” simulations should be based on forward-looking estimates, but I know of no brokerage or advisory firms that are prepared to take on the liability of customizing those inputs.

May-Investments solution is to admit mistakes, adjust portfolio risk based on the current market environment and economic fundamentals, and to try to stay in the way of what’s working in the market – and get out of the way of what isn’t, allowing current market action and industry-specific economic fundamentals (rather than a computer simulation) to drive our portfolio construction process.

By proactively managing portfolio risk throughout the market cycle, we hope to be able to take the most risk only when risk-taking is being rewarded, and more effectively preserve wealth when markets turn down.

Plasma ray guns are great weapons, in theory. Hollywood used them in Star Wars, The Terminator, StarTrek and dozens of lesser known works of fiction. Like MPT, plasma guns are theoretically possible. In reality, however, plasma torches which have existed for some years can project plasma streams only about a foot. If an intruder breaks into your home, common sense says that an old-fashioned colt revolver would be a better choice.

The markets turned ugly in August. Are you still relying on Modern Portfolio Theory to protect your financial house?
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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The Will Rogers Portfolio Maneuver

Will Rogers once counseled investors to “only buy stocks that go up.” About stocks that go down, he replied famously, “don’t buy them!” While his counsel frustrates portfolio managers because it creates an impossible performance benchmark by applying a standard of 20/20 hindsight to a world fraught with uncertainty, it is an important remark to consider if the market cycle is ready to roll over and start going in a generally downward direction.

The market is always moving, but it doesn’t only move “up” and “down.” It also changes in character – the type of stocks with the biggest moves up or down varies through the course of the market cycle – on a weekly, daily, and even intra-day basis. We do our best to monitor these changes and, ideally, stay in the way of what’s working and get out of the way of what isn’t working.

At the moment, international investing isn’t working. The U.S. stocks have been dominating the performance derby for the past few months. At the beginning of the year, perhaps coincident with the Arab Spring events, commodities rocketed higher and dominated the market’s move higher. Most recently, however, defensive stocks have been moving into the spotlight.

Many of the sectors that are doing better than average are considered “defensive” sectors. Consumer staples (soft drinks, personal care products, drug stores) have started doing better than average. Healthcare stocks, like the pharmaceutical and biotech companies in which we’re invested, are moving up near the top of the performance derby. Utility stocks, which were on the verge of getting kicked out of the portfolio a couple of months ago, are now back “above water” (doing better than the market over the past six months).

One problem that I have, personally, in trying to “hide out” in defensive stocks is that when they are doing best, often you would have been better being out of the market altogether. If you try to hide out in stocks that are going down less than the market, then you have good “relative performance,” which means that when the stock market turns in dismal performance, the good news is that the amount of money that you lose isn’t quite as bad – but losing money is always bad! The last time we bought consumer staples was in 2008. While the sector gave us good “relative performance,” we would have much rather just owned cash.

Good “absolute” performance means that your money wouldn’t have gone down at all. The problem that I have in hiding out in defensive sectors is that, often, you would have been better not being invested in stocks at all during those periods. If you knew that stocks were selling off, then rather than tweak the portfolio by owning defensive stocks, you would cash out of stocks altogether. Then, again, there’s that Will Rogers 20/20 hindsight problem. Without a crystal ball, sometimes it will make sense to stay on the sidelines, and at other times buying consumer staples truly does represent an opportunity to make more money than the broad market.

In any case, signs that defensive stocks are doing relatively better is a red flag that concerns us. In spite of a few economic variables that concern me – including a slight inventory build and unemployment starting to get slightly worse – our Leading Indicators remain stable. But problems in Europe seem to be serious, getting worse, and potentially as devastating as the sub-prime problems. Greek two-year bonds yield 25%. The market is clearly expecting a default in Greece, and worries about Spain are increasing as the dominos overseas weary of leaning against one another in order to support the fiscal irresponsibility of the European Union’s weaker and most profligate members.

There’s also our own government deficit in the U.S., and the unwillingness of either party to risk offending their political base in order to solve the problem. If a “Mediscare” can be used to win elections, then “truth” and problem-solving will be sacrificed to the greater God of partisan politics, until we experience Greece-like interest rates in this country.

Many client portfolios recently sold off gold, in spite of our long-term concerns about inflation and the dollar. Similarly, this week we further reduced our commodity position, which was starting to lag and really acted as a drag on portfolio performance during three successive sell-offs over the past two months. The main reason, I think, for commodities to decline is that the U.S. economy may be joining other global economies in a slowdown. In the long-run, the dollar may decline and inflationary pressures may continue, but if the U.S. economy goes back into recession, industrial demand for commodities will slow and commodity prices, likely, will fall.

If a slowdown is indeed what is being priced into the market, apparently it’s too early for it to show up in our Leading Economic Indicator. Though the LEI could be turning down, it hasn’t yet. However, the sell-off in commodities has been serious enough for us to sell out of some of our commodity investments and for now the proceeds of the sales remain in cash.

We’re taking reinvestment on a day-by-day basis. There are some new asset classes and industry choices that are beginning to show up as “buyable.” Most of the new alternatives are these “defensive” sectors. If they are just going to fall at a slower pace than the rest of the market, then perhaps we would be better off holding cash.

Hopefully the pause will be temporary and the economy can work through this. However, I still believe that the potential upside, from this level, is not as large as the potential downside should Europe implode. These problems in Europe, which caused us to get defensive a year ago, were never really resolved. Things are worse now. It is somewhat reminiscent of the sub-prime problems which were pooh-poohed by the incompetent bank managers that created them, and when the Fed started cutting rates in 2007 the strategists said that the issues were resolved. In fact, they weren’t, and a year later the bank panic unfolded with the bankruptcy of Lehman Brothers.

A year ago, the international bankers told us that they had bailed out Greece, and the problem would not spread beyond that country. They also implied that if problems did spread, they would be solved, just like the Greek bailout solved Greece’s problem. A year later, we know for a fact that the problems did spread and the the Greek problem wasn’t solved. The problem is growing and spreading and threatening Europe’s largest banks. Will Rogers also observed that, “If you ever injected truth into politics you’d have no politics.” So true.  Like the old saw - how do you know that a politician is lying?  Answer: his mouth is open.

Europe might well experience 2008 redux. It won’t be centered in the U.S., this time, but it would be silly to think that the U.S. would be immune to a bank panic on the other side of the pond. Since we never fixed our own “too big to fail” problem, a crisis will likely bring another round of misguided and costly political response. The risks are large enough to justify selling off a portion of our beloved commodities position, if only for a little while.
 
For the past year, we’ve been asking our “red money” clients to re-affirm that the long-term appreciation portfolios are truly invested with a long-term investment horizon. I don’t know if we’re going to have another big dip or not, but it’s always a good time to be certain that your long-term portfolios have only long-term money invested in them. 
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

Go to Investments main page.