July 2013 Portfolio Summary

As the summer rolls on and the market continues up, the May-Investments portfolios sit pretty fully invested and well positioned, we believe, for the current market environment.

Generally speaking, the mutual fund portfolio has nine fully invested positions and a tenth position in gold, which is only a partial position but the remaining cash in the portfolio is tentatively scheduled to increase our investment in the precious metals asset class.  We’re just waiting for it to stop falling before we double up.  It has been a long wait.

Eight out of ten positions are in U.S. stocks.  The U.S. market is much stronger than most international markets and alternative investments, so we are less diversified than we would be were that not the case.  We are over-weighted in financials (banks and brokerages), healthcare (biotech as well as a more broadly diversified fund), and consumer cyclicals (automotive and a more diversified consumer discretionary fund).  We are under-weight technology (but do have a position in software).  Our position in Japan is back up to a full weighting.

In the Custom Wealth Management portfolios, the core equity portfolio is fully invested again after a management buyout at Zhongpin, a Chinese pork producer, forced the sale of one stock and opened up room for a couple new positions.  The “flexible middle” part of the portfolio is fully invested, home to exchange traded funds in the financials, healthcare, and consumer cyclicals sectors, as well as an automotive industry sector mutual fund.  In the diversification part of the portfolio, we have Japan and a partial position in gold.  We also own the S&P MidCap 400 Value Index position, which isn’t much of a diversifier, but reflects the fact that few markets are keeping up with the U.S. market.  Why diversify when the best performing market seems to be our own?  Generally speaking, the remaining cash is set aside for us to allocate back into precious metals at some point in the future.

It looks like the economy may continue with its slow growth on into the latter part of 2013.  For the past three months, the May-Investments Leading Economic Indicators have posted modest increases, reversing a three-month decline during the first quarter of the year.  The fear of sequestration during the first quarter turned out to be worse than the reality of sequestration thereafter.

There is modest strength in retail sales, global shipping, corporate profits and manufacturing new orders.  Weakness is apparent in the outlook by small business owners, drilling activity, and capacity utilization, and the rate of growth in commercial & industrial loans and the money supply (M2) is declining. 

Overall, the LEI isn’t projecting robust growth, but at least there is a slight upward trend. The indicators are supposed to help us look forward about six months, so hopefully our January forecast for continued economic growth throughout the year will remain on target through the rest of 2013.

If so, I would expect markets to cooperate as well.  As money begins to dribble in off of the sidelines, valuations (Price/Earnings ratios) are adjusting up.  Corporate profits have increased slightly, but as P/E ratios increase the value of stocks goes higher and the strong performance of stocks is attracting the attention of investors who are getting paid almost zero, nada, zilch to have their life savings invested in banks.  Today’s low interest rates continue to enable huge deficits by the government at the expense of consumer spending, particularly by seniors.  It probably isn’t a good thing that “savings” are being moved into “investment” accounts, but it’s happening every day and it’s one reason why the market keeps rising even as the pace of economic growth simmers down.

The biggest market risk remains…the political mess in Washington D.C.  While we got past the debt cliff and have even moved past the onset of sequestration with minimal fanfare, the budget wars are far from over and it’s never too late for the folks in Washington to step in and make matters worse.  It seems to be what they do best. 

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

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.

A Question For Secretary Lew

I’ve met two U.S. Treasury Secretaries in my lifetime.  Technically, when the Stanford Committee On Political Education dined with G. William Miller, he was a former Secretary.  He was relatively disgraced at the time, so the campus speaker bureau paid a lower fee than we would have paid for Paul Volcker, his successor.  Volcker later became a national hero for having the courage to raise interest rates until the inflation beast was tamed.  Often times, doing the right thing requires a thorough understanding of what ails us, in order to do the unpopular, but ultimately necessary, thing.

Last week, I had my 45 seconds of fame with Jack Lew, the current Secretary of the Treasury Department during the Colorado Capital Conference. 

I would have enjoyed having more time - enough time to have an extended discussion, but that wasn’t in the cards.  I decided, instead, to ask a question that sends a message, just in case the administration official with the most direct influence on my financial well being was in a mood to listen.

After noting that in 2009, bank examiners came into our neck of the woods and forced local banks to cut back their real estate loan books, forcing them to call in loans (even ones that were current) at the worst possible time – and making things worse than they needed to be – and then after noting that even now the mortgage markets remain much tighter than necessary, with even millionaire clients having difficulty getting loans that ought to be a lay-up, I told Secretary Lew that I did not blame him.  After all, he was just newly appointed to the position.

Prior to that, he’d been doing a bang-up job for the administration on debt reduction, as he is the author of sequestration.  Before that, he was a Chief Financial Officer at Citigroup, joining the firm just as the real estate bubble was getting going, shepherding that failed organization into the financial crisis and collecting multiple million-dollar bonuses funded by taxpayers as it unfolded, before finally jumping back to the mother ship to re-join the newly elected Democratic administration. 

Now this man who helped sink the ship at Citigroup is in charge of defending Americans against a Federal Reserve hell bent on impoverishing the elderly with 0 percent Certificate of Deposit rates in order to bail out a banking sector so flush with cash that it can’t think of anything to do with the money, other than return to the days of multi-million dollar bonuses for its hard working executive staff.  Is he up to the job?  Is he even trying to fix the problems in the banking sector?  Is he even vaguely aware that the problems exist?

Which is why I asked him if he was aware of the fact that the Treasury Department, itself, is part of the problem.  If he’s not aware of this, then he probably isn’t working too hard to find a solution, was my thinking.

Others heard his response, which was long-winded and in which he noted that we don’t want to return to the days of “no-income check and low-doc loans.”  I would agree with him on this point, which was (alas) irrelevant to the question that I asked.  He also pointed out that evidence of problems in 2009 is not important to today, however the mortgage loan example that I gave him happened only a month ago.

I didn’t want to be one of those people who demand 120 seconds of fame by asking a 3-minute question, so I left out a few other examples of why I believe that the Treasury Department, itself, is part of the problem.

For example, I’ve been told that banks which used to specialize in farm and ranch lending are now no longer allowed to have an above-average concentration in…farm and ranch loans.  Every institution must conform to the average, which is itself constantly declining because there is no longer any incentive to be particularly good at a certain type of lending.

These days, clerks at Fannie Mae and computers programmed to reflect the new bank Examiner requirements are making lending decisions, easily automating tough decisions that once required experienced credit analysts to decide.

Nor did I question the current regulatory imperative to consolidate the banking industry, forcing small community banks to merge into the fold of growing regional giants.  This, they think, will ease the burden on regulators.  However, it wasn’t the community banks that were the root cause of the sub-prime crisis.  Ground zero for those problems were the financial industry giants who packaged up toxic loans in order to sell them through their investment banking subsidiaries.  You know;  companies like, well, Citigroup.

The Treasury should be pushing back against the Federal Reserve.  The Fed’s charter is to protect the banking system.  The bankers in the system are doing quite well, frankly.  Wells Fargo’s CEO, on the backs of government subsidies and benefitting from Dodd-Frank regulations that have left it with nearly 100 percent market share of the local mortgage business, was paid $19.8 million in 2012.  Now, I happen to believe that Wells Fargo is one of the most profitable and rational of the big money center banks, but if they’re paying Stumpf $20 million bucks a year, I maintain that they are not in need of their free money subsidy.  Savers, most of whom are retirees and many of whom are low income elderly, are the folks in need of an advocate.

Logically, that advocate should be the Treasury Department, rather than the Fed.  The Treasury Secretary is the President’s key advisor on the people’s financial plight.  He’s supposed to be on our side, right?

But, to fix a problem requires a certain amount of insight.  Enough, for example, to realize that a problem exists.

I asked Lew a “yes” or “no” question.  Is there an awareness at Treasury that they are part of the problem?  The Treasury Secretary’s long-winded statement should probably be interpreted as a “no” answer.  I sure didn’t hear a “yes” hiding in there anywhere.  Really, is it that hard in Washington to admit that the government is not perfect?  In any case, I was discouraged by his response.  I see no signs that the leadership at Treasury is going to do anything to fix the problems that he refuses to acknowledge.

Volcker had the knowledge to understand what it would take to whip inflation, the courage to take unpopular measures in the interest of restoring long-term health, and the integrity to do what was best for the people of America, even when they didn’t like him (or the Administration) for doing it.  Jack Lew, I’m afraid, is a political hack who neither understands the problem nor has the integrity to acknowledge there even is a problem.  His crowning achievement up until now, sequestration, is both foolish and cowardly, and designed to fail by relying on formulas instead of accepting responsibility for making responsible budget cuts.

He is unlikely to understand what ails us or take the unpopular but necessary actions required to make things better. 

Fortunately, worldwide, the resilience of America’s economy is still the envy of the world.  But someone in Treasury needs to start working on these problems.  As someone once said, what good does it do if we’re still nothing more than the best looking horse in the glue factory?

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

2013 Colorado Capital Conference

I just returned from the Colorado Capital Conference, hosted by Colorado Mesa University, the University of Colorado, and Senator Mark Udall’s office.  Hopefully the conference organizers will post Congressman Tipton’s opening remarks, or even the session where Treasury Secretary Jack Lew dropped in for a quick visit.

There were several points where the legislators emphasized how well both parties work together to help Colorado, and how we need to work together to begin making progress on unemployment, the deficit, and other problems.  Senator Udall reiterated his support for a Simpson-Bowles type of compromise, as well as his support for a balanced budget amendment.  The Budget Hero exercise we discussed demonstrated just how hard it will be find a solution.  While meeting within our diverse groups, the face-to-face time led to a more civilized conversation, but it is also much more difficult to slash and burn programs when personally faced with an advocate for that issue in the group.

At the end of the conference, it was hard to understand how our legislators are having as much difficulty as they are.  The people I met were hard working, smart, open to other ideas – even from the other party.  Still, we asked them tough questions about the irrational formulaic budget cutting method we’ve adopted (sequestration), trillion dollar deficits, cumbersome and nonsensical education regulations and tax rules, and an arrogant bureaucracy that wants to dictate how many days a week the local school cafeteria can serve potatoes. (More than one day?  It literally took an act of Congress to get them to change.)

Should we blame Congressional leadership?  The Administration?  Is it the fault of Congressional gerrymandering?  Would redistricting or more open primaries help?

It was a fascinating opportunity to meet some of the problem solvers and public servants who are working together to solve some of these problems.  I came away with more of an appreciation for our representatives in Washington.  However, I am even more convinced that government has over-reached and is crazy out of control.  When even good people can’t make the bureaucracy listen, what hope to mere citizens have?  Because even the lawyers acknowledge that the laws are strangling the teachers and businesses and doctors trying to help people, there is hope that something might be done to change the status quo.  I do hope they’ll try more, smaller solutions and fewer 2,000-page legislative opuses (like Dodd-Frank).

Personally, meeting the lawmakers helped me come to terms with our blue state status.  While I may not have personally supported a number of the folks whom I met at the conference, these are sharp, experienced people, with Colorado-moderate tendencies, and worthy of support for the hard work that is ahead of them.  I wish them luck, but at election time we should hold them accountable, too.  While the problems are dire, I think that we’ve put capable people in charge.  I wish them the best and am far more optimistic about the future than I was before making the trek to the Capital.

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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Dow Hits New Record High

Today’s media is focused on the new high set by the Dow Jones Industrial Average index yesterday, and apparently an even higher and newer high, today.  While I’m generally happy that the markets have been strong, as we anticipated in our January economic forecast, the fact that we’ve hit a new high neither makes me excited, nor anxious.  I’m in the camp that “it’s just a number” and, despite the hubbub, a pretty meaningless number at that.

Still, it's certainly not bad news that we finally recovered back to the 2007 market high.  In fact, it didn't take all that long, historically speaking.  Ned Davis calculated that it took 5.4 years for the market to make its roundtrip after its 54% 2007-2009 decline.  In the two previous crashes (declines of 40% or more), it took 9.8 years to bounce back after the 1974 bear market, and 25 years to recover after an 88% plunge during the Great Depression.

Setting a new high doesn’t make the market attractive, nor expensive.  Granted, I’d rather have the market move up than down, but the fact that it is now at a “new high” doesn’t necessarily make it expensive, nor does it indicate anything about the market’s future prospects.  Think about it.  Bank savings accounts make “new highs” every day.  Their principal doesn’t go down, and each day they earn a tiny fraction of a percentage in interest, which is added to yesterday’s total, so that each day the savings account makes a new personal best.  But this steady progression upward doesn’t make it an attractive investment because the alternatives to savings accounts are (generally) doing so much better.  What makes a savings account attractive, or not, is its rate of return (i.e. its income-generating power).

With stocks, what makes a market attractive is its income-generating power and its valuation related to its future earnings potential.  In the case of stocks, the Dow Jones Industrial Average currently trades at only 13.5-times earnings.  For most of the past 20 years, this group of stocks has traded at more than 15.5-times earnings.  Based on current projected earnings, if the Dow just gets back to that average multiple of 15.5X and current earnings forecasts are met, the index could rise to nearly 18,000 in the next few years.  That cheap current valuation, and potential for additional upside, is what makes equities exciting, not the fact that we’re at a new high.

Folks worried that the current market is expensive, because the last time it reached this level it peaked, ignore the fact that earnings power is much stronger now than was the case in 2007, the last time we were at these levels.  Inflation-adjusted earnings are just getting back to 2007 levels, but in 2007 the earnings were jacked up by a number of builders and financial companies that has faked their earnings amidst the real estate bubble.  Today, it is harder to find similar instances of earnings puffery, although some companies are clearly beneficiaries of today’s unrealistically low interest rate environment.  In general, however, earnings quality is much better today than was the case back in 2007.

Still, we will caution investors not to get too excited about the stock market.  Particularly when the government is holding down interest rates, punishing savers in an unsustainable attempt to juice the financial markets, some might be tempted to invest “savings” in the stock market.  We’ve always said that it’s a mistake to confuse “green money” (savings, which typically can’t tolerate the ups and downs of the stock market) with “red money.”  We’ve had our red money mostly invested in the market since 2009.  Investors who succumb to the temptation to move “green money” into the market are taking a big risk that interest rates go back up and the next time the market falls, they will succumb to the temptation to take it out of the market at just the wrong point in time.

We’ve often said that we prefer it when pop culture “news” dominates the front page instead of business or economic events.  We would much prefer Britney Spears in the headlines than things like “sequestration” or “tax increases” or “unemployment.”  Having said that, if the media is going to focus on an economic story, probably the best event they could focus on would be the market reaching new highs.
 
 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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Fiscal Tiff

The Lame Duck Congress (emphasis on the word “lame”) thinks that they “resolved” the fiscal cliff with a late night New Years day vote.  In fact, all they did was raise taxes, but there is some good news buried in those actions of incompetence.

First, looking at the late December retail sales figures, it looks like consumers ignored the political grandstanding and kept right on spending.  In spite of the uncertainty, and potential anxiety, shoppers were not so put off that they stopped spending.

Second, most of the “fiscal cliff” drama is now behind us.  I think we’ll find that there was more (negative) impact to the economy during the 4th quarter, than there will be in 2013.  The melodrama was costly.  Economic activity did slow as the year ended, but now there are some rules for income tax planning and estate planning that can form the basis for decision making in the future, so maybe it will allow investors to begin making decisions, once again, and start moving forward.  We almost hit stall speed during 3Q 2012.  Personally, I am really happy to put 2012 behind me.

Third, it appears that Congress has re-learned how to compromise.  Rather than letting extremists hold Congress hostage, the Administration (Biden, mostly) and Congressional leadership figured out how to find some agreement near the center, involving both sides of the aisle, in order to forge a majority.  Previous administrations haven’t had such difficulty doing this, but the agreement surrounding tax hikes was the closest thing to a traditional compromise that we’ve seen in at least four years.  That is, after all, how Washington D.C. is supposed to work.  I thought that they’d forgotten.  Maybe now they can repeat the process and come to some agreement on the spending reduction side of things.

Fourth, most of the tax rates determined are “final.”  The accountants have been dealing with temporary estate planning rules since 2001.  Many of the rules established in the fiscal cliff negotiations are actually supposed to be permanent.  Wow.  What a concept. The Alternative Minimum Tax (AMT) fix, indexation, is also permanent.  It’s great to have some sense of finality to the negotiations.

Fifth, in my opinion, the GOP was more successful than I would have predicted.  Especially given that they lost the election in November, so taxes were bound to go up, the impact of these tax increases negotiated over the New Year holiday are relatively limited.  Given a trillion dollar annual deficit, if the tax increases account for roughly $60 billion (only 6% of the gap), that is pretty minimal.  If the rest of the gap gets filled from spending reductions (Ha!), then that would be about $16 spending reduction for every $1 of tax increase.  In reality, I think the deficits will continue ad nauseum, but the basic point remains; given the size of the deficit, the extent of the tax increase was pretty minimal.

There are plenty of things not to like about the upcoming potential for a constitutional crisis related to the debt ceiling debate we’ll be hearing over the course of the next few months.  Still, there are a few good things that came out of the final package that will help investors going forward.  It doesn’t hurt to notice them, too.

Addendum(dtd 1/7/2013):  Fidelity Investments just published a good summary of the recent changes.  Let us know if you would like us to e-mail you a copy of their Crisis Averted report.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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2013 Forecast: I dunno

Will interest rates finally go up in 2013, or stay low?  I dunno.  Will the “fiscal cliff” cause the economy to stall, or decline?  I dunno.  In the next decade, what “sustainable withdrawal rate” should retirees use to determine how much to take out of an IRA so that the account isn’t depleted prior to death?  Hmmm.  Don’t know.

Let’s face it.  One reason that economists and financial advisors are sometimes caricatured as not knowing anything is because, well, there IS a lot that we don’t know - in fact, that we can’t possibly know in advance.  When planning for our financial futures, we are forced to operate in the world of possibilities and probabilities, whether we’re looking out 40 years – or 365 days.

So how should investors handle this uncertainty?

First, in financial planning, probability analysis can help us understand what a “worst case” scenario probably looks like.  In our planning, we use what statisticians call a “Monte Carlo simulation” to help us determine the likelihood of running out of money during retirement.  These projections help us keep retirement spending in check so clients get a satisfactory answer to the question, “Do I have enough?”

Second, in market and economic forecasting, we use back-tested models to look for indications about what is most likely to happen in the future.  In 2009, May-Investments developed its own proprietary Leading Economic Index to help us anticipate where the economy is headed.  For the past four years, this indicator has correctly projected that economic growth would continue.  While it can’t be relied upon to be 100 percent accurate, at least the indicator gives us a sense of what is the more likely outlook going into 2013.

Finally, in stock-picking, we look for asymmetrical return distributions in the stocks purchased in the portfolio.  We like to own stocks with the potential for growth in the Price/Earnings ratio that the market applies to the stock.  A company that normally sells for 15-times earnings, if purchased at 10X, has room for 50 percent upside even if earnings stay flat, if only the stock valuation returns to normal. 

Ideally, portfolio companies are experiencing upside earnings growth and also have room for P/E expansion.  By buying stocks with steady earnings growth and relatively low valuations, we should be able to reduce the likelihood of a major decline in the stock price while preserving the potential for significant upside potential.  Or, in English, we are hoping to find stocks with a better chance of going up a lot, even if it means taking a chance that they go down a little.

We don’t want a normal bell-shaped curve where upside and downside are evenly distributed.  We prefer the added protection that accrues to investors who purchase shares at a discount to intrinsic value.  Although we can’t actually know ahead of time how the stocks will perform, we can reduce the amount of risk we’re taking by focusing on good companies whose valuations are already depressed.

Investing and financial planning are long run endeavors.  Only after a series of decisions are made and subjected to the fickle fortunes of chance will the solid plans stand out.  In the short run, luck distorts the results.  In the long run, however, diligent planning pays off.  In fact, having a financial plan is the primary determinant of whether or not people are satisfied in retirement.  And although I’d rather be “lucky” than smart, wisdom suggests that prudent planning helps people take advantage of good fortune and can protect them against misfortune.  More than likely, it is discipline rather than luck that separates winners from losers in the long run.

Our disciplines suggest that economic growth will continue into 2013.  The stock market could have another pretty good year.  The political grandstanding demonstrated by our so-called leaders did more to hurt the economy at the end of 2012 than it will to depress spending in 2013.  Maintaining a 4% to 5% withdrawal rate will likely work for most people, unless they are overinvested in cash equivalents and bonds.  Updating your financial plan will help you keep your spending to a reasonable level.

Will these disciplines work for you as well as they’ve worked for us?  I have no idea.  If we did know, exactly and precisely with crystal ball clarity, we could certainly make more money for clients and ourselves by operating using a lot more financial leverage.  But where do we get one of those crystal balls?  That’s the problem.  I dunno.
 
 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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Bond Choices For The Timid

With interest rates near all-time lows and about a trillion dollars chasing today’s low yields (it’s more like 3 trillion dollars if you include bond purchases by the central banks), finding decent bond investments is a bit of a challenge, these days.  In general terms, I thought I’d mention some of the types of fixed income securities that we’ve been buying for clients in this low interest rate environment.

Since bond prices and interest rates move in opposite directions, the risk in the bond market is that rates move higher (they can’t move much lower!), which pushes bond prices down.  This risk is much greater in a long bond than it is with a security that matures in just a couple of years.  The Leuthold Group gives the example of a 20-year Treasury bond that sells for a 2.35% yield.  The bond in question has a coupon of 5.625%.  On a $100,000 original investment, it pays $5,625 annually.  To buy that bond in the current low-yield environment, however, investors would have to fork over $140,240.  (Yes.  In the past few years, somebody has already made a 40% profit on that bond.  And they are selling it to you.)

The bond has a price of $140.24.  Should rates go back up by 1.65%, so the bond yields a more normal 4% yield-to-maturity, the price of the bond would decline to $117.10.  If that rate increase happens over the course of the next year, the bond would fall nearly 19% in value.  However, it would spin off income of about 4%, so an investor’s total loss would be about -15%.

While a 15% loss isn’t quite the same magnitude of losses that stock investors experienced during the technology bubble, for someone trying to be “safe” with their money, a 15% loss would come as a rude awakening as to the risk out there in the supposedly “safe” fixed income asset class.  A novice investor might buy the bond thinking that they were getting a “safe” 2.35% return, only to get hit with a 19% loss, instead.  A real rube might think that they were buying a bond that pays 5.625%, but experience that same 19% loss.  In either case, buying a bond for safety, and then losing principal, isn’t going to make folks happy.

A 12-month Treasury bill, by comparison, would not lose money.  However, the return on a 1-year T-Bill is only 0.17%.  It’s almost as bad as losing money, since you’re loaning the money to the U.S. government to buy a lot of things that, well, you probably wouldn’t buy if you had a say in the matter.

We are shopping for reasonably short maturity fixed income investments that provide a better return than T-Bills.  Heck - let’s face it - we’re just trying to find something that will give up a POSITIVE return for the next couple of years.  And we’ve found five different types of securities that we believe offer both positive returns without taking a lot of risk.

In the past, we’ve been a regular buyer of short-maturity junk bonds ever since the high yield market blew itself up in 2008.  With so much money being created by the Federal Reserve, we believe that it makes far more sense to take “credit risk” than it does to take on “interest rate risk.”  The risk of default, we believe, is far lower than the risk that higher interest rates will depress the value of what we own.  However, in 2008 investors could by short-maturity junk bonds with yields of 10% to 20%.  These days, even on junk bonds, short-term yields may be more like 2% to 3% for most names.  It’s tough to take any risk to principal when the investment return is that low.  Still, in a few cases, we’ll buy short-term high yield bonds because we expect to hold those bonds to maturity.  Rather than selling them, we can just let them mature.  If the bonds are backed by hard assets, even in a worst case scenario we foreclose on assets that have value to investors.

Second, a little over a year ago we added a mutual fund that owns short-term government guaranteed mortgage-backed securities in its portfolio.  The bonds aren’t backed by Fannie-Mae or Freddie-Mac, which are entities in guardianship currently because their overpaid traders and executives bought too much junk at the behest of Congress during the real estate bubble.  Instead, we own mortgages that are fully guaranteed by the full faith and credit of Uncle Sam, just to be sure.  Periodically, mortgage market participants blow themselves up by buying sophisticated securities on the premise that they’re a simple investment.  In fact, mortgage-backed securities are easy to buy, but in a crisis they can be very difficult to sell.  It happened after Orange County, California bought too many mortgage bonds in the early 1990’s, and again after the 2008 financial crisis.  As a result, mortgages still offer reasonable returns, but they don’t belong in an individual’s portfolio as an individual security.  They are just too hard to sell.  For this reason, we invest in them through a mutual fund.

The fund we own has bonds in the portfolio that yield 3.09%.  The fund’s 0.55% expense ratio must come out of this return.  The fund’s price (net asset value) has been fairly stable.  The N.A.V. was $10.62 in 2001, fell to $10.16 at the end of 2006, and is currently $11.29.  We actually do expect the N.A.V. to lose some value, but not a lot.  We’re hoping that our investment will earn 1% to 2% during our holding period.  Also, it’s good to have funds around because they can be easily liquidated in the event we want available funds to use to buy long bonds later, after rates have gone up.

Another alternative we’ve started using is an exchange traded fund that owns a broad portfolio of short-term high-yield bonds.  In this case, the bonds in the ETF all mature in 2014, so in two years we expect the ETF to self-liquidate and give us back our money.  It’s similar to owning an individual issue, but with junk bond yields so low, it’s hard to justify taking much of any credit risk.  By using a fund to diversify the investment, we reduce the likelihood that we happened to buy just the wrong bond, and lose a significant amount of principal in return for an insignificant rate of return.

The ETF we own has bonds in the portfolio that yield 5.39%.  The fund’s 0.42% expense ratio must come out of this return.  The fund is diversified across more than 100 individual securities, but trades easily throughout the day so it provides both diversification and liquidity benefits.  In an economic downturn, we might want to sell these short-term bonds in favor of buying longer maturity investments.  In the event of an economic recovery, presumably Treasury rates would move higher and we might want to lock in rates by purchasing longer maturity Treasuries.  In the meantime, we’ll be paid a little to wait, and we hope to be able to have liquidity when the time is right to redeploy funds into different types of securities.

We have also found a few floating-rate bonds to be of interest.  With interest rates so low, floaters whose interest rates are based on short-term interest rate indexes have plenty of room for their rates to increase when interest rates, generally, do start moving higher.  In this case, it’s okay to buy a longer-term bond because the price should be protected (generally) by the increase in the bond’s coupon.  Also, in some cases, the current interest rate is so incredibly low that the bonds are actually selling at a discount (i.e. below maturity value), so in addition to some modest coupon income, the bonds can be expected to appreciate as they move toward maturity.

A typical recent example is when we purchased the bonds of a too-big-to-fail bank which is paying IRA investors 0.55% to invest in a 4-year certificate of deposit.  Although not insured, like a CD, the bank’s bonds pay a floating rate of interest currently set at 0.60%, and the bonds should appreciate from $89.4 to par ($100) between now and June 15, 2016.  Combining the appreciation and the coupon interest should yield roughly a 3.25% return to investors.  If short-term rate indices rise, the coupon on this bond goes up, which helps boost the ultimate return to investors.

Finally, there are a few callable bonds that are of interest.  Callable bonds have a final maturity date, but they can be subject to early maturity at the whim of the issuer (i.e. they can be “called away”) based on current interest rate conditions.  In this low rate environment, most callable bonds are called at the first opportunity because issuers can float new bonds, at lower rates, and use the proceeds to get rid of that old, high-coupon debt.  It’s really not much different than what homeowners have been doing with their old mortgages.  They take out a new mortgage and use the funds to pay off the old, higher rate debt.

The interesting thing about callable bonds is that they trade to the short-term call date.  A bond with a 4% coupon won’t have much of a premium because buyers know that the bond will likely be called in a year or two.  However, if rates increase between now and the call date, it’s possible that it won’t make sense to pay that bond off early, after all.  In that case, the 4% coupon might last a lot longer than originally thought.  The key is to find bonds with coupons that are high enough to be attractive, if kept to maturity, but low enough that it wouldn’t take much of an interest rate increase for it to no longer make sense to call in the bonds.

In today’s bond bubble, with the demand for bonds so much higher than the current supply of new bond issuance, it’s a very difficult place to find value.  Hopefully the securities we’re buying will give us a 2%-3% return without exposing us to a lot of interest rate risk.  We’re looking forward to the day when fixed income investors are no longer treated with contempt by the central banking system, which is looking to retirement savers to subsidize the mistakes made by the central banks and Wall Street bankers during the period leading up to the financial crisis.

In this environment, it’s good to be timid.  It may not pay a lot, but it will likely pay off in the end.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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