Rising Portfolio Cash Speaks to Market Concerns

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

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

 

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

 

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

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

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

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Get Out The (Proxy) Vote

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

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

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

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

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

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

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

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

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

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

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

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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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Signs Point to Further Growth

Emotional markets are often irrational markets. In both real estate investing and in the financial markets, investors without a discipline can be easily swayed by fear and greed. By developing a discipline and anchoring decisions to specific facts, investors can maintain their bearings amidst uncertainty and turbulence. Many facts, today, point to continued growth in the U.S. economy.

However, in 2011 the level of angst and vitriol in the markets and the political arena caused markets and fundamentals to disconnect. While the economy moves up at a modest but consistent pace, the stock and bond markets seem to be priced for drama and despair. In spite of impressive growth in corporate profits, last year, the U.S. stock market went nowhere. While European leaders assemble trillions of dollars in rescue funds, the markets contemplate the impact of a colossal meltdown of the global financial system. These worries seem overblown.

The May-Investments Leading Economic Indicator keeps climbing, forecasting continued growth into 2012. Of the ten indicators that comprise the May-Investments LEI, all but the export sensitive Baltic dry freight index are positive, or strongly positive. The collapse of the freight index indicates a slowdown in global shipping activity, probably as a result of a recession in Europe and possibly Asia. The rest of the indicators focus more on domestic economic activity and suggest continued growth in the U.S. economy. If the markets begin reflecting a return to economic “normalcy” and we can get out of this “bond bubble,” or “fear bubble,” or whatever you want to call it, the stock market could do very well in 2012 and interest rates could shoot higher.

Locally, there are additional reasons to be optimistic. Dale Beede, Managing Director of Coldwell Banker’s Grand Junction commercial properties division, notes that the local real estate market looks like it can improve. “We’re starting to see more investor traffic which is creating new opportunities for sellers.”

Commercial real estate prices have adjusted down, but to reasonable levels, not to fire sale price levels. Taking advantage of the lower prices while interest rates are very low creates opportunities for potential real estate investors. The stock market is also inexpensively valued, especially compared to alternatives such as bonds, TIPS, and bank certificates of deposit. We would not argue that “savings” should be invested in more volatile “investment money” alternatives. However, it is getting harder to argue that “investment money” should be on the sidelines invested in savings accounts.

In 1979, Woody Allen wrote that, “mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.” Allen was wrong, in 1979. And we think that the financial markets, priced as if they are caught between a rock and hard place, are wrong today.
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Following Germany...to Where?

In spite of continued strength in the leading economic indicators we watch, the market can’t seem to muster a sustained rally. Furthermore, market volatility is extremely high, with the market seemingly locked in crisis mode in spite of strong corporate profits and an over-priced bond market. What’s keeping the stock market cheap is the crisis in Europe.

Europe’s banking crisis is somewhat different than the 2008 U.S. bank crisis. At the height of the bank panic, a run on the banks occurred where banks could no longer tap the U.S. bond market for capital. Banks couldn’t roll over debt. The resulting lack of “liquidity” threatened to spawn a full-fledged bank run. The government stepped in with bank-backed funding (TARP funds) to reassure bank customers and creditors. Ultimately, TARP halted the panic and eventually the vast majority of the banks were able to pay the government back, with the government making a profit.

Unfortunately, many believe that the problem in Europe stems from those institutions being insolvent, meaning that shareholders could be wiped out and borrowers won’t be fully repaid. In general, we don’t know if this is true. In the case of Greece, at least, it is definitely true. Greece can’t afford its current debt burden, so the owners of Greece bonds will definitely lose principal unless they are bailed out by someone willing to come to the table with a checkbook.

The Germans are one of the few entities with a big enough bank account to fund the bailout, but oddly enough the Germans aren’t anxious to subsidize the losses of its Eurocurrency partners.

Germany isn’t the only country working to resolve the problem. France, and others, are also working overtime to save the euro. Although neither camp wants to trash the euro, the two alternatives being considered are polar opposite prescriptions for how to resolve the crisis.

Our view is that the German plan – whatever it is – will prevail.

Germans (legalistic believers in the rule of conviction) advocate that the rule of law should determine what happens next. France and others in the creditor class (expedient believers in the rule of responsibility) believe that the end justifies the means. Aware of the suffering that would occur if the crisis isn’t resolved soon, France feels a responsibility to prevent economic catastrophe by whatever means are available. Germans want to use the current treaty to force the spendthrift nations to live within their means in order to protect lenders. Troubled free-spending nations in Southern Europe want to print money a la the U.S. “quantitative easing” policies in order to inflate their way out of debt.

It’s not a matter of right and wrong. People have values. Money doesn’t. Money, in and of itself, is value-less. Nor is it merely a matter of expediency. In the short-run, the best solution is to hit the printing presses. However, as the Germans remember, bad short-term fixes can have dire long-term consequences. While the socialists in Southern Europe push for a quick fix, the Bundesbank fears the hyperinflation which might result from a continuation of spendthrift policies.

As several experienced analysts have observed, it rarely makes sense to bet against the Bundesbank.

My best guess is that Germany won’t cut a check to Greece, per se, but eventually Germany will give the OK for a Quantitative Easing program in Europe. Europe can follow the Federal Reserve’s lead and simply buy up the outstanding debt of the troubled countries, assuring borrowers a market for Italian and Spanish debt.

Germany will not agree to this plan until it has extracted a price from the spendthrift countries that led them into the crisis. At summit after summit, Germany is enforcing the adoption of new austerity measures and tighter banking controls on other EU members. All but the United Kingdom have agreed in principle, although getting country-by-country approvals will take months.

These are not easy measures for Greece, Italy, France and the other EU member countries to adopt. They must be doing it for a reason, however. I believe that they are adopting these new policies with the understanding that once these policies are in place, Germany will step up to the table with much needed help. I believe that Germany is holding approval of a quantitative easing program hostage to these austerity and responsibility measures.

In the end, however, Germany must be holding out a carrot. Otherwise, why would the other countries agree to such politically costly treaties?

Until the final solution is in place, the risk is that a large bank could fail. It could happen any day, and one large failure could trigger others. Time is not the friend of a crisis.

Some have estimated that Europe needs to roll over or borrow nearly $250 billion in 2012. In the past 12 months, estimates are that the region has only succeeded in borrowing $17 billion. Somehow, despite markets that are effectively closed, Europe needs to find investors willing to risk nearly 15 times more money in 2012 than was wagered, unsuccessfully, in 2011. All the while, austerity programs and the near certainty of a new recession in Europe from sovereign spending cutbacks and bank credit-tightening make these investments much more risky next year than was the case in 2011.

Do you see anyone out there with a checkbook looking to make an investment in Europe? China took a pass. Republicans in the Senate have given a thumbs down to the idea that IMF funds (from the U.S.) be used. The Central Banks are on board, but the traditional political institutions outside of Europe won’t stand for it. Traditional fixed income investors aren’t going to fund the Old World until the entire region steps up to back the bonds of individual countries. Buyers of Spanish debt are on strike until they know that someone, other than Spain, is willing to back those bonds.

Until agreement is reached on a solution, yields are likely to ratchet higher until they are high enough to attract equity money into the arena. However, once the sovereign risk is taken out of the equation, Spain, Italy, Greece and others will once again be able to access the market.

Germany can say, all day long, that the current treaty won't allow the region to backstop individual countries.  In reality, either an ECB-backed bond or some form of quantitative easing IS the end game for Europe, but Germany won't approve the plan until it has won concessions from its more profligate partners.  It is blatent brinksmanship, but in a distressed situation the lender gets to write the rules.

The euro has been an interesting indicator. While the U.S. market goes up with each meeting in Europe (and there have been a lot of them), the euro itself is getting ready to re-test lows and is likely a better indicator of eurosummit achievement (or lack thereof).

However, once the solution is unveiled, the market could easily “melt up.” But will it melt up FROM current levels? Or back TO current levels?

In any event, we remain in a high risk market. We have reduced (but not eliminated) risk in equity oriented accounts. While the chances of a melt down and a melt up are roughly equal, the PAIN involved in a meltdown would drastically outweigh the happiness felt if we were to melt-up. Furthermore, judging by the price action of the Eurocurrency itself, the trend remains down, at this moment, so we remain on high alert.

The good news is that this is occurring in the background at a time when the U.S. economic turnaround is marching forward. In the long run, the good news surrounding the potential for a full U.S. economic recovery outweighs the headlines overseas. In the short run, all asset classes seem to be correlated, so it’s hard to imagine a crisis in Europe not coming back to haunt U.S. equity investors.
 
Arguably, it’s a great time to be investing in stocks, for many reasons. Unfortunately, an even better opportunity might be just around the corner. Having reduced our exposure to equities during the third quarter, we are busy kicking the tires on opportunities as the crisis unfolds. We intend to take advantage of the opportunity to buy solid assets selling at very attractive prices if events unfold as we anticipate. 

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

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Changing From Worse to Bad

U.S. businesses are doing remarkably well, so much so that it feels to me like the Great Recession is slowly morphing into a new, different, and better stage of recovery. The U.S. stock market seems like it wants to rally off of very low valuations, but concerns about the European debt crisis are a giant overhang preventing the rally from gaining momentum. It feels like the weight of the world is on the shoulders of Germany’s Angela Merkel as she tries to negotiate a settlement to this crisis.

Back home in the U.S., the economy feels like it is coming out of a recession. Consumer confidence is low, but retail spending is reasonably strong. Corporate America has been in recovery mode since June 2009, but the tepid recovery has restrained hiring. Consumers are hampered by both high unemployment and punitive savings rates (what economists now call “financial repression,” which describes the Fed’s practice of forcing rates down in order to subsidize the recapitalization of the banking sector).

The great news is that the problems in the U.S. seem to be evolving from one of excess supply to one of not enough demand. We are moving forward from The Great Recession to a run of the mill recession. With a little more activity, we could move beyond recession to recovery. But, hey – this is America! If there’s one thing we still know how to do, it’s shop!

Since 2007, the economy has been dealing with an excess of housing inventory. At first, we just built fewer units. Soon, however, unqualified borrowers who should never have received loans began receiving foreclosure notices, pumping up the inventory of foreclosed but not yet sold homes. By 2009, the excess inventory had shut down the U.S. building sector. A million construction workers lost their jobs and a huge segment of the U.S. economy closed down. Bank regulators forced banks to call loans on struggling builders, wiping out all but the most deep pocketed firms.

The recession we face in 2012, however, looks much less daunting. Although the inventory-to-sales ratios are still high, the “problem” has shifted from the numerator to the denominator. Home inventories are still a bit high, but nothing like the levels seen in 2009. If economic activity was anything near normal, and household formation wasn’t in collapse, then the industry might be fairly close to stabilizing.

At a Grand Junction Chamber luncheon this week, Richard Wobbekind, the Senior Associate Dean for Academic Programs at the University of Colorado, agreed that household formation as been far below norm, and that an employment recovery would dramatically improve the construction industry’s supply/demand balance. He also agreed with the notion that the recession we’ve experienced for the past three years, as a result of supply excesses, will look a lot different than the slow growth period ahead of us, which results from a lack of economic vigor.

Stimulus efforts in 2009 failed to revive the U.S. economic engine. We are now much closer to economic equilibrium. Real estate inventories are down. Over-leveraged businesses were forced into foreclosure by the banks, while low savings rates have encouraged consumers to de-leverage as well. Only the government sector lags in the de-leveraging department. If regulatory or monetary stimulus were used, today, I think that they would have a much improved chance of succeeding. In 2008, we applied the wrong type of stimulus, at a time when the economy was just too moribund to keep going once the stimulus ended.

In spite of continued strength in the leading economic indicators we watch, the market can’t seem to muster a sustained rally. Furthermore, market volatility is extremely high, with the market seemingly locked in crisis mode in spite of strong corporate profits and an over-priced bond market. What’s keeping the stock market cheap is the crisis in Europe.
 
Arguably, it’s a great time to be investing in stocks, for many reasons. Unfortunately, because of the crisis in Europe, an even better opportunity might be just around the corner. Having reduced our exposure to equities during the third quarter, we are busy kicking the tires on opportunities as the crisis unfolds. We intend to take advantage of the opportunity to buy solid assets selling at very attractive prices if events unfold as we anticipate. 
 
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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