2012 Mid-Year Forecast Update

On August 16 May-Investments updated its January Economic Forecast lunch.  The bottom line was that our optimistic January forecast, which called for continued slow economic growth but a much better environment for the stock market, seems to be on target as of mid-August.  While the equity market remains pretty skittish, strong earnings power and reasonable market valuations combine to provide solid upside opportunity for equity market investors unless conditions in Europe and China continue their downward slides and eventually drag the U.S. market down with them.

While May-Investments leading economic indicators are getting slightly weaker, as of mid-August our January forecast for the year remains virtually unchanged.

We’ve been waiting for the “fear bubble” to pop, which would likely allow both interest rates and the stock market to rise.  For the most part, we’re still waiting for that eventuality, but one important place where we did see some sense of normalcy return to the markets was in how the U.S. market reacted to the European sovereign debt crisis.  While the problems in Europe continue to crescendo, the U.S. market’s response has been more muted than it was in 2008, when Lehman was at the center of the world financial crisis, or in 2010 and 2011 when the sovereign debt crisis first appeared, only to be denied by Europe’s Central Bankers and governmental leaders.

In 2012, with Greece having paid creditors less than 20 cents on the dollar and on the verge of being kicked out of the European Union, and despite the problem of high and rising interest rates in Spain and Italy and threats that the crisis would extend to now AA rated France, volatility in the U.S. market (as measured by the so-called “Vix Index”) was much lower than in previous years.  True, the market did, by our measures, go into a downturn in May.  Although the downturn was severe enough to get us into risk reduction mode, it was not as severe in the past and the daily volatility was much lower than in previous incarnations of the EU debt crisis.  In our view, the liquidity measures put in place in December of 2011 are having a positive impact and have prevented the crisis from jumping over the pond and spreading to the U.S. financial sector.

Nonetheless, the markets (generally and) in the second quarter (particularly) are trading as if we are already in a recession.  The top performing sectors in Q2 were telecommunication services, utilities, consumer staples and healthcare – precisely the sectors which typically fair best in a recession.  But instead the U.S. economy continues in its slow growth mode, with consumers continuing to spend, businesses afraid to invest, governmental entities cutting spending while imports and exports having very little impact either way.  In the same fashion as predicted in the January forecast, the economy keeps moving forward, albeit at a modest pace.

Of more concern, the May-Investments Leading Economic Indicators have turned down, slightly, and need to be watched closely.  Whereas in January, 9 out of 10 of the index segments were indicating healthy growth, by mid-August only 4 of 10 sectors were moving up, while half were beginning to decline.  If those trends continue, May-Investments would be inclined to pull its optimistic forecast.  As of mid-August, however, the down trend was too new to warrant a change in the forecast. 

The biggest concerns are in the areas of global economic activity, where the slowdown in Europe is impacting economies in Latin America and Asia as well.  The outlook for small businesses declined as well, and the Institute for Supply Management “New Orders Index” fell precipitously, very recently. 

As a result of these mixed economic signals, the U.S. stock market rallied in a very unique way.  The U.S. equity markets have risen during 2012 (so investors with 20-20 hindsight should have been aggressively positioned, “all in” as it were, yet the sectors which are performing best are the “defensive” industries that typically do best when the market is weak.  Leuthold Capital Management’s research folks have noted how unusual this market is from an historical perspective.  The 2012 rally is unique in many ways, but we believe it all ties back to the “all in and maximum defensive” nature of this current phase of the bull market.

Updating our industry work, the sectors with the most upside potential appear to us to include technology, healthcare, basic materials, energy, industrials, and financial stocks.  High dividend yield stocks, and utility stocks in particular, are among our least favorite sectors.

Overall, it felt good to optimistic again, and it feels particularly good to be optimistic while the equity market remains in a bubble of fear, generally.  While there are excesses in the bond market, and in unique sectors like the social media stocks and REITs and Master Limited Partnerships, in general the level of investor interest in the market is very low, trading volumes are low, and optimism is in short supply.  It is exactly the sort of market that whets the appetite of a contrarian investor.

In the short run, contrarians often have to fight the current trend, so our contrarian interest in equities is certainly no guarantee that our positive short-term forecast won’t have to be changed.  In the long-run, however, the contrarian nature of our portfolio holdings really is an encouraging sign.  It means that the years of swimming upstream, as investors have had to do since valuations first got stretched in 1998, are nearing an end.  Good riddance!
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Electing A Media Platform

Congratulations to Retirement Outfitter’s Barbara Traylor Smith who is getting married this weekend.  Since she was out with family, preparing for this weekend’s big event, I joined KREX television’s Meaghan Wallace for the “Money Matters” noon news segment.  We talked about the relationship between the stock market and the election cycle and I managed to convey most of the facts, but few of the conclusions, which I’d hoped to deliver in the interview.

At the time of the interview, the Standard & Poors stock index was up about 13 percent year-to-date.  Although you’d never know it by reading the political headlines, it has been a good year for stocks, especially in the United States.

One interesting election year statistic that I’ve seen is that in years since 1904, nearly every year that the market has been up 8 percent or more, the incumbent candidate has won re-election.

There are three exceptions to this rule of thumb.  The first exception was in 1912 when Theodore Roosevelt ran on the Progressive (“Bull Moose”) Party ticket, splitting the Republican vote and enabling Woodrow Wilson’s election victory.  President Taft, the Republican incumbent, came in third.  Roosevelt’s challenge to Taft solidified Wilson’s victory.  His unusual third-party candidacy turned the tables enough that normal rules of thumb didn't matter.  In 2012, the Republicans avoided a similar fate when Ron Paul decided not to run as a third party candidate.

The second exception occurred in 1976 when Jimmy Carter defeated Gerald Ford.  Although an incumbent, President Ford had been appointed rather than elected and the election came only two years after the 1974 watershed election when “throw the bum out” resulted in the largest number of incumbents thrown out of office since the French Revolution.  (OK, that statement might need some more fact-checking.)  President Ford paid a political price for pardoning Richard Nixon, resulting in Jimmy Carter’s election and, once again, defying the simple election rule that incumbents win re-election during years when the stock market is on the rise.  Although he lost, Ford carried 27 out of 50 states, the most ever won by a losing candidate.
 
Four years later, in 1980, Ronald Reagan beat President Carter in an electoral college landslide in spite of election polls that heavily favored President Carter.  Not since Truman beat Dewey has the polling been so wrong in the presidential race.  In 1980, you also had a third party candidacy by John Andrews impacting the race, with the Republican Senator from Illinois siphoning off large numbers of independent votes.  Still, as a former Republican, you would think that Anderson was probably splitting republican votes, rather than denying President Carter his re-election.  In any case, the market seemed to accurately forecast Carter’s loss, even if the polls didn’t.  The market started to rally in March and never really stopped as investors celebrated the end to what many Republicans viewed as an anti-business administration.

For Republicans, 1980 is the model year for the 2012 market/election cycle.  Is the current market rally predicting regime change, or validating the Obama recovery? 

Typically, markets rally briefly in the spring of an election year, drop back to even in mid-summer, and then rally into year-end as the parties pick their candidates and uncertainty diminishes.  Then again, typically, incumbents win re-election, having spent four years using our money to purchase their victory.

During years when incumbents lost, however, typically the market remains flat after the June trough.  Unless we’re in sort of a 1980 market/election cycle, the current rally would not be considered good news for Republicans.

During my television interview, this is where I ran out of time.  Meaghan Wallace did a great job trying to lead me through the interview, but I just flat out ran out of time.

And so, as Paul Harvey used to say, this is the rest of the story.

As near as I can tell, this market rally is not predicting anything.  The polls suggest that this election is a toss-up.  The structure of the electoral college, with so many states virtually locked up for one party or another, also forecasts a tight race.

However, the election might be indicating something positive for the market.

In the event President Obama wins re-election, as incumbents typically do, the market’s typical election year pattern suggests that prices between now and November can continue to rally through election day as uncertainty recedes.

In the event Mitt Romney unseats the President, a la 1980’s election year storyline, the markets could rally as investors look forward to what Republicans hope to achieve – a kinder and gentler business and investment environment.
 
In either case, the markets could remain in rally mode between now and the November election.

Many investors in Western Colorado have voiced to me concerns about the investment environment should the President win re-election.  Western Colorado is, after all, a pretty conservative part of the world.  As I think about it, though, how many investors are sitting around thinking, “I’ll sell every stock I know, if Barack Obama is re-elected.”  For the most part, those inclined to sell everything for political reasons, have probably already done so.  They’re not waiting until election day.  They’re already out.

So even if the President is re-elected, I don’t look for an immediate sell-off in the market.  If anything, the President’s re-election would likely have very little market impact.  On the other hand, if Mitt Romney wins, there are a lot of investors, I’m told, which would be much more comfortable investing the trillions of dollars that are sitting on the sidelines, given the likelihood of a more friendly business environment.  There is potential for a market rally, in that event.

Unless the rally has already happened – between now and election day. 

It is this more bullish message that I’d hoped to convey during the noon news segment.  Instead, all I delivered was a brief history lesson that seemed to point leaders to the conclusion that I thought President Obama was destined to win re-election, which really wasn’t my point at all.

I really admire politicians and media personalities who are able to convey their message in the brief window of time that television allows.  This week’s interview was yet more evidence that I have a lot of improving to do in the TV interview department.  Trying not to convey my biases, I failed to deliver the core message.  That’s why I like blogging, I suppose.  I can script and edit and nerves don’t get in the way.  I’m glad I don’t have to make my living by going on camera every day.  Everyone would regret it!

In a blog post, I can take the time necessary to get my point across, and give more thought to the way in which these election year thoughts are presented.  Which is better?  You decide.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Internet Tools For Wise Giving

Albert Einstein was once quoted as saying, “Any man who can drive safely while kissing a pretty girl is simply not giving the kiss the attention it deserves.”  Whether Einstein said it or not, this quote brilliantly illustrates an important point – anything worth doing in life is worth doing well.  We’d like to make the argument that this principle should apply to all areas of our life, including an often overlooked one – charitable giving.

While giving is easy (and it is certainly easy to find a cause to give to), giving well requires thoughtfulness and planning.  Most of us want the hard earned dollars we give to make the biggest impact possible, but how do we know if what we are giving is being utilized efficiently?  How do we know if a charity is legitimate, or whether what we give actually accomplishes what they claim?   How can we be sure that we are giving our charitable ‘kiss’ the attention it deserves?

In our present information age, the internet is turning up some creative solutions to this age old dilemma, making it easier than ever to ‘check-up’ on charities and be thoughtful in our giving.  We have reviewed three such sites for you, and hope that you will find them helpful next time you engage in that ‘kiss’.

www.GuideStar.org

GuideStar is a true ‘data-base’ of non-profit information.  Searching for non-profits in their data-base is free and does not require registration, however if you register (also free) you will have access to more complete information.  The databases they maintain are a combination of information provided by the ‘non-profit’ itself, and data they collect from other sources (such as the IRS).  You can search the site by non-profit name, though for local charities, We found it more helpful to search by location (i.e. Grand Junction, Colorado).  We did receive hits for about 30 local groups. The information accessible to a non-registered user was basic, though instructive, and certainly would be helpful in determining the ‘legitimacy’ of an organization, if nothing else.

www.GiveWell.org

Founded by two Ivy League grads who gave up their high paying jobs as hedge fund analysts in order to use their skills to evaluate charities, this site upholds rigorous standards, recommending less than 2% of the charities they review.  They do maintain a highly international focus, with most of the charities on their list serving developing third-world countries.  Their philosophy is that, by donating to the developing third-world, every dollar gets ‘stretched’ further, so that even a small gift can have a major impact.  We don’t know how instructive this site would be for local giving, but it does include a neat ‘Do-it-Yourself’ link, where they share questions they recommend you ask when conducting your own analysis.  These questions could be applied to any charity and are broken down very specifically by type of organization. 

www.CharityNavigator.org

This site reviews a lot of national charities, and is a good resource for topical searches (i.e. breast cancer awareness).  It does not review any international charities (only those based in US) or organizations exempt from filing IRS form 990, which excludes many religious organizations (i.e. the Salvation Army).  We didn’t find any local charities listed, save a couple based out of Denver.

A quick spin around these sites will, if nothing else, show you the questions that others use to critically evaluate organizations in the non-profit world.  We know that clients have your own favorites, but when evaluating new organizations, this perspective can be helpful.  One of the key issues is how much of each dollar is spent on administration, versus going out to those in need.  So when clients tell us about organizations like the United Methodist Committee on Relief (Umcor.org), for example, which says that it spends 100 percent of designated donations on the projects specified by their donors (the United Methodist Church handles all of the administrative functions as a ministry of the church), it's hard not to get excited about the good that comes from contributions to that organization.

Money represents a lot of different things to different people.  To some it represents security.  To others, achievement.  When organizations are able to use money to present the hands and feet of Christ to those truly in need, however, it can accomplish miracles.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Flip Flopping in the Worst Way

President Obama slams Mitt Romney for flip-flopping on the healthcare issue, while Candidate Romney accuses the President on flip-flopping on his pledge not to increase taxes on middle class Americans.  But the most tiresome flip-flopping of all, it seems, is the market’s flip-flopping back and forth between fear and greed, crisis and stability, optimism and negativity about 1) the prospects for economic recovery, 2) a financial meltdown, 3) renewed quantitative easing, and 4) any number of alternative doomsday scenarios.

In the short run, the market has been flip-flopping in a relatively narrow trading range since the beginning of 2010.  After plunging in 2008 and roaring back in 2009, the market has climbed slowly but steadily except when interrupted by ham-handed bumbling by politicians here and abroad.  But for the recurring fears of a Eurodollar crisis spreading to the U.S., the market would have been a dreary backwater for most of the past 2 ½ years.

Only consumer cyclical stocks, buoyed by a recovery in auto sales and a stabilization in the construction sector, have performed particularly well during this period.  The U.S. consumers’ ability to keep on spending ought to make the Energizer bunny envious.  On the down side, the heavily regulated and government subsidized financial sector failed to participate in the rebound.  Otherwise, nearly all U.S. stock sectors have participated, at least to some degree, in the slightly improving trend in stock prices since 2010.

Stepping back for additional perspective, the flip-flopping that began in 1998 has even deeper roots.  The twentieth century ended with a bubble in the tech sector, rather than a bang as Y2K fearmongers imagined, and 1999’s rampant greed resulted in unrealistic expectations about what the overpriced equity markets could deliver in the decade to come.  Now, more than fourteen years later, valuations are lower, the froth has been wrung out, and expectations have come down to the point where stock investors, those that remain, have nearly lost hope altogether.  Trading volume is down.  Market rallies are sapped by fearful headlines.  Companies are afraid to invest and hire.  Those young people lucky enough to have jobs show little interest in accumulating equities.

Warren Buffett famously reminded his shareholders to, “be fearful when others are greedy, and be greedy when others are fearful.”  My contrarian radar is picking up the sort of antipathy toward stocks that ought to make an investor drool.

Unfortunately, the fundamentals continue to disappoint.  Our May-Investments Leading Economic Indicator has turned down a bit.  Corporate profit margins are too high, primarily as a result of unsustainably low borrowing costs.  Europe is in a recession.  Even a recession in China seems like a possibility.  Employment in the U.S. has been anemic for more than a decade.  Private sector economic growth has been anemic for nearly three decades.  What growth we’ve had, for most of my working career, has come from the ever expanding government sector, both at the local and national levels.  Now that our national balance sheet is starting to look like Greece, our ability to keep expanding the size of government has been hindered but the still lackluster private sector hasn’t been able to fill the gap.

Until we begin to fix the private sector, we will probably continue to be buffeted back and forth between the forces of government inflation and private deflation.  Until we begin to address the core problem facing the U.S. private sector, this flip-flopping gag-inducing trading range may continue.  Maybe the stock market will rise in nominal (before inflation) terms, but in real (after-inflation) terms it probably isn’t going anywhere.  Equities and real estate may be the best games in town, because bond investors and cash equivalents will likely be losing value when adjusted for inflation, but until we start taking our medicine and addressing the problems that have prohibited private sector job growth for over three decades, I fear the flip-flopping blip-chopping drip-hopping rip-topping madness will continue.

Negotiating this politically driven market has been difficult, and we do not claim to have been particularly successful.  We used to readjust portfolios monthly in order to take advantage of long-term trends in various asset classes.  In 2008, when things began to fall apart, we began trading intra-month and by the end of that year we were tracking markets on a day-to-day basis.  More recently, we have had to adjust our clocks once again and many days have been forced to track trends on an hourly basis.  Literally, we come in to the office unsure of whether we ought to buy into the recent uptrend or keep our stash of money on the side, waiting for lower prices and a better time to buy.

This makes it nearly impossible to write a blog post worth reading.  Should I write about the U.S. economic indicators that are falling, suggesting that the U.S. economy is about to fall into recession?  If I write about that, what will people think if I end up buying back into the market at the end of the day?

Or should I write about the enormous upside that stocks offer at current levels, given the healthy return on invested capital at current prices, and the potential for future appreciation offered particularly in light of low returns elsewhere.  When the gloom and doom fades away, buying stocks at today’s prices will be a smart move.  However, it’s not clear that, a month from now, we won’t have an even better opportunity.  We are investing on a moment-by-moment basis, rather than on secular growth trends in favored asset classes, trying to get in the way of what’s working but often getting whipsawed because today’s mini-rallies have the half-life of a fruit fly.

The portfolios have a lot of cash on the side ready to reinvest and the technical signals are trending back up and close to signaling that it is time to buy back in.  We are prepared to follow the discipline, with this caveat.  My best guess is that this is yet another head fake.  If we do buy back in and the markets turn down, it might be just a matter of a few days (or even hours) before the technicals go negative once more, suggesting the downtrend is re-emerging.  If this happens, we would likely sell immediately, and put the money back on the sidelines.

It is not our wish to be day-trading the stock market.  We would much rather have a Congress focused on boosting employment rather than partisanship, a President focused on getting America working again rather than on the next election, and a market signaling positive trends rather than flip-flopping in a narrow trading range.   While we wait for markets to return to health, we will continue to follow the flexible Beta discipline that we have established to manage risk in this high risk environment.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Six Steps To Prevent Identity Theft

Joe Garagiola tells the story of a baseball star who wouldn’t report the theft of his credit cards because the thief spent less than his wife.  In today’s world, identity theft of my medical identity could mean that I end up with someone else’s medical records.  What happens if the thief is in better condition than me?  Would my insurance rates improve? 

In reality, of course, identity theft is no laughing matter where the average “simple” case costs victims 81 to 600 hours, $2,000 to $15,000 in lost wages, and $850 to $1,400 in out of pocket expenses.  Indirectly, identity theft can cost victims by driving up insurance rates and credit card fees, result in being denied loan approval, housing, employment opportunities and even travel privileges.  In a worst case scenario, it can lead to victims being arrested.

Phishing occurs when thieves impersonate someone you know and request private information that they will later use to assume your identity.  The safest rule, of course, is to not provide personal information unless you initiated the correspondence.  Sometimes that is easy to forget, however, especially in the form of e-mails that appear to come from a vendor you use.  When I receive an e-mail from KeyBank, it’s easy to know they’re fishing because I’ve never had an account there.  When it comes from my own bank, it is easier to set my phishing concerns aside, but don’t!  That’s how they get their victims.

I looked at the web traffic on my blog, last night.  Fully a third of the traffic going to my site comes from European and Russian IP addresses.  I’m not too proud to admit it that I know they are not visiting my site to read my investment opinion.  We are up against a worldwide organized crime effort with computer skills that vastly exceed our own.  Fortunately, they tend to write in broken English.  But you can’t guarantee that will always be the case!

Another popular scam is to impersonate a relative in distress.  Using information gathered from Facebook, they can impersonate a grandson who needs bail money (please don’t mention it to his parents because he might get in trouble), or a granddaughter on the side of the road needing car repair money.  Double check all family distress tales before sending any financial help.  These scams are more prevalent than any of us want to imagine.  Of course, these days, the financial distress might come as a result of having bought Facebook shares when the stock came public!

ABM News just released a story about phantom debt collectors from India that harass Americans, demanding money.  Hundreds of thousands of cash-strapped Americans have been targeted by abusive debt collectors in a phantom debt collection scam. 

Retirement Outfitters recently invited an investigator with the Colorado Bureau of Investigation to the Tuesday Noon Lunch series and attendees received a rapid fire list of steps that can be taken to reduce the risk and impact of identity theft.  Here’s an abridged list of suggestions from that workshop.

1. Opt out of receiving junk mail so no one can steal a pre-approved application from your mailbox.
2. To protect against electronic “skimmers” that steal your card information when it is swiped, cover the keypad and pretend to type some extra numbers so that no one can learn your PIN code by watching.
3. Use a separate credit card for travel, or to carry with you, from what is used for monthly utility payments.  If the travel card is compromised, you don’t have to change payment instructions on all of the other accounts.
4. Monitor bank and credit card spending, online or through household spending software (like Quicken), or consider using a credit monitoring service.  The quicker the ID theft is discovered, the less you’ll have to unravel, later.
5. Rotate among the three major credit report services and use www.annualcreditreport.com to check for unusual activity every four months.  You get one free report per year from each service, so rotating among them allows you to check more frequently.
6. Determine if your credit card company offers a smart card, chip card, or integrated circuit card (ICC).  These cards can’t be effectively skimmed because authenticating data changes after each transaction.  However, some of these “contactless” cards emit a wireless signal that can be read by a nearby reader, so customers should also consider buying a credit card RFID blocking sleeve as well.

Retirees are targeted by identity thieves because they don’t use credit as often and are less likely to immediately notice when their card or medical identity has been compromised.  For this reason, retirees who aren’t borrowing money very often ought to consider putting a freeze on their credit record by contacting the three major vendors (Experian, Trans Union, and Equifax).  This can prevent fraudulent applications from being processed in the first place.

Children, newborns even, are also targets.  The beautiful part of stealing the identity of a baby is that it could be 18 years before they grow up, apply for credit, and discover that they already owe thousands of dollars in debt against their social security number.  The Social Security Administration, realizing that its formulaic way of determining social security numbers was part of the problem, is taking steps to make this more difficult.  For years, however, thieves could easily “guess” a new baby’s social security number and they would have an 18-year free pass to spend before they would be noticed.  Children would reach the age of 18 and immediately be faced with paying tens of thousands of dollars in debt.  This doesn’t happen as often as it used to, unless you want to include Congress among the list of criminals.

The Colorado Bureau of Investigation has a small Identity Theft unit, including a Victims Advocate.  The cases they work on usually span multiple jurisdictions, making enforcement action more complex.  The statewide hotline to report identity theft activity is 1-855-443-3489. 

Barbara Traylor Smith, Retirement Outfitters President, also received a stack of materials at the workshop to help educate Coloradans about identity theft prevention.  Email info@GJretire if you want to stop by Barbara’s office to pick up a packet.
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Rising Portfolio Cash Speaks to Market Concerns

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

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

 

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

 

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

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

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

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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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