In January I wrote two columns that served as exercises in speculative thinking. The second article described a scenario that might produce a bullish blow off in the markets during 2013:

But what if 2013 is the year in which fear fades from the backdrop? What if system risk in Europe dissolves, the U.S avoids a major debt ceiling fallout, and confidence returns to markets? What if CEOs start spending again, and retail investors trade in all that money parked in very low yielding bond funds for stocks? In short, what if this is the year where fear is replaced by greed? Improving confidence, diminishing fear, and huge amounts of liquidity could lead to a blow off overshoot to the upside in equities.

So far it looks like fear is indeed fading from the investment scene. It’s been a robust year in equity markets, with the domestic markets now up about 15%. Europe has had a few setbacks, but nothing like prior years. The fiscal cliff and debt ceiling have receded to the background and folks seemed to be piling into yield based stocks as they weigh the relative value between stocks and bonds. CEOs haven’t started spending yet, but global liquidity and central bank activism have more than made up for the current lack of capital spending. With the chase for equity returns heating up, one wonders how high this could go? We’re not entirely sure ourselves, but we’re keeping an open mind. The current environment of suppressed system risk, slow growth, and buoyant liquidity might take this up market farther than most think.

Just for fun, I’ll take a guess (and it is only a guess) at how high the market will go before it peters out. A 15 multiple on forward earnings would take the S&P 500 a little north of 1700. If the market achieves 1700, it would be about a 62% rally off the October 2011 bottom, and if it happened by the end of the second quarter the rally would span 600 calendar days. That would be close to the average cyclical bull market within a secular bear, which according to Ned Davis averages 66% in gains and 523 calendar days in duration. Of course, some think we’re now in a secular bull; if that’s the case the Ned numbers for those regimes are gains of up to 110% and over 1000 days in duration. We remain unconvinced that we’re out of the secular bear regime, though we’re also open to the fact that secular forces for stocks may have changed for the better.

Of course, this is all just a guestimate of where we could go if the current scenario continues to play out — this view does not drive our allocations. As risk managers in a low conviction market, we recognize that the high liquidity environment driving assets north does not come without big risks and unintended consequences attached. Our investment process tells us it’s getting late in both the business and market cycles; this is not a time to load up on risk. Despite my guess that the market could continue to confound by climbing higher, our weight of the evidence approach has us tucked close to benchmark levels of volatility, and utilizing sector and industry rotation to try to garner portfolio alpha. We’re riding enough of the market to make sure we participate in the liquidity wave while it exists, but we’re also watching for divergences that could be signs of a market top.

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I have been on the road quite a bit recently, appearing at several professional conferences around the country. One fellow speaker at a conference in San Diego was Dr. Christopher Geczy, a finance professor at the Wharton School and the new academic director of the Wharton Wealth Management Initiative. His impressive resume features a B.A. in economics from the University of Pennsylvania and a Ph.D. in finance and econometrics from the Graduate School of Business at the University of Chicago. Professor Geczy’s talk was both much anticipated and well received.

That will help provide some context for an email I later received from one of the conference’s sponsors (Bob is not his real name).

Hi Ken,

It was a pleasure to meet you (though only briefly) after your panel discussion at the SSG conference. After listening to your comments and reading a couple of your Pinnacle Monthly’s (I liked the Moneyball one), I was particularly interested in getting your feedback on Professor Geczy’s presentation (if you even had a chance to watch it), and otherwise your perspective on alternatives* and their place in client portfolios. I know you’re a busy guy, so I’d keep any conversation brief. But it would be great to get your feedback.

All the best,

Bob

Hi Bob,

Thanks so much for writing, and I appreciate your interest. I did see Professor Geczy’s presentation. He is obviously smarter than the rest of us by multiples so any comments I share should be read knowing the great respect I have for someone who has accomplished so much.

I only find alternative investments interesting to the extent that:

1. You need to “hedge” the risk and returns of traditional investment allocations in your portfolio.
2. The value proposition of any particular alternative investment is attractive based on traditional definitions of value.

If you believe that traditional asset classes will “misbehave” in the future, and if you are forced to own them, then alternatives are your last best refuge. The belief (hope, prayer) that somehow alternative managers (hedge funds or private equity) or alternative asset classes (timber, etc.) will deliver high returns with less risk and low correlations to traditional asset classes makes them look terrific in optimizing models that are populated with data that is based on past performance. If you believe that hedge managers are smarter than other managers; that alternative asset classes like timber, precious metals, managed futures, etc., will outperform; and that leverage properly used will add to returns, then by all means load up with alternative investments.

For our part, we prefer to manage risk by tactically changing the allocations in our portfolios based on our forecasts for markets. If we don’t like traditional equity positions, we are free to own less of them, or (theoretically) none of them, to manage risk in bear markets. I much prefer this to loading up 20+ percentage allocations to opaque and hard to understand alternatives. While we can and do own alternative investments at Pinnacle, we certainly own less of them than we did five years ago.

Using alternative investments to hedge fixed income positions seems more attractive to me than any other asset class. I can see several low volatility alternative strategies being added to Pinnacle portfolios in the future once the bond market finally breaks (which might still take some time). However, I find the long-term value equation for bonds to be frightening, so perhaps alternatives will find a home here as fixed income alternatives.

In closing, modern finance is filled with those who model the most “efficient” portfolios with models that depend on assumptions of returns, correlations, and variances that are no better than yours or mine. So the models — impressive as they appear to be — run the risk of seeming to be scientific when in fact they are no more than bottles of snake oil wrapped in the persuasive package of obscure Modern Portfolio Theory terminology and math that only ‘experts’ can understand. Don’t be fooled by any of this. Instead, concentrate on why asset classes will perform well in the future. What is the value equation for each of them? Your conviction in these answers should guide your investment philosophy.

I address much of this in my book, Buy and Hold is Dead (AGAIN): The Case for Active Portfolio Management in Dangerous Markets. You might enjoy it.

I hope this helps,

Ken Solow

* “Alternatives” refers to non-traditional investment strategies like hedge funds, or non-traditional asset classes like managed futures, commodities, timber, etc.

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So far in 2013, U.S. investors have enjoyed a steady climb in stocks, with the major market averages surging into record-high territory. There’s been a near absence of any sort of market volatility, with the CBOE Volatility Index (VIX) sliding to multi-year lows. Whatever the reasons behind the rally, it’s been gradually bringing back positive vibes on the part of market participants. In other parts of the world, however, the story is different: There’s been a greater degree of volatility in many international markets, and in general, international stocks have lagged behind the U.S.

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Over in Europe, stock markets continue to gyrate based on the latest developments in their ongoing debt crisis and weak economic data. After experiencing a big rally over the second half of last year, stocks cooled during the first part of this year in large part due to the surprising result of Italian elections and the botched bailout of Cyprus. After a sizeable rebound over the past couple of weeks, an ETF that tracks the MSCI Europe ex-U.K. Index (EZU, the red line on the chart) is now up a little more than 6% this year, compared to 15% for the S&P 500 (the blue line on the chart).

Emerging markets stocks have been surprisingly soft, considering how well U.S. stocks have been doing. Over the past few years, when risk is “on,” meaning risk assets are rallying, emerging markets have typically been big beneficiaries and tend to outperform. After being down by 8% through mid-April, emerging markets have also had a nice bump higher recently and are just about flat on the year (based on EEM, a large emerging market ETF; the green line on the chart).

The hottest market continues to be Japan. The Nikkei Index is now up by more than 37% this year (the purple line on the chart), as investors continue to respond favorably to aggressive stimulus measures.

We continue to believe that longer-term valuation opportunities have developed in some international markets. We came into the year thinking that it might be time to “go global,” and that the international outperformance experienced over the second half of last year had a good chance of continuing (especially if global economic growth began to improve). We’ve backed off that idea somewhat based on what’s occurred this year, but continue to keep an eye on these markets for signs that things are picking up again. In the near-term, it looks like the roller coaster ride will continue.

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There is an entire school of investing that would have you screening for stocks that are making new lows in price on the assumption that the best values can be found in that group. I recently wrote about the strange psychological wiring of value investors who believe that they can outsmart Mr. Market and find investment ideas that are mispriced by the crowd. They are supported in their belief by the study of momentum and crowd psychology which shows that investors often over react to bad news and sell securities at prices well below their intrinsic value. With steely nerves and an ability to see value that the rest of the market doesn’t see, value investors are the heroes of the professional investment universe (foremost among them, of course, is Warren Buffett).

On the other hand, there is a huge school of investors who search the universe of stocks looking for stock prices that have just made a new high. Making a new high in price is a magical moment for these investors because it means that everyone who had previously purchased the stock at the old high and wants to get out of the position to cover their losses has now already done so. In other words, if you bought a stock at $100 per share and it declines in value to $75 per share, you might be anxiously waiting for the stock to recover to $100 per share so you can sell it and escape your position without a loss. Identifying the highest price at which the ‘suckers’ purchased the stock in the past allows us to draw a line called price “resistance.” Until the stock (or the stock market) makes a new high, there are still sellers out there selling the stock as it moves higher in price. But once the stock makes a new high, then all of the resistance is gone, all of the prior buyers have sold, and now the price is free to soar without the baggage of selling by previous buyers. Wonderful!

In addition, by buying when a stock (or the stock market) reaches a new high, you can claim that you are free to participate in a longer-term secular bull market move, which implies that huge gains are just ahead. While the market may have rallied 100% (in our case it has rallied over 130% from the market lows in March of 2009 to the new high of 1569 last week), excited investors would gleefully and correctly point out that you can’t gain 1000% in the stock market without first gaining 100%, and then 200%, and then 300%, and so on. When the market makes a new high, it is a signal that the optimism of investors who had the nerve to buy at the lows was correct, and there’s still time for everyone else to get in on the action. It’s a great feeling for investors who completely missed the bull market cycle from the previous trough to a new high to know that the market can move higher still.

Those investors who screen for new highs are the complete opposite of investors who buy at new lows. Bottom fishers revel in the notion that they are being contrarian investors who are buying when there is “blood in the streets.” After all, you don’t buy umbrellas in a rain storm if you want the best price. But investors who screen for new highs revel in the notion that they are in sync with the crowd of investors. They believe that the market has all of the information it needs to make a good decision about stock prices, in aggregate; so if the market reaches a new high, it is signaling good times ahead. When the crowd of investors feels the same way about this very positive turn of events, then positive momentum in prices takes over and the thundering herd of bullish investors is free to take prices even higher.

Today’s financial news is filled with pundits taking one side or the other of the Value Versus Momentum debate. To my mind, both camps have a point. Pinnacle tends to view new market highs in the context of the current market cycle. In this case, the investment team has concluded that the cycle has more room to go… though the risks are increasing. We are now four years into the current bull market cycle that began in March 2009. It is worth noting that the last bull market in the current secular bear lasted five years, from 2002 to 2007. Needless to say, that bull market didn’t end well for investors. We continue to monitor the weight of the evidence in deciding whether risk taking is still warranted at this new peak in market prices. So far the answer is yes, but only at neutral or benchmark levels.

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The last two days in gold have been downright nasty, as it has lost roughly 13% of its value in that time. That is clearly not what one would have expected in a so called “safe haven” asset class. As always in markets, with a huge move comes big media attention when everyone gets to weigh in on why gold has plummeted over the past few days. Some say large hedge funds have been forced to liquidate, some think the safe haven trade is over, and some believe the great rotation might be a commodity rotation into equity.

I covered our reasons for selling gold in January in a prior column (“No-One told Gold About the Currency Wars”), and some of what I about wrote about clearly factored into why gold got thrashed the past few days. Given the magnitude of the recent move, I wouldn’t be surprised if the selloff blew up some hedge funds that were over-levered in the space. (Stay tuned on that.)

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Our decision to sell gold earlier in the year was a very good one, but it won’t show up as a big positive number on our statements. Our clients won’t see a plus 8%, even though — in just the last day — we saved them in excess of 8% absolutely, and 6% relatively by eliminating this position. That is a huge relative win, but it’s not the kind of win that can be easily quantified on a standard gain/loss report.

In our business good risk management is a key to long term success, and knowing when to avoid a big loser can be just as important as knowing when to own the next big winner. While folks naturally gravitate to what they own and how it did, sometimes the real story is about what they don’t own.

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The way we explain our process for managing portfolios has significantly changed over the past few years. It seems that both retail and institutional investors want to hear more about how ‘the sausage is made’ than they did a decade ago. And why not? The financial markets have been difficult to navigate since the market topped in the year 2000 and good consumers want to know how we might fare if the markets remain challenging in the future. While I appreciate the work that has gone into fine-tuning our message, one aspect of our investment process is just as relevant as it was when we started tactically and actively managing portfolios in October 2002: We try to find investment opportunities that have a great story.

For us, a great investment story typically involves fundamentals, market psychology, or traditional valuation – or some combination of the three. (Astute followers of our investment process will recognize these points as the three ways we determine value as a value investor.) One of the trickiest stories to tell has to do with traditional value, because there are trainloads of data supporting the idea that if you purchase a security when it is cheap there is a high likelihood that you will earn above average returns over a long period of time in the future. The problem is that investors reward securities with cheap valuations for a good reason (typically cheap valuations accompany investment stories where there are significant problems with the underlying investment), and markets and individual securities can remain cheap for an exasperatingly long time.

The investment universe is awash in stories that begin with a great value proposition, as defined by low price to earnings, price to book, price to sales, relative performance, absolute performance, intrinsic value, and so on. The key is to find a value story that includes a catalyst that allows you to profit when the rest of the market gets around to seeing the same value opportunity that you do. Value investors are often the most obstinate of characters, convincing themselves that they are correct in their assessment of value and the rest of the market is wrong. It takes chutzpa to win the value investing game. Furthermore, valuation stories often take a long time to play out (and the financial markets delight in letting us know that our analyses is faulty or our timing is wrong). But when you get it right… these stories often offer the biggest gains.

The Dangers of Storytelling

One of the problems with investment stories is that they are too easy to tell to our clients – they make everyone feel good because the narrative always has a happy ending. Americans are aging, so investing in health care companies will be profitable. America is becoming energy independent, so investing in energy companies will be profitable. China has a high rate of GDP growth, so investing in emerging markets will be profitable. Unfortunately, while all of the above may be true, they may not be true in a time horizon that is meaningful for our investors.

In other cases, the cast of characters in our story changes — or the news changes the plot — and then the story doesn’t make as much sense as it once did. Our current “go global” story is a good case in point. In the case of Europe, the story goes something like this: By uttering the words, “We will do whatever it takes” to maintain the viability of the common European currency, Mario Draghi, President of the European Central Bank, changed the investment landscape. While Europe has many fundamental problems to deal with, the fears of a systemic meltdown in the European Union are misplaced. Therefore, European markets offer good value since many European economies are in recession, or are close to recession, and stocks in many countries are trading near their all-time lows (as opposed to the U.S. stock market which is trading right at its all-time high). Investors should buy while there is ‘blood in the streets,’ and Super Mario (as named by our investment team) will save us from any major market collapse while we wait for the excellent value in Southern European countries to be realized.

The problem is that voters in Italy didn’t get the memo and recently had an election with results that frightened those who want to see the austerity measures favored by the ECB carried out. Additionally, the EU has resolved a sovereign bank crisis in the tiny country of Cypress in a way that has also alarmed investors. The net result is that the cast of characters for the Europe story may be changing, and the resulting plot twist may not be to our liking.

Story telling is a great way to explain what we are doing in terms of managing money, but there’s a risk that investors forget that stories can change. Pinnacle analysts are tasked with monitoring every aspect of the stories we invest, and if the story changes, we respond accordingly. For us, these changes are nothing more than business as usual. For example, we are restructuring our European positions and will be selling some to invest in what (to our eyes) represents an even better story.

If you want to know what’s happening in your portfolio, listen to the stories we’re telling, and recognize whether the plot is about fundamentals, market psychology, or traditional valuation. Our next investments will take advantage of one or all of them, and will also have a catalyst to get the prices moving in the right direction within a period of time that is acceptable to all.

The plot thickens….

The post Telling Investment Stories appeared first on Pinnacle Advisory Group.

J.C. Parets with Allstarcharts.com does fantastic technical work, and he is telling his readers to watch the Yen/USD exchange. The chart below shows this relationship; a falling line means that the Yen is gaining against the U.S. Dollar. The Yen is rallying hard today on the back of a manufacturing miss here in the U.S., and is pushing below some key technical levels. The short term uptrend marked in white has been broken, the $94 support/resistance level has been broken, and the 50 day Moving Average has been broken. A stronger Yen seems to be the play here.

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This is important, because the Yen has been the Safest of Safe Havens, according to Parets. If we analyze the correlation data between the Yen and the S&P 500, we find a -.93 correlation over the past month, -.96 for the quarter, and -.77 for the trailing year. Money flows into this asset class when equity investors start to sell.

The post Is the Yen Moving Higher Again? appeared first on Pinnacle Advisory Group.

With the payroll tax in effect and the sequester beginning to slowly phase in, many have worried that the U.S. economy is on thin ice. But those looking for the economy to fold might have been caught off-guard with the economic data starting to surprise on the upside since the beginning of February.

Thursday we had the conference board leading indicators, Philly Fed, and Market preliminary PMI surprise expectations to the upside. Existing home sales did ease and buck the trend, but one quick look at the U.S. Citigroup Surprise Index (on right) shows that on balance the U.S data is coming in better than the muted analyst estimates.

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I wouldn’t dismiss the fact that the payroll tax, the sequester, and higher gas prices are all headwinds pressing against the U.S. expansion. And I also wouldn’t be surprised if the market corrects at some point in the near future since it’s overbought after its impressive start to the year. But beyond a healthy correction, I would say that the continuing improvement in housing, jobs, and leading indicators will likely allow the economy to fight off these headwinds and continue a slow growth profile.

Tactically, it might be time to dial down the enthusiasm a little. But don’t get too bearish here, because the data is getting better, the Fed Chairman is supporting the economy and asset  prices, and slow growth plus flush liquidity is usually a pretty good environment for asset prices.

The post Surprise! U.S. Data is Picking Up appeared first on Pinnacle Advisory Group.

One concept that is common in the investment world is the idea that assets will typically revert to the mean (the average). This may seem a bit contrarian since it essentially means that when an asset price returns in excess of its long term average return profile, over time it will likely reverse course and return to that long term average. Imagine a rubber band that gets stretched…. and then eventually snaps back to its normal size.

But that’s not always the case. As famous technician John Roque often says, “we are in a reversion beyond the mean business, and not just to the mean.” The core point here is that markets can (and often do) overshoot to the upside and the downside.

This applies to today’s markets. Many are looking for the correction that should materialize any second, while others are looking for a big drawdown that might be coming as soon as the Quantitative Easing rig is up. But how many are expecting a liquidity based overshoot or a reversion past the mean to occur before this cyclical market is over? True, there are many scary scenarios that could unfold if the wrong things happen. But it’s also true that central bankers seem focused on producing growth in asset inflation to promote a wealth effect in the economy, and are throwing trillions of dollars into the global hopper to make that happen.

There are no guarantees in life except death and taxes, and with the short term complacency, a correction could break at any moment. I’d give as much respect to the possibility of a reversion past the mean to the upside as I would to a market meltdown, given present conditions. It’s dangerous out here, but as Roque said, this is a reversion past the mean business. If this kind of liquidity can’t produce an overshoot, I’m not sure what would.

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In a blog post I wrote in June 2012 (“Under the Hood of the New Manufacturing Report”) I wrote about the difference between the New Orders component and the Inventory component of the Manufacturing PMI, and how it tends to lead the overall PMI by about three months. Today, I want to look at how this indicator has performed since then, and what it is signaling for the near future.

At the time the previous post was written, the “New Orders minus Inventory” indicator was suggesting the Manufacturing PMI would rise over the following three months, as indicated in the chart by the rising blue bars from June through September of last year. That however was not the case, as the PMI actually declined from 52.5 in May to 50.7 in August. In this indicator’s defense, other factors may have played a role in the result. For one, the n-th European scare was taking the stage at the time, accompanied by bear market-size declines in many European stock indices. That may very well have invalidated the message given by the “New Orders minus Inventory” indicator in the previous months by putting a temporary lid on economic activity.

Following this temporary malfunctioning, the indicator resumed its leading role in September, by capturing the renewed weakness in the PMI going into November, as well as the recovery through February, when the PMI reached the current level of 54.2. Going forward, the indicator is projecting a small incremental advance in March, followed by some weakness in April and a subsequent recovery to the previous level in May. Pending another major shock with the potential to change the economic picture, the current trend points toward manufacturing activity holding (more or less) steady at the current level of moderate expansion.

As always, only time will tell.

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