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One for the Road
July 26, 2010
“Our approach to asset allocation is focused on wealth preservation by controlling the overall exposure to risk assets in relation to macro conditions, valuation and market psychology. We are not attempting to forecast the specific performance of various asset classes as a means of facilitating market timing decisions, as history has shown that this is rarely a winning strategy. Rather, we will attempt to provide analysis that will help investors play a more active form of defense and offense with their portfolios. In order to achieve these goals, we favour a dynamic approach to asset allocation, reviewing the portfolio and making adjustments on a quarterly basis or as conditions evolve, rather than sticking with fixed allocations come ‘hell or high water.’ Systemic risk in the global economy is far higher than in the previous post-World War II years, volatility promises to remain extraordinarily high and the financial system may be subject to major shocks. This is a major theme running through The Great Reflation. In such an environment, a buy and hold approach to asset allocation will carry a lot more embedded risk than most people expect.”
“In practice, the execution of dynamic asset allocation is subjective and highly complex for global investors. Many attempts have been made to create models or algorithms that rely on indicators to calculate an optimum asset allocation. However, this sort of quantitative approach inevitably breaks down as the assumptions that underpin the model cannot fit every set of economic conditions. We use indicators selectively to inform decision-making, but at its core, asset allocation is an art, involving equal measures of analysis, intuition and common sense. Above all, investors must have a clear idea of their tolerance for risk, exercise discipline and stick to a plan. Some prefer one of rigid allocations and the literature tends to support this approach. We favour a dynamic allocation process which allows for some flexibility in order to better control risk at important market junctures (e.g. stocks in 1999, housing in 2006-2007).”
...Tony & Rob Boeckh, The Boeckh Investment Letter
I have often opined that asset allocation is the key to bringing alpha (read: outperformance) to portfolios. I have also stated I am not dogmatic about asset allocation. For example, I have not owned bank stocks for eight years. I “missed” them going down and have “missed” them going up. Obviously, I agree with the Boeckh’s more “dynamic approach to asset allocation.” To be sure, for years I have advised participants to think of investing for the future as an automobile, conveying investors to their financial goals. The investment portfolio is its motor, the asset allocation model is the fuel mixture, and the invested assets are the fuel. As John Valentine, of Valentine Capital, notes:
“The more efficiently the motor runs, the greater the speed with which the whole vehicle travels toward the destination. Should the fuel mixture, or asset allocation, run too rich, the motor wastes precious fuel. Should it run too thin, the car has trouble achieving enough forward momentum... Many individuals on the road to their financial goals fail to make these periodic adjustments and still eventually arrive. Not surprisingly, the investor who rebalances his portfolio at regular intervals may arrive sooner and with more fuel in his tank... Rebalancing a portfolio is crucial to the investor seeking to reduce the volatility in a portfolio and increase cash flow simultaneously... The longer a portfolio is left unbalanced, the more compromised its asset allocation may become. There are two potentially negative repercussions associated with a compromised allocation: being overexposed to the downside and underexposed to the upside. Don’t let this happen to you!”
I revisit asset allocation today because I think we are approaching a point where rebalancing portfolios may be in order. To wit, the June “closing highs” for the DJIA (INDU/10424.62) and the DJTA (TRAN/4369.71) were 10450.64 and 4467.25, respectively. Currently, both averages are approaching those levels. Either both averages will break out above their June highs (a Dow Theory buy-signal), one will break out and the other won’t (an upside non-confirmation), or both will fail to close above their June highs (trouble). Meanwhile, my proprietary intermediate-term trading indicator is still flashing caution, as are the stochastic and 12-month moving average indicators. That said, I have been constructive on the stock market since the beginning of July despite the parade of negative indicator events registered since the April peak. My bullishness was driven by the most oversold reading since the “capitulation alert” of October 10, 2008 when 93% of stocks traded on the New York Stock Exchange made new annual lows. Regrettably, the extreme oversold condition that existed three weeks ago has now been largely erased. Accordingly, this week shapes up as a pivotal week and I will be watching the action closely.
While in the short-run the stock market is a beauty contest (picking the “prettiest” stock), over the long-run it is a weighting machine. Plainly, the “weighting machine’s” metric is earnings. To that point, this earnings season has been pretty good with about 76% of the S&P 500 companies reporting positive earnings surprises and ~70% showing upside revenue surprises. Interestingly, of the S&P’s 10 macro sectors, Technology’s weekly forward earnings per share are at a record high. Since the bottoming process began (October 2008) I have emphasized technology stocks. Most recently, I have talked about Microsoft (MSFT/$25.81) and the potential for a huge upgrade cycle. Coincidentally, the invaluable GaveKal organization wrote this last Friday:
“In a recent ad hoc comment (Is It Still Time to Overweight Tech?), we highlighted that the average PC used in US companies is now six years old and has a DRAM memory of 2.5GB – both of which lag US consumer PCs. Along the same lines, it is estimated that 75% of US business PCs still use Windows XP... a point that came home to roost yesterday with Microsoft's very impressive earnings: thanks to a +21% YoY jump in global PC shipments last quarter, Microsoft reported sales of 175mn copies of Windows 7, making this latest flagship product the fastest selling operating system ever. And given that Windows 7 is not even twelve months old yet (the typical span of time for CTOs to appreciate a new operating system and decide whether to upgrade their firms' software and PCs), there could well be a whole lot more to come. Thus, Microsoft's numbers, coming hard on the heels of similarly strong numbers out of Intel, raise the possibility that we could be witnessing the dawn of a new PC cycle.”
I like tech! Using my proprietary intermediate-term trading indicator, I screened all of the technology stocks in our Analysts’ Current Favorites list and found the following tech stocks to be favorably positioned: Iridium (IRDM/$10.26/Strong Buy); NII Holdings (NIHD/$39.88/Strong Buy); Nuance (NUAN/$16.95/Strong Buy); and PAREXEL (PRXL/$24.29/Strong Buy). Remember, however, that in the short-run the stock market is a beauty contest and what happens this week, as we approach the June reaction highs, should determine the near-term price action for most individual stocks.
The call for this week: When I entered this business, some 40 years ago, one of my mentors told me to put 20% of my money into Treasury Bills, 20% into stocks, 20% into bonds, 20% into precious metals, and 20% into real estate. Clearly I have not followed that advice, although vetting it over a long-cycle shows it has a pretty decent track record. More to my liking is the attendant asset allocation chart, which has nothing to do with ANY of the Raymond James Asset allocation models, but rather how I would structure a “businessman’s risk” portfolio. For international exposure, I would use funds like MFS International Diversification Fund (MDIDX/$11.71), which just got the mandate to increase its exposure to emerging markets. For fixed income, I would use funds like Putnam Diversified Income Fund (PDINX/$7.95), which as a side note was included in a report from our Mutual Fund Research Department last week. And for precious metals, I continue to like OCM Gold Fund (OCMGX/$24.21), which is managed by my friend Greg Orrell. And don’t look now, but crude oil ($78.98/bbl. basis September future) traded above its 200-day moving average ($77.69) last week, which is a step in the right direction for our energy investments.
Don’t Bet the Farm!
July 19, 2010
“In 1965 Steve McQueen starred in The Cincinnati Kid, the classic poker movie of all time. This movie has so far saved me from becoming ultra-broke or ultra-rich. The climactic scene in the movie involves a showdown hand of five-card stud between Steve McQueen (“the Kid”) and Edward G. Robinson (“The Man”). This scene made an indelible impression on me during my school years. With three cards dealt, Robinson bets heavily on a possible flush, a stupid bet if there ever were one, particularly since McQueen has a pair showing. The pot gets bigger and bigger. McQueen ends up with a full house – aces over tens, which loses to Robinson’s straight flush. When Robinson turns his hole card, the jack of diamonds, McQueen looks as though he is going to throw up. He has been wiped out. The movie’s soundtrack is throbbing. Sweat is dripping down McQueen’s face, as he stares at Robinson’s hand in disbelief.”
... Frederick E. Rowe Jr., Forbes
I am familiar with cards, dice, and betting in general. While in college I supplemented the monthly stipend from my parents with the winnings from playing cards. The bluffing, the betting, the showdown was all great drama to me. Back then I learned the “one chip” rule. To wit, each time I won two chips I would put one of them into my pocket, not to be used again that night. When I entered this business in 1971 I found that same kind of strategy useful in managing risk. In the stock market’s case, while the human natures of fear, hope, and greed still play a large roll, I tended to substitute card players with the personalities of stocks, the market makers, the Fed, Washington, and the politicians. Using such strategies I found that if you do your homework, and manage the risk, the odds of success in the markets are much better than a card game. When you lose in the markets at least you get back most of your money (if you manage the risk) and the government shares in a portion of your losses via the capital gains/capital losses tax system. In a card game it tends to be basically all or nothing with each hand.
Subsequently, I practiced and honed my market skills in the early 1970s on a trading desk, chalking up my early “lumps” to learning the game and paying my dues. Later on I started winning fairly consistently by sticking with well-defined rules to guide my decisions and by managing the downside risk. Indeed, managing the risk is crucial, for like Mr. Rowe I too remember “The Cincinnati Kid” and while Steve McQueen made the “intelligent” bet (consistent with the odds), “The Kid” made one big error... you do not bet the farm no matter how good the hand looks. Or as one savvy seer suggests, “If you’re going to bet the farm, you had better have two farms!” Manifestly, in life, in cards, in the markets, anything can happen and you never take that “bet the farm” kind of chance because occasionally “The Man” hits the long-shot and you’re busted.
I reflected on mathematics, probabilities, and odds last week after again reading the book “Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street” by William Poundstone. The book centers on Claude Shannon, who in the late 1940s had the idea computers should compute using the now familiar binary digits 0s and 1s such that 1 means “on” and 0 means “off.” Shannon’s information theory is what lies behind computers, the Internet, and all digital media. As the book notes – when asked to characterize Shannon’s achievement, USC’s Solomon Golomb said, “It’s like saying how much influence the inventor of the alphabet has had on literature.” In 1956 Claude Shannon and John L. Kelly turned their skills on how to mathematically “win” at the casinos and eventually on how to “win” in the stock market. Those mathematical insights were subsequently employed by the phenomenally successful hedge fund Princeton-Newport Partners. While there were many formulas for their success (edge/odds; Gmax = R; etc), the manner in which Shannon rebalanced portfolios was elegantly simple. To reprise some lines from the book:
“Consider a stock whose price jitters up and down randomly, with no overall upward or downward trend. Put half of your capital into the stock and half into a ‘cash’ account. Each day, the price of the stock changes. At noon each day, you “rebalance” the portfolio... To make this clear: Imagine you start with $1000, $500 in stock and $500 in cash. Suppose the stocks halves in price the first day. This gives you a $750 portfolio with $250 in stock and $500 in cash. That is now lopsided in favor of cash. You rebalance by withdrawing $125 from the cash account to buy stock. This leaves you with a newly balanced mix of $375 in stock and $375 in cash. The next day, let’s say the stock doubles in price. The $375 in stock jumps to $750. With the $375 in the cash account, you have $1,125. This time you sell some stock, ending up with $562.50 in stock and cash. Look at what Shannon’s scheme has achieved so far. After a dramatic plunge, the stock’s price is back to where it began. A buy-and-hold investor would have no profit at all. Shannon’s investor has made $125.”
I have often written about portfolio rebalancing as one of the keys to successful investing. And, while Shannon’s simplistic example is too short-term oriented for me (aka, day-to-day or even week-to-week), I am intrigued with it. For example, say you put $100,000 into a cash account and similar $100,000 into Raymond James’ “Analysts’ Best Picks” (ABPs) and then rebalanced the portfolio every other month, or at the end each quarter, using Shannon’s methodology. Another approach I have recommended for the ABPs is to scale buy them by purchasing one-third when they are released in December, one-third sometime in January, and the final one-third in February. This strategy also makes sense because history shows many of the ABP’s stocks can be purchased below their original recommended prices sometime during the first quarter of the new year. As a sidebar, Shannon’s rebalancing methodology could likewise be employed with this scale-in buying approach. I think these types of strategies can improve the odds of success for most investors.
Speaking of odds, what are the current “odds” for the stock market? Well, two weeks ago I suggested that despite all the often mentioned negative technical readings following April’s stock market peak, the markets were almost as compressed (read: oversold) on a short-term basis as they were when the bottoming process began in October 2008. Further, a week ago I opined the real upside challenge should come at the S&P 500’s (SPX/1064.88) 50-day moving average (DMA), which last Monday stood around 1100. The very next day the SPX “tagged” an intra-day high of 1099.46 and from there spent the rest of the week on the defensive; that is until “Friday’s Fall” of 2.9%. Of course Friday was option expiration expiation, so the downside dump was probably exaggerated. Nonetheless, it did raise questions if my hunch that the 1040 – 1050 level would contain any selling is correct.
Obviously time will tell, but as the equity market slid into its July 1st lower lows Lowry’s Selling Pressure Index was 17 points lower than it was at the May intra-day “lows.” As Lowry’s notes, “When Selling Pressure begins to consistently contract, despite new lows in the major indexes, such a divergence usually indicates the desire to sell has been largely exhausted; and, the end of the decline may be near at hand.” Moreover, following the 90% Downside Days of June 22nd, 24th, and 29th quickly came a 90% Upside Day. Then on July 13th another 90% Upside Day was registered. Such sequences often mark the beginning of a rally. If so, the bulls’ case would be dramatically bolstered with a decisive move above the SPX’s 200-DMA at ~1112, with a subsequent confirming upside breakout above the June 21st intra-day reaction high of 1131.23. Until this occurs, I am content to remain flat in trading accounts, yet continue to position favorable stocks for investment accounts. In past missives I have mentioned investment names like: Enterprise Products Partners (EPD/$37.53/Strong Buy); Intel (INTC/$21.02/Outperform); Wal-Mart Stores (WMT/$49.67/Strong Buy); Allstate (ALL/$27.83/Strong Buy); and Microsoft (MSFT/$24.89), which is followed by our research correspondents with a favorable rating. Note that ALL of these names have decent dividend yields. And again this week, I reiterate YIELD, suggesting you reread this quip from last week’s missive:
“Speaking of yields, I spent an hour last week talking with the head portfolio manager of Putnam’s Fixed Income division. Rob Bloemker manages roughly $50 billion and has 70 professionals working with him. While pessimistic about many things, Rob is personally buying stocks. Because earnings tend to grow at the same rate as GDP, with the S&P 500 trading at a P/E multiple of 13, and an earnings yield (earnings divided by price) of 6 – 7%, Rob believes stocks will return 6 – 10% above the rate of inflation. ‘Wow,’ I said, ‘That’s pretty bullish equity talk from a fixed income manager!’ But of more interest was his discussion about Putnam’s Diversified Income Fund (PDINX/$7.94), which Rob thinks will give investors equity like returns over the next three years without the concurrent risk of equities. With duration of 2.06 years, and a 10% loss-adjusted return, I would agree.”
The call for this week: Place your bets!
A Man Lived by the Side of the Road ...
July 12, 2010
“... and sold hot dogs. He was hard of hearing, so he had no radio. He had trouble with his eyes, so he had no newspaper. But, he sold really good hot dogs. He put up a sign on the highway telling how good they were. He stood by the side of the road and cried, ‘Buy a hot dog, mister.’ And people bought. He increased his meat and bun orders and he bought a bigger stove to take care of his trade. He got his son home from college to help him. But then something happened. His son said, ‘Father, haven’t you been listening to the radio? There’s a big depression on. The international situation is terrible and the domestic situation is even worse’.
“Whereupon the father thought, ‘Well, my son has been to college. He listens to the radio and reads the papers, so he ought to know.’ So, the father cut down his bun order, took down his advertising signs and no longer bothered to stand on the highway to sell hot dogs. His hot dog sales fell almost overnight. ‘You were right, son,’ the father said to the boy. “We are certainly in the middle of a great depression’.”
...Author Unknown
Depressions, and recessions, are even more difficult to predict than the stock market. Yet, most economists agree the recession ended around this time last year. Currently, the question du jour is whether the economy is going to slip back into recession; aka ...the dreaded double-dip. While there is always the chance of a double-dip, they are pretty rare. For example, using industrial production as a “measuring stick,” there have only been three, out of the 38 recessions since 1880, which qualify as double-dips. Interestingly, all three of those double-dips were characterized by a mild first recession followed by a more severe secondary recession. Plainly, what we experienced in the 2007 – 2009 recession was anything but mild. Accordingly, I continue to think the odds of another recession are low. There is the risk, however, like the man “who lived by the side of the road,” we “talk” ourselves into a recession.
At present, while the economy has hit a “soft spot,” the odds of a sliding into recession are indeed low. To this point, our friends at Credit Suisse constructed a Six-Month Recession Probability Model that puts the odds at zero, as can be seen in the nearby chart. Said model is comprised of:
1) Real Fed Funds Rate (level)
2) S&P 500 (6-month % change)
3) Private Non-farm Payroll Growth (6-month % change)
4) Single-Family Housing Permits (6-month % change)
5) University of Michigan Consumer Expectations Index (6-month % change)
6) Initial Jobless Claims (YoY% change)
7) “TED” Spread (spread between 3-month LIBOR and 3-month T-bill yields)
8) Relative Price of Energy (deviation from trend)
Dating back to 1964, the model has registered only one false signal. That signal occurred in 1984 and is likely attributable to the Continental Illinois banking crisis. As the model’s title suggests, the average lead time from when a signal is registered and a recession begins has been 5.7 months. To reiterate, the model indicates there is zero probability of another recession. Yet, over the past few months, the stock market has been transfixed by the possibility of a “double dip.”
To be sure, Mr. Market has been manic this year having peaked in mid-January and then sliding by over 9% into early February. Fortunately, I entered the year in a cautious mode with the mantra, “I think the trick in 2010 is going to be to keep the profits accrued to portfolios since the March 2009 lows.” Also fortunate is that we identified those early February “lows” and tilted accounts appropriately. Not so fortunate, I turned cautious in late-March, yet the S&P 500 (SPX/1077.96) continued to rally into my long envisioned 1200 – 1250 target zone. Nevertheless, during the rally over much of the month of April I recommended the purchase of downside hedges, as well as “bets” on increased volatility, as a hedge for the “long” positions in investment accounts. Subsequently, I recommended selling those hedges in the weeks following the “flash crash” of May 6th. Therefore, coming into last week I opined:
“Since the flash-crash low, we have had a Dow Theory ‘sell signal,’ a sell-signal from my proprietary intermediate trading indicator (the first since December 2007), the monthly stochastic-indicator has turned negative, a downside violation of the 12-month moving average has occurred, most indices have broken below spread triple-bottoms and in the process traced-out a head and shoulders topping pattern in the charts, and most recently we got a ‘death cross’ when the S&P 500's 50-day moving average (DMA) crossed below its 200-DMA. All of this suggests a cautious stance on stocks. Indeed, of all the vehicles I monitor, only the Yen, Gold, Silver, and Fixed Income are higher for the month of June, the 2Q10, and year-to-date. That said, such extreme downside readings typically imply stocks have been too compressed on a short-term basis and consequently a rally may be in order.”
Obviously, we got that rally last week. And, the rally came within “spitting distance” of the 1080 – 1100 target zone I spoke of in my verbal strategy comments early last week. In the near term, I think any pullback will be contained in the 1040 – 1050 zone. In the intermediate/longer-term I remain cautious due to the aforementioned metrics. In such an environment I think risk adjusted stock selection, and risk management, will be the keys to portfolio performance. I was particularly struck by a phrase a gentleman I know used on CNBC last week. Bill Fleckenstein remarked, “If you can’t make money in stocks like Microsoft and Intel, then you probably can’t make money in the stock market.” Both Microsoft (MFST/$24.27), and Intel (INTC/$20.24/Outperform), are names I repeatedly recommended for investment accounts during the bottoming process of October 2008 through March 2009. At the beginning of July 2010, I revisited these names given their precipitous declines. You can read my analyst’s reports for the story on INTC. MSFT is followed by our research correspondent with a favorable rating. Hereto the story is simple. MSFT has $3.50 per share in cash, possesses a pristine balance sheet, throws off tons of cash flow, sports a 2% dividend yield, and ex-cash per share is trading at 10x this year’s earnings estimate. If Raymond James is typical of corporate America, we are just now switching to Windows 7 (having skipped Vista), which implies a new upgrade cycle for MSFT.
Other names on my investment account “shopping list” include: Enterprise Product Partners (EPD/$36.43/Strong Buy), Allstate (ALL/$29.44/Strong Buy) and Walmart (WMT/$49.43/Strong Buy). Walmart’s story is also simple; it is likely a high single-digit revenue grower, a low double-digit earnings grower, it adds 3 – 4% of floor space per year for as far as the eye can see, the company is buying back a lot of shares, and it trades at a discount to the group. Indeed, WMT is being valued as if it were purely a grocery store chain despite the fact 50% of its revenues are not food related. Even if it were only a grocery store, it should command a premium valuation because it “does it” better than anyone else! As a sidebar, there is a feature story in Barron’s this week about how “cheap” Wal-Mart shares are. Note, all these recommendations have decent dividend yields.
Speaking of yields, I spent an hour last week talking with the head portfolio manager of Putnam’s Fixed Income division. Rob Bloemker manages roughly $50 billion and has 70 professionals working with him. While pessimistic about many things, Rob is personally buying stocks. Because earnings tend to grow at the same rate as GDP, with the S&P 500 trading at a PE multiple of 13, and an earnings yield (earnings divided by price) of 6 – 7%, Rob believes stocks will return 6 – 10% above the rate of inflation. “Wow,” I said, “That’s pretty bullish equity talk from a fixed income manager!” But of more interest was his discussion about Putnam’s Diversified Income Fund (PDINX/$7.99), which Rob thinks will give investors equity-like returns over the next three years without the concurrent risk of equities. With a duration of three years, and a 9 – 10% loss adjusted return, I would agree.
The call for this week: I am leaving for the Raymond James National Conference in Boca Raton, so these will likely be the only strategy comments for the week. That said, in a past life I wrote fundamental research on container board companies. Currently, those companies are raising prices, which only happens when demand warrants. Then too, rail traffic is increasing and diesel fuel consumption is rising, another metric that is inconsistent with a double-dip recession. Moreover, the number of Manhattan apartment rentals doubled in 2Q10 on a YoY basis, while office vacancies in U.S. metro areas fell in 2Q10 vs. 1Q10 for its first drop since 2007. Ladies and gentlemen, these are NOT the metrics of a double-dip recession! Meanwhile, since 2008 there has been almost NO difference between the forward PE of the S&P 500 Growth and Value composite indices. Obviously, this favors growth versus value, which is why I have been emphasizing Technology in these missives. This morning, however, the pre-opening futures are lower on rumors that Deutsche Postbank had failed the stress test. Nevertheless, I think the selling will be contained and in the short- term be resolved with higher prices. The real upside challenge should come at the S&P 500’s (SPX/1077.96) 50-day moving average (DMA), which currently stands at 1100.30, and the 200-DMA at 1111.60. Longer term, I remain cautious.
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