Archive for the ‘View on Market’ Category

Should you be a buyer or a seller between now and year-end? That seems to be the question on everyone’s mind as we enter December. The answer is, of course, that it depends. If you were wise enough to invest early in this bull market you should be considering peeling back some risk at this point.

That is, reducing your level of investment in high yield bonds and/or low-quality stocks. We would not advise abandoning them altogether but taking some reasonable profits. If, on the other hand, you are late to the party and are now thinking about taking money from the sidelines and placing it back into the market we would suggest you do that with caution. Specifically, you don’t want to chase gains that have taken assets to above fair value. Many parts of the market are currently overheated and likely will not produce above-average results going forward.

Looking at it in another way, you need to determine whether the odds are on your side or against you going forward. They certainly don’t seem to us to be strongly in your favor. On the other hand, we certainly have no reason to be sure that the market will not continue to run from here. A plan to cautiously reinvest might be the most prudent. You could plan to buy into the market monthly for the next six or eight months. If we did then see a market correction, you could use that opportunity to alter your plan and  purchase more aggressively into the market.

Your focus should be on buying high quality assets on which you have conviction that they will do well for years to come. That should be a recipe for success as we move forward through turbulent waters.

The market surge continued this month, though perhaps sanity is beginning to finally come back to the table. For the first time during this huge rally, quality seemed to matter a bit. The Russell 2000 (an index of 2000 small companies) has fallen to its 90 day trading average while the indexes of larger companies continue to trade well above their average. We see this as a trend that is likely to continue for quite a while. We have no idea whether this market is at a top right now, but we do know that the risks are growing that we could see a correction at any time. When the correction comes, do you want your portfolio focused on quality companies selling at average prices or low quality companies with no current earnings? To us, that is one of the easiest questions to answer that we have seen. The strategy, oft times referred to by Jeremy Grantham, is known simply as “survive to fight another day”. If you own good quality companies with earnings and dividends, they will still be around in a couple years even if we hit another large market slide. We can’t say that is true about owning a small company with no earnings in this economic environment.

On the flip side, we also expect the higher quality stocks to outperform should this market continue to escalate. These companies have good earnings, fair pricing, cash on hand, etc. Their future is bright, they have to wear shades! On the flip side, we continue to have a negative outlook for the Russell 2000 stocks.

In currency, we think the dollar may have a short rally in coming months, followed by a return to weakening against emerging market currencies. While we hope to participate in this area, we are not rushing into it with guns a blazing as we think the dollar may rally for a bit first.

Lastly, do we think the economy is fixed or sinking? That seems to be the topic that everyone is weighing in on. Our belief is that it was not as bad as most thought last November and isn’t as good as many think this November. We think things are getting worse more slowly and that the turnaround will be slow and muted from here. That seems to us to denote a period of slow growth and small returns, not the continuation of a huge bull market that   will make us all rich.

We spent a day recently with a group of advisors who cling to all the orthodoxies of financial services (Modern Portfolio Theory, static asset allocation, etc.). According to them, all you need to do is divide up your money into a bunch of style boxes (e.g. large company value stocks) and keep it there. We know that this has been a dangerous belief for the last decade and we think it will continue to be dangerous in the future.   But, it got us thinking about what people still call “modern”.

Modern Portfolio Theory basically states that the selection of assets (stocks, bonds, and cash) is the major factor in determining risk and return for a portfolio. It was developed in the 1950s by Harry Markowitz. That is over 50 years ago. Is it time to re-consider whether we need something even more “modern”? Markowitz, of course, never talked about the style boxes that have become part of the orthodoxy of financial services. Style boxes were invented by Morningstar in the early 1990s. So, a marketing scheme that was invented more than thirty years later has come to be considered by many financial advisors to be an essential part of “modern portfolio theory”. What else has transpired since this modern theory was published?

Hawaii and Alaska became states the year that Markowitz’ book was published.

WalMart was founded in 1969, a decade later.

The NASDAQ stock exchange began in 1971.

The first color television broadcast was in 1974, 25 years after the “modern” theory.

The term personal computer was first coined in 1975.

Enron did not come into existence until 1985.

The World Wide Web was invented in 1989.

So, we shouldn’t throw out Markowitz’ theory because of its age, but we need to consider whether or not it still applies and perhaps tweak it a bit if it is to be relevant in the 21^st century. A few things may have changed during the past 50 years! Perhaps most importantly, his message has been transformed to mean what the financial services industry wanted it to mean rather than what he actually said. He never told anyone to fill a bunch of artificial “style boxes” and hold on to overpriced assets in a bear market. That would not be a Nobel Prize winning concept.

Lost in the froth of the recent market is the fundamental truth of why anyone buys stocks in the first place. In investing, you are buying a future stream of earnings. So, if you buy a one year CD at the bank that pays 2% interest, you are investing in an extremely low risk choice that has a 2% future stream of earnings. The reason stocks historically have higher returns on investment is that they involve more risk (i.e. you expect a larger future stream of earnings from stocks because you are accepting a far greater degree of risk than in a CD, a US Treasury Bond, or a corporate bond). So, you make a rational decision to invest in a stock because you believe the risk you are taking is justified by the higher expected return.

At the turn of the new millennium, stocks were priced extremely high compared to historic norms. The return, not surprisingly, has been pathetic so far this decade. We have had a secular bear market and investors would have been better off choosing almost any other investment vehicle for the past 9 years. Commodities and gold have led the way, offering an excellent return on investment during this period. The low return on equities makes perfect sense by fundamental standards.

We believe that this fundamental truth has been lost on investors and that we are at a crossroads. The highest quality stocks are priced near historic norms and we believe you can make the case that owning them going forward is a rational decision. You stand to receive a larger income stream on your investment than in safer instruments. According to the Wall Street Journal, the Russell 2000 stocks (an unmanaged index of smaller companies) has an expected Price to Earnings ratio of 55 as of this morning. So, if everything goes well (no small feat in this economy), an investor should reap an earnings stream of less than 2% for the next year from investments in the Russell 2000 stocks. Why would an investor make the choice to buy these stocks at this time with a lower stream of income than in any other investment? We believe another wave of punishment will arrive for those who choose to ignore the fundamental fact that these companies are not currently a prudent investment. Perhaps then investors will come to grips with the fact that buying stocks is a rational decision based on the choices that exist when you make an investment choice.

For the first time since the huge rally began in March, we were faced yesterday with a decision that was painful. We like alternative energy. No, we love alternative energy! If our economy is to rebound and grow, it will be a driver of growth. But, this pullback has revealed considerable weakness in the sector. Yesterday, one of our alternative energy positions hit the price that triggers a sell for us. We had to face the choice, process or emotion. Of course, we stuck with our process and sold the position. We hope to own it again in the future and to see it grow and produce considerable profits for our clients. For now, however, it had slipped in price and momentum to where we needed to sell the position before it damaged portfolio values any further. The trigger (a loss beyond the normal range of pullbacks and advances) has told us that now is not the time, based on risk and reward, to hold this position. We will see you again down the road, friend!

We enter another week beginning with a stupendous market rise. With more and more experts sounding words of caution on this market, the bulls seem to respond ever more resolutely by moving the market to new highs. We have seen this movie before. We don’t know when it will end, but we know it is not a happy ending. We need the financial equivalent of the term “post 9/11”. Have we really learned nothing? Isn’t the value of a stock determined by what the return on your investment is likely to be? Once again, the riskiest stocks seem to have the lowest return on your investment going forward, but are the stocks that are rising the fastest.

I understand taking risks when they make sense. For instance, investing in emerging markets makes sense because these economies are likely to have much faster growth over the coming years. So, the risk you take may be rewarded by larger returns than safer investments. Small, financially less stable U.S. companies do not fit this profile. As a group, they are more likely to be losers moving forward than their higher quality counterparts (who have cash to fund operations and growth) and there is no proof that they are about to enter a period of strong growth.

Investors should approach this market with great caution. They should let their gains ride, but with a very short chain from here. Capture profits and limit losses as we move forward in an overheated market. Live to fight another day by remembering we are in a “post 2000” market.

The rally continues against all odds at present. The oddest part of it is that the lower the quality, the higher the gains year to date. The Russell 2000 index (an unmanaged index of 2000 small companies) is now up 22% through September. The price to earnings ratio for the index, according to the Wall Street Journal Market Data Center, is……………………………NIL!!! The 2000 stocks combine to have a loss, so……no ratio of price to earnings as there are no earnings. Forward looking estimates for the next year give the Russell 2000 a price to earnings ratio of over 44. So, if things go really well you will have a net earnings return of just over 2% on your investment for the next year. Do you want to invest in a basket of risky stocks so that you can hopefully earn a bit over 2% if things go well? This is not to say that these stocks can’t get more overpriced in the next year, giving you a terrific return. They can. It is just that the odds are not with you, they are against you.

On the other side of the coin, let’s consider the SPDR Global Titans ETF, made up of the largest multinational companies. It is up just over 16% year to date through September . Nothing to sneeze at, but a far lower return than the Russell 2000. This investment, made up of the highest quality companies from both the United States and other countires, has a price to earnings ratio of just over 15 and a dividend of over 3.5%. So, this investment is priced around historic norms, has a nice dividend return, and is filled with companies who are well poised to survive (and possibly thrive) potential economic problems should they arise.

As a rational investor (investing in often irrational markets), I can’t help but think that the odds are overwhelming from here. You should buy the highest quality, most reasonably priced investments you can find. You may suffer in the short term but should be fine longer term. At the same time, you should be considering taking profits and possibly shorting in the lowest quality parts of your portfolio. Warren Buffet famously said “it is not until the tide goes out that you know who is swimming without trunks.” The tide is likely to go out. It may be very soon or it may be much later. Don’t get caught again.

On reflection, it was an astounding quarter. Last year, we saw a meltdown in asset prices like no other since the great depression. No matter what the type of asset, if it involved any level of risk nobody wanted it and selling it was a painful event. This event took market prices far lower than rationale evaluations and we tried to take advantage of that by buying assets that we thought were extremely undervalued.

A year later, the trend has reversed in a shocking manner. Almost all assets had headed back up in prices at a speed that seems turbocharged. While we expected an initial rebound followed by slow growth, we have witnessed what Vinny Catalano has called a “melt up”. Money has come in from the sidelines and forced asset prices to keep ascending at a rate that seems removed from the reality of our lives. The “new normal” is a world in which a slow economy will not be buoyed by consumers spending money they don’t have to buy things they don’t need. The piggy bank (i.e. home equity withdrawals) is closed and does not appear as if it will be opening any time soon.

Even more astounding, the huge rally has been focused on all risk being rewarded the most. Low quality stocks and junk bonds have led the way, gaining more than high quality stocks and better quality debt instruments. How long can this go on and how will it end? If we knew the answer to those two questions, we could solve all your problems easily and could sit back and watch the unfortunates struggle to not stub their toes. How long can it go on? As long as people continue to pour in from the sidelines and pay little or no attention to fundamental values, the market can continue to go up. How will it end? It can end peacefully if it ends soon-markets can take a breather and allow valuations to catch up slowly to current prices. If the market continues to skyrocket, the end could be less pleasant-another meltdown seems unlikely but can’t be ruled out entirely.

How should we position portfolios moving forward? The answer is cautiously. The gains we expected to see over a period of years have come to us in  a period of months. There are some assets that appear to us to be fairly valued and there are some assets that now appear to us to be somewhat overvalued. We believe that the way forward is to overemphasize quality (which has now gone up as quickly), hold on to assets that appear to be fairly valued, and selectively take some profits in areas that are now overvalued. Couple this will a discipline that includes stop sell limits should the market begin a free fall and some hedging that reduces portfolio risk a bit at this time and you have our strategy moving forward. The game can change quickly from here and we must be ready to react to what is no longer a rally driven by fundamentals. It is a more dangerous moment now- the tail end of a huge rally in what is most likely still a secular bear market.

The market continues to bubble away. Since its early March lows, it has risen like a Phoenix from the ashes. It is enough to restore joy and confidence in many an investor and advisor. The sales drums are beating-a new bull market is under way-hurry up and get on board.

We suppose it is possible that a bull market has begun, but it is definitely a long shot. In 2004, we wrote a white paper stating that we believed that we were in a secular bear market that would last for many years. The point of that paper was that while markets remained in a narrow range from start to finish, the bear market included many large up (bull) and down (bear) moves over a period of years. That view has been prophetic to date, as we have had several good years and one of the largest slides in history. The paper expressed the idea that secular bear markets have historically ended when stocks became cheap (i.e. had low prices compared to their earnings). The point could be argued, but we do not believe that stocks have ever become cheap during the secular bear market that began in 2000.

We have learned a lot during the way and hope to continue learning as we move forward. However, that article featured this quote from one of our favorites, Bill Gross.

“We are condemned to live in the real world, where making money is hard.”

Those remain words to live by. Active management focused on managing risk still seems to us to be the only way to succeed in this market. Simply put, try to capture as much of the gains as possible during the good periods and try to reduce the losses during the market slides.