Portfolio Update - 02/29/08
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Dear Clients,
The following is my Performance Update and Outlook for February. All prices and returns are as of 2/29/08.
The Stagflation theme has finally caught on with the investing public. On February 21st, both the Wall Street Journal and Larry Kudlow’s show Kudlow and Company dealt with the prospect of Stagflation. I just got an e-mail from an analyst in Dallas by the name of John Mauldin and his article is titled Stagflation and the Fed. (I think these guys are bit late to the party as I’ve been preaching about Stagflation for some time. Last April I wrote a post titled Goldilocks or Stagflation which concluded that Stagflation was the more probable outcome.)
Stagflation is simply persistent price inflation coexisting with a cyclical slowdown in the economy. It’s not the end of the world, but it can do nasty things to a portfolio invested in equities and bonds.
Inflation pressures are undeniable. I wrote in my Annual Update that we are experiencing unprecedented long-term inflation. The 5 year appreciation in commodities as measured by the CRB Index is running at it fastest clip since the index’s inception. The CRB index is up almost 200% since the beginning of 2002. And this month it got worse as the CRB Index increased by 12.4%. Since the “omniscient” Fed started their rate cutting campaign in August, the CRB Index is up 36.8% - the second largest 6 month increase since the index’s inception. The biggest increase was in 1973, not exactly the best time to be invested in equities as they fell 49% in 18 months. (Are you growing tired of me quoting that stat in every single update? If so, my apologies, but I feel the need to include it for non-clients who might be visiting this site for the first time. Feel free to skip over such redundancies in the future.)
Another certainly is the reality of a slowing economy. For reassurances about the slowing economy you can check out my Stagflation Alert or just read any of the latest Fed minutes, speeches or Congressional testimonies. (Federal Reserve Website link)
But this introduction has run on long enough; let’s get to the good stuff.
Here is how my performance measured up to the averages for the first two months of 2008:
| PORTFOLIO | ||
| The MAC’s Core Portfolio | ||
| The MAC’s Focus Portfolio | ||
| S&P 500 (VFINX) | ||
| NASDAQ 100 (QQQQ) | ||
| Benchmark |
We had another stellar month in February. On a YTD basis, My Core Portfolio has beat the S&P 500 (VFINX) by over 30% and Scott Burn’s Couch Potato Portfolio by nearly 24%. In a $1M account, my strategy would have yielded nearly $240,000 more than the Couch Potato Portfolio. Not bad considering that 75% of financial advisors are supposedly incapable of beating his benchmark.
In last month’s update, I stated
If the current investment trends continue, your account should continue to perform well – but I would not get used to 9+% returns every month. Nearly 80% of your account’s allocation did very well and 20% was flat to down. I invested the portfolio to be more balanced and I expect it to act accordingly going forward.
Fortunately, I was wrong about not being able to generate 9+% returns but I stand by the idea that we should not count on near double-digit monthly returns going forward. In January, 80% of the portfolio appreciated where as in February, practically 100% of your positions made money (with the exception of an individual stock that I bought in the last week of the month. Also, a couple of trades I made in my swing allocation, consisting of Direxion funds, had small losses but the average return for all of my Direxion funds’ positions were up for the month.)
Certainly, we cannot count on every position making money in any given month. It was just 10 months ago, that the majority of my positions went down as I was early implementing my Stagflation strategy. In fact, I question my ability to generate any significant gains in the next few months which I’ll discuss in Part IV.
Before I continue with my Market Outlook and Forward Strategy, I need to provide you a back drop for the next two sections.
While February was certainly a Red-letter month for your accounts, I have to honestly say that the last couple of weeks have been as exhausting as any time in my professional life. Just as my strategy began to “hit on all cylinders” causing your accounts to jump in value, I started agonizing over everything I was doing in your account. Starting on 14th of the Month, numerous anomalies began to develop in the market which has caused me to question everything about my strategy. Currently, I have severe doubts about which way the capital markets are headed over the intermediate term and for those of you who know me well, this is not an insignificant development.
Valentines Day: There was an ominous jump in bond yields despite nothing really happening in the equity or currency markets. I originally discounted this move as I had long been predicting an increase in yields but for some reason it just didn’t seem right. From that point forward, the markets have not acted in the same fashion as they have over the last several months. All the correlations that I had counted on started breaking down. Trend and Technical analysis were rendered useless in the last two weeks.
President’s Day:Then came the worst news I’ve heard in quite some time. On President’s Day, the PBGC made the following announcement:
The Pension Benefit Guaranty Corporation has adopted a new diversified investment policy to help ensure the federal insurance program can meet its long-term obligations to America’s retirees, PBGC Director Charles E.F. Millard announced today. “The PBGC is responsible for the pensions of 1.3 million Americans, but we don’t currently have the resources to keep all of our future commitments,” Millard said.…The PBGC currently has approximately $55 billion to invest in the new investment policy. Under this new policy, the PBGC will allocate 45 percent of its assets to a diversified set of fixed-income investments, 45 percent to diversified equity investments and 10 percent to alternative investment classes. The agency’s previous policy set an equity investment target of 15–25 percent, although the actual level of equity investments was 28 percent at the end of FY 2007. (emphasis mine)
The reason so many Pension plans have been turned over to the PBGC is because their original investment strategy was too aggressive! The PBGC is implementing the exact same strategy that doomed these plans in the first place. We should all be very scared that the PBGC is turning up their risk levels as we are entering a cyclical bear market. If there are doubts about its ability to reach future commitments now, what if their higher allocation to equities falls 20-40% as I’m expecting equities to do over the next 18 months?
Week of February 18th – 22nd: Since July, the market volatility has been gut-wrenching with 1-3% daily swings in both directions. From the 18th through the 22nd, the market trended sideways for five straight days, the longest such stretch in over a year. Markets don’t go “sideways” in a bear market – they either go up or down.
February 22nd: Never in all my days of investing have I seen a “melt-up” like the 22nd. There were several disturbing attributes of this rally. First was the leadership or lack there of. Prior to every rally in the last 8 months, a couple of sectors were leading the market up by a day or two. On the 22nd, these sectors were hitting multi-day lows and headed down and magically they shot up once the news of an imminent AMBAC bailout was rumored (which coincidentally still hasn’t been confirmed). Another ominous detail about the rally was how broad based it was. An AMBAC bailout should have mainly benefited the financials but all equities rallied with the financials trailing the rally.
Week of February 25th – 28th: A slew of terrible economic and inflation reports were released and the market never sold off with any conviction. PPI and CPI were far hotter than economist’s expectations. Existing and New Home Sales were disappointing, Durable Goods orders were lackluster and GDP was not revised higher as expected, but the market never sold off. In fact, everytime the market tried to sell off, there was a significant rally. Furthermore, all the rallies were broad-based. There was no leadership. There wasn’t one sector under or over performing by any significant margin. Technical trading indicators were rendered useless as markets defied trends and correlations.
For two weeks, I struggled mightily with the market action and what it would mean for your portfolios. I subscribed to numerous newsletters racking up over $1,000 in fees in addition to the dozen or so newsletters that I am already subscribing to in the hope that some piece of news or analysis would give me a better idea of what in the wide-wide world of sports was going on.
One thing I knew for sure was that Wall Street was not behind the rumor or the rally because the financials did not lead it. I’ve never been a conspiracy theorist and while the Fed and the Plunge Protection Team have been given marginal authority to stabilize the markets, I have a difficult time believing that the government would outright manipulate stock prices. So, I’m still at a loss as to what has happened over the last few weeks. Perhaps, it was simply the PBGC reallocating hoards of cash (approximately $10+b) from bonds to equities. That would explain the steep sell-off in bonds and the broad-based nature of the equity rally. Perhaps it was a fundamental shift in the markets that I am not yet aware of. Maybe it was just an anomaly and the markets will return to their historical correlations. Unfortunately, I cannot say for certain.
Regardless of what was the prime motivator behind the rally was, I’ve decided to “take my foot off the gas” and position your account more conservatively until I can get a better understanding of what is going on.
I fancy myself as an intermediate term investor. I’m a lousy trader so my outlook must take on a longer-term perspective than a few days or even weeks. However, I believe in a semi-efficient market that does provide above average returns for opportunistic investors who can identify intermediate trends. My focus has always been the 12-24 month timeframe. There are a lot of reasons why this timeframe is exploitable but I don’t have the time to get into them here.
The market’s unusual behavior in the past month has led me to question my 6-9 month outlook and my near-term investment strategy – a strategy that has generated 30% returns in my Core Portfolio over the past 3 months. I stand by my 12-24 month outlook of continued Stagflation. Here is a rundown of the primary macro trends that I’m studying in attempt to create a profitable strategy over then next couple of quarters.
ELECTION YEAR MARKET STRENGTH: Why both parties seem to disagree on practically every issue, there are two issues that both parties are in complete agreement. One issue is the idea of bigger government. The other issue is maintaining equity bull markets in election years. Nobody on either side of the isle wants to see an equity bear market in an election year which may result in them not getting reelected.
At the beginning of the year, I was convinced that a combination of high valuations, weakening economic pressures, increasing inflation pressures and a credit market teetering on collapse would be too much to overcome in stopping the ensuing bear market. But now I’m not so sure.
The Congress passed a stimulus bill earlier this month to provide a handout to Middle Americans with the hope of increasing consumer spending which will help keep the economy afloat. Given the bloated deficits that the government is currently running and a War with no foreseeable end, this type of stimulus plan can be deemed irresponsible in the long run but helpful in the short-term.
The government stimulus package, the ominous timing of the PBGC reallocation and the actions by the Fed (see below) are making a clear statement that this government will pull out all the stops to keep the stock market up this year.
DOVEISH FEDERAL RESERVE:
- Marc Faber, March 1st, 2008 -
“Don’t fight the Fed” is a popular Wall Street saying and it certainly is valid. Only on a couple of occasions has the market continued to plummet during a Fed cutting campaign – 2001 being one of them.
It is quite obvious that the Central Bank is pursuing a reckless attempt at keeping both the equity and credit markets afloat with little regard to the consequences. Since the Fed started cutting rates in August, the US$ has dropped over 10% and commodity inflation has increased at a 70% annualized rate! A sizeable percentage of commodities are at all-time, record highs. The things that we consume everyday such as energy and food are experiencing substantial price increases.
In order to get a better idea of where Bernanke and friends stood on the economy and inflation, I reluctantly sat through his congressional testimony last week. Bernanke reiterated his fears about the economy while downplaying any real inflation threat. He keeps saying things like “inflation expectations remain anchored”. I don’t know where he’s getting his intel, but when I talk to clients and friends, it seems that inflation is anything but “well anchored”.
In a Bloomberg article posted on Monday (3/3/08), the following was written…
The Federal Reserve is wrong to lower interest rates while inflation is still a threat and shouldn’t bail out investors who made wrong-way bets, economists said in a survey by the National Association for Business Economics.
There are only two conclusions that can be drawn from the Fed’s actions. Either the Fed is far more scared about the situation in the credit markets than they are letting on or the Fed members are total fools. There is no other way to explain the hyper-inflationary monetary policy that they have adopted. To keep rates this low with the prospect of even lowering them further (the market is betting on another 50 bps cut in March) is completely irresponsible unless there is a very sound reason to do so.
Regardless of the reasoning behind the Fed’s actions, it seems clear that they are going to keep cutting. Bernanke is auditioning for reappointment and if he allows the markets to fall this year, he’ll likely be replaced. The question is will he succeed?
BOND YIELDS: Long-term Treasury bond yields are ridiculously low right now given the inflation pressures in the economy. I’d like to meet the people buying 10-year treasuries at 3.5% when reported inflation is at 4.5% and commodity inflation is running at a 70% annualized clip – not to mention the freefall in the US$ which is what these bonds are denominated in. I’ve addressed this issue many times and I’m of the opinion that rates have no where to go but up. But I’ve felt that way for a while now while rates continued to trend sideways to slightly down. About the only play I’ve lost money in over the last few months is betting on higher rates. (I think the first post I made that went into depth in this topic was my November 2007 Update and I addressed it even further in last month’s update.
But as long as bond yields stay this low, equities are relatively attractive meaning they can sustain higher valuations. Bond yields will be a key in determining the sustainability of equity prices. If bond yields increase, which I’m convinced that they will and I have your account positioned accordingly, than equities could sell off regardless of the actions of the Federal Reserve and the US Government.
AVAILABLE CASH: There is still a lot of cash sitting on the sidelines in Foreign Sovereign Wealth Funds, money market funds and brokerage accounts. While Equity Mutual Funds are as fully invested as they ever have been, there is cash sitting in a lot of other places that if deployed in the equity markets, could cause them to rally.
BOND & EQUITY FUNDAMENTALS: I’ve harped on this topic for nearly two years now, but the fundamental situation for bonds and equities continues to worsen. Inflation is an enemy to equity and bond prices. Furthermore, the falling US$ should make equities less attractive to foreign investors (I’ll address this subject more below).
The lynchpin is falling earnings which seemingly peaked in the middle part of last year. Once you extract financial earnings from the S&P 500, something I’ve long argued for as their earnings are merely a smokescreen, the P/E for the S&P 500 is probably north of 21 or 22. Historically, the outlook for equities when valuations are that rich is very poor regardless of the inflation picture. When you factor in excessively high inflation with sky-high valuations, the outlook for equities is downright miserable.
TECHNICAL STRENGTH: Again, I’ve covered this subject ad nauseam for the last 18 months. Nothing has changed in last couple of months except that the market did reach a significantly oversold situation in late January. Breadth is still neutral to bullish and while I question it’s predictive ability due to numerous factors, a turn towards bearish levels would provide some much needed confirmation that markets are headed lower.
CONSUMER STRENGTH
- 24/7 Wall St., February 29, 2008 -
- CBS Marketwatch, February 29, 2008 -
The consumer buoyed the economy throughout the last recession and the hope was that they would remain strong regardless of what happened to credit markets, banks, ect. Unfortunately, the Housing ATM is out-of-order and inflation in necessary goods such as energy and food has put the kibosh on discretionary spending. The fall in both Consumer Sentiment and Confidence in the last couple months has been monumental. Sentiment is at a 16 year low. (source: Bloomberg) Without consumer strength, the economy and the equity markets have no hope. Unless the Government continues to pump out $600 checks to every man, woman and child, consumer spending is likely to slow.
I am undecided how the following macro economic trends will impact the stock market and unfortunately for me, it is the outcome of these wildcards that will largely impact the direction of the market up to the election in November.
THE IMPACT OF A WEAKENING US$ ON THE TRADE DEFICIT: In my opinion, this is the biggest wild card of them all. The US government, despite its countless ascertains to the contrary, are seeking a weak US$ policy. The primary motive is to improve the trade deficit. A secondary motive would be to reduce the debt burden by paying back debt with a cheaper currency.
But what if their strategy backfires? In economic theory, a declining currency should help trade deficits; however, a country’s economy has never thrived when its currency is purposely debased. Here is the how and why a declining US$ may actually hurt the trade deficit.
Compared to other countries, we buy a lot more stuff from foreigners than we buy from ourselves. If the demand for stuff we import is more inelastic than goods that we buy domestically, a declining currency could actually make our deficits worst. For example, the demand for Oil has proven to be extremely inelastic. Despite the price of gasoline increasing nearly 200% in the last 7 years, we are consuming more of it today than we did 10 years ago. By debasing our currency, imported goods become more expensive and if we keep buying the same amounts of them, then our trade deficit will worsen. (In absolute dollar terms, the trade deficit could go down because we would simply buy less stuff, however the ratio of imported goods to domestic goods could get worse.)
Furthermore, when economies go into decline, consumers shift their buying patterns towards more affordable goods. Everyone on Wall Street knows that Wal-mart is a counter-cyclical play and where does Wal-mart get all their stuff from - China! Goods from China, India, East Asia and Latin America are currently more affordable so when our economy weakens, we could increase our consumption of cheap foreign products and reduce our consumption of expensive domestic products.
So despite our governments best intentions, debasing our currency may not solve our deficit woes. As with so many government agendas of the last decade (The War in Iraq, healthcare, house ownership, ethanol, ect) this one may backfire in the end. If our declining currency actually leads to an increase in our trade deficit, I shutter to think what will happen to our nation’s producers and their stock prices.
THE RESILIENCY OF US DEBT HOLDERS: The inflationary policies of the last decade have caused a massive decrease in the strength in our currency in addition to an unsustainable valuation for US treasury debt. The US$ is down almost 40% since it peaked earlier in the decade. Since the Fed went on their money printing spree six months ago, the US$ is down over 10%
Treasury yields simply cannot stay at their current level given 20% plus annual commodity inflation worldwide. I touched on this idea in last month’s update where I quoted what George Soros and Nobel-prize winning economist Joseph Stiglitz had to say on the subject – two gentlemen whose opinion carry a bit more weight than mine. Eventually, it seems that foreign investors will abandon our treasury bonds yielding 3.5% while the US$ falls over 10% in six months. While our government can bail out its own companies and the PPT can use its various tools to manipulate the market, they cannot control the behavior of foreign central banks and investors.
However, there is a global prisoner’s dilemma game going on. While our government is endlessly sticking it too foreign investors by debasing our currency and creating massive amounts of inflation, there are economic incentives for foreign central banks to do nothing about it. If foreign debt holders dump our debt it could hurt their own economy b/c it would further erode our currency handicapping US consumers from buying goods from them. It is in everyone’s best interest for the US$ to remain strong but fundamentally, US$ strength can not be maintained.
So when will it break? I certainly don’t know and it seems that very few others do either. Some of the brightest investors in the world are calling for a US$ rally in the first half of this year. Maybe the great selloff in US debt will begin in Q3 or Q4 or perhaps in ’09. What I do know is that when it happens, we should expect much higher rates in the US, an increase in inflationary pressures and consequently much cheaper equities.
IMPACT OF THE FALLING US$ ON US EQUITIES: For the last several years, we’ve exchanged billions of US$’s for foreign goods. A lot of these dollars were recycled into US Treasury debt but recently, there has been a trend of foreign governments to invest their imported US$’s into US equities through vehicles called Sovereign Wealth Funds.
While the US equity markets have been challenging to say the least for US investors over the past 9 months, foreign investors have seen equity losses compounded by losses in the US$. So, will foreign investors eventually get fed up with US equities given the currency headwinds or will they see US equities as “cheap” because the currency has fallen so far? I don’t know, but if foreign investors abandon the US equity markets, not even “Helicopter” Ben will be able to drop enough money from the sky to sustain any sort of significant rally in US stocks.
GSE AND OTHER BAILOUTS: The Government Sponsored Entities (GSEs) are in very bad shape. For confirmation of this fact, just check out the 5 year stock chart for Freddie (FRE) or Fannie (FMA). Unfortunately, nobody knows just how bad of shape they are in because they are not subject to the same accounting standards as our nation’s publicly traded companies. Fannie Mae, Freddie Mac are basically insolvent. If they were a private company, they would be in Chapter 11. The PBGC is on the brink of collapse (see above).
Will the government be able to bail out all the GSE’s? Are they responsible for bailing them out? If they do, who inevitably pays for it? Somebody has to pay for all this. Somebody will have to pay for all of the bailouts, all the handouts, all of the failed attempts by our government to provide economic security to Americans. Nothing is free.
There are only two ways for the government to pay for their amazing deficits. First, they can inflate their way out of the problem. Second, they can tax their way out of the problem. I don’t know which they’ll choose but both provide for a catastrophic outcome for the US economy.
Unfortunately, I have no answer for any of these issues over the short-term, which means I’m essentially “flying blind” when it comes to investing your portfolio. I’m actively searching for answers but until I find some I’ll remain conservative with your accounts. Over the long-term, the inevitable will take place but that might be several months from now.
As I’ve alluded to a few times in this post, I don’t expect to be able to generate the same types of returns in the coming months as I did in January and February. Due to breakdowns in various asset class correlations, I’m not comfortable with taking an excessive amount of risk in your account. I have a fair amount of cash in your account and while I’m anxiously looking for ways to deploy it, I’m not going to jump into something unless I can achieve some level of comfort that I won’t be putting your YTD returns in jeopardy. I’m not going to be satisfied with ending the year up 22% but I sure as hell will be upset with myself if your account loses anything between now and then.
If correlations in the market return to some level of normalcy, I’ll feel confident in taking some more risk in your account, but until I see evidence of it, I’ll stick to the few things that I’m more confident in even if they don’t offer the opportunity for explosive returns.
I significantly reduced your commodity exposure in the last couple of weeks of February. Every commodity fund in your account was up 25-40% over the last 3 months and I thought it was prudent time to lock in some profits. Furthermore, we are entering a seasonally weak period for non-cyclical commodities which are the positions I liquidated.
The spring shoulder season for energy coupled with increasing inventories should result in some kind of pullback in the energy space. However, if OPEC announces production cuts, then all bets are off and we could see energy prices shoot much higher.
Furthermore, I think we’ll see some pullbacks in the agricultural space. Last year, prices came down in the spring and early summer as farmers reported planting record crops. As I mentioned on this website last year, record planting doesn’t necessarily result in record crop yields. The US government provides incentives to farmers based on the amount they plant, not the amount they harvest, so farmers will plant regardless of conditions. In the long-term, I’m still bullish on these funds and I will be rebuilding many of those positions in coming months. Hopefully, I’ll be able to buy in at lower prices.
I have continued to maintain your Precious Metal exposure and I’ve even added a few positions in this space over the last couple of months which are up marginally. I’m tracking several indicators which should help me decide when to liquidate these positions but for right now, the PM space looks healthy over the intermediate term.
But I can’t be so certain about the short-term. I stated in my Year-End report that I thought Gold might see a fairly quick ascension to $1000 because that was the consensus price for it in 2008. I had no idea just how quickly Gold would ascend to that level. I’d expect the PMs to take a break now that Gold is in the $1k neighborhood.
Possibly the best news is the action in the mining stocks which are starting to show a little life. After falling in January, they are now beginning to catch up to Gold and Silver. Furthermore, Silver is finally providing some long anticipated leverage over Gold.
Finally, our foreign bond exposure is starting to show some nice returns. The discount in our Foreign Bond ETF’s is finally starting to diminish. I believe that the precipitous fall in the US$ will result in money being attracted to these funds.
- Bloomberg, February 26th, 2008 -
The aforementioned quote actually appeared in an article about Brazil and a few of the “big government” programs they had just adopted contradicting Lula’s previous agenda (BTW, I’m a big fan of President Lula). But regardless, the principal is true for all governments and our government has become so bloated, they have no choice to inflate or tax their way out of it. The article includes debt as a third option but I’d argue that debt is nothing more than deferred inflation or taxes.
Our government has to pay for the enormous debts they have incurred. I’ve addressed this issue in many posts and specifically in my Market Outlook. The Republican’s answer, starting with Nixon, was inflation. The democrats answer to the problem typically leans towards taxation but the neo-liberal Clinton was not shy about inflating the economy either – he just had more economy to work with. What we all need to understand is that somebody at sometime has to pay for deficits.
By using inflation, we can shift a lot of the burden to foreign investors but we will have to bear some of it. This has all happened before. It happened to Great Britain in the 1900’s. It happened to us in the 70’s, the late 30’s and the early 1900’s. It’s a part of the cycle compounded by irresponsible government intervention. Once the cleansing is done, the US economy will come out just fine on the other side (if our government doesn’t totally destroy our currency) and we’ll be able to buy some incredibly cheap equities. And in the interim, we’ll make some money investing in Stagflation themes.
In the near-term, don’t be alarmed that I’m a little flustered with the current market activity. I think it’s better for an adviser to question his strategy and occasionally admit to being unsure of what he is doing than just blinding accepting the path that he is on. A lot of buy-and-hold investors are just sitting around hoping the market turns and by the time they question their strategy, their clients will be selling their incredibly cheap equities to us.
I’ll get us back on track. I’m actively reading and studying new research. I’ve worked harder this month than I have for some time and I believe that my frustration has focused me even further. I have discovered numerous new technical trading tools which will aid me in buying and selling new positions. I discovered a non-cyclical sector that I’m turning bullish on and will likely be building a position for you over the coming weeks or months. I will go into more detail about this sector in my written quarterly update.
Until I figure out how to fully reinvest or reallocate your account, we can take comfort in knowing that we have a 30% head start on the market. I have no official statistics, but I’m assuming that your accounts have done better than 99% of the investors out there. I haven’t come across any who has even delivered double-digit returns this year. I do know that several of my clients have made more money in their retirement accounts in the first two months of this year than they ever made in a full year of working and I’m very encouraged by that.
As always, please call me if you have any questions or concerns about your account.
Matt
