Stocks continue to perform well with all of the key indices making good progress. The S&P 500, Dow, NASDAQ and Wilshire 5000 recorded bull market highs this week, although we are still below the all time market highs seen in 2007. Since the end of January, the NASDAQ has been the strongest performer gaining+8.62%, while the S&P 500 is ahead +6.87%. The Russell 2000 has lagged +4.87%.
After an extremely volatile end of the year in 2011, 2012 has been primarily smooth sailing. On March 6th, all of the key indices were moving lower with the Dow losing 203 points (-1.57%) while the S&P 500 lost -20.97 (-1.54%). This marked the first time the S&P 500 had lost more than 1% in a single session since December 28th. This amounts to over 40 days without a single 1% decline. According to research by trader Patrick Chu, since 1980 there were 18 occasions when the S&P 500 had gone at least 41 trading sessions without a single 1% decline. He then tracked the market’s performance after the first 1% down day had occurred. The subsequent gain after 20, 60, and 120 trading sessions was 0.8%, 3.7% and 6.7%, respectively.
Another report from Ned Davis Research confirms that this lack of volatility could be healthy for the market. Based on his study, this is only the ninth time since 1928 that the S&P 500 has started the year without a 1% correction during the first 40 days of trading. The average gain for the remainder of the year for these periods was 18.4%. There was only one year that started this way where the March to December period suffered a loss. This was in 1966. Since the S&P 500 suffered its first 1% loss for the year on March 6th, it has rallied 4.41% over the subsequent seven trading sessions while the Russell 2000 has gained 5.64%.
In the meantime, the CBOE Market Volatility Index (VIX) closed at 14.80 on March 13th. Many analysts feel that the contraction in the VIX (it was as high as 46.88 in October) is evidence that investors have become overly complacent. They feel that a sharp correction shaking up this complacency is in the cards. We continue to be cautiously optimistic and continue to ride this wave of good fortune. However, while we have one foot on the gas, we also have one foot on the brake, ready to move to a defensive posture at some point within the next two to three months.
The market continues to show resilience, with investor sentiment very bullish. At the same time corporate insiders are selling at an unusual pace into the continuing strength. One group or the other will obviously be wrong. We plan to remain invested for the near term while keeping an eye out for the next downturn. The insiders actions tend to be a better guide over the long term than does the crowd. We would like to see more confirmation that the trends have changed before we make any shifts.
WHAT ABOUT THE FED?
There was unexpected excitement in the market this week, created by the Fed’s more positive statements on the economy after its FOMC meeting, and the even more exciting announcement from JP Morgan Chase that it had passed the Fed’s bank stress tests, which could lead to a dividend increase and would undertake a huge $15 billion stock buy-back program. The Federal Reserve’s most recent Open Market Committee Meeting ended without any major changes to its policy statement. With some Fed watchers anticipating another round of monetary easing, it held rates steady (in the 0.0% – 0.25% range) where they have been since late 2008. It did, however, offer a slightly upgraded assessment of the economy from its previous meeting. “Labor market conditions have improved further; the unemployment rate has declined notably in recent months, but remains elevated.” It also
noted: “Household spending and business fixed investments have continued to advance. The housing sector remains depressed. Inflation has been subdued in recent months, although prices of crude oil and gasoline have increased lately. Long-term inflation expectations have remained stable.” In its view of financial conditions it said: “Strains in global financial markets have eased, though they continue to pose significant downside risks to the economic outlook.” The Fed concluded that to achieve its dual mandate of stable prices and maximum employment, it will most likely keep short-term interest rates at historically low levels at least through 2014.
The Federal Reserve also said it will continue its “Operation Twist” program “to extend the average maturity of its holdings of securities.” The program is scheduled to end in June, but many expect the Fed to possibly extend it after its next scheduled meeting. While the Fed remains wary, there are notable signs of a recovering economy. The unemployment rate has declined to 8.3% as employers added 284,000 new jobs in January and 227,000 in February. Both numbers easily exceeded expectations, although the reduced rate may be due primarily to a reduction in the numbers of individuals filing unemployment and not necessarily from the addition of more jobs in the economy. Weekly applications for unemployment benefits have declined for six months and the four-week average is now at a four-year low. By the end of 2014, the Federal Reserve expects a jobless rate of 6.7% - 7.6% which is good, but still below the Fed’s target of 5.2% - 6.0%.
Although many economists believe that consumer confidence, and more importantly spending, needs to improve significantly before the economy can kick into high gear, there have been encouraging signs. Consumer Confidence in February rose to its highest level in a year, while retail sales jumped 1.1% for its largest increase since September. One of the biggest risks to consumer spending is fuel prices which have surged to a national average at $3.81 from $3.28 at the beginning of the year.
Indications are piling up that the U.S. economic recovery is following its pattern of the last three years, showing signs of impressive strength during the winter months, and then beginning to stumble in the early summer months. This strength has tended to coincide with the two Quantitative Easing programs and now with Operation Twist (Or Stealth QE3) which as we noted earlier is set to end in June. If the last two years serve as a guide, we should see higher volatility in the later half of the year. Bernanke seems to want to avoid too much turmoil as he continues to guide us in letting us know that the Fed stands ready to provide more stimulus if necessary.
All this fits in with our forecast for the market this year, which was for continued strength for the economy and stock market through the market's favorable season, but then for the economy to stumble again, creating a sell-off in the stock market. However, we do not expect as serious a correction as the last two years, since it is an election year, and the Fed will probably come to the rescue sooner rather than later not wanting to be accused of attempting to affect the election.
FAQS ABOUT OUR RESEARCH & INVESTMENT PROCESS
We have received a number of questions over time regarding our process and our publication.
Below are a few that pertain to our Mutual Fund Models:
How often do you review portfolio holdings?
We have developed an investment matrix for mutual funds, ETFs, bonds and preferred stock which is reviewed on a monthly to quarterly basis. Considering that we own these investments alongside our clients, we keep tabs on each of these holdings daily, but rarely see the need to make changes as often as we would with closed end funds and especially our equity holdings. If a mutual fund loses a portfolio manager, merges into another fund, changes its investment objective or if there is some material change with any of these investments, this is cause for immediate action. Likewise if a preferred stock or bond matures, is called or starts to trade at a large premium to what the company will eventually pay back to investors, we start looking for a good replacement. We tend to be more active in looking to make changes in the models when we feel the investment climate is changing. Toward the end of the favorable season for the stock market, we formulate what our model changes are going to look like during the "bad season" but wait until the markets have confirmed to us that the current uptrend is over.
For the stock and exchange traded fund holdings, we review all holdings at least monthly keeping track of current valuations versus what we have determined to be each security's true worth. If a stock hits our price target, we will start looking to liquidate this holding, especially if market conditions are deteriorating. We will be more aggressive in reducing exposure to any holding which we feel is more expensive compared to its true worth but will typically wait until the charts start to show us that the trend is changing. A breakdown in the charts may be cause for the sale of a security, trumping our assessment of how inexpensive it is.
We typically reassess all securities which break down below our mental stops to determine if we may have purchased too early or we did not adequately assess all information available concerning the given investment security. Considering most closed end funds trade at a discount to their Net Asset Value (NAV) we typically start reducing our exposure when the current price exceeds the NAV (or true value) of the fund.
Please explain to me how owning a small percentage of "risky" investments reduces my overall portfolio risk?
Modern portfolio theory holds that diversification is key to minimizing overall risk. In other words, investors should populate their portfolios with assets that yield returns with sufficiently different attributes from their other investments, i.e. create a portfolio of assets that behave differently across market conditions. Doing so requires investors to seek out different types of assets with low correlation—a measure of the extent to which returns from different investments move together over time.
To explain correlation in another way, let us assume that we own a retail shop on the beach. If we want to consider what types of items to sell in our beachfront store, at first blush we would want to sell things like beach towels, suntan lotion, sunglasses, ice cream & various beverages. Our sales would be strong as long as the weather was nice, sunny and warm. However, over time we would want to diversify our inventory so that we would have something to sell when conditions were not quite as favorable. For cold or rainy weather we may want to consider umbrellas, rainy day clothing, gifts, videos and other things for indoor activities. Beverages should sell well at all times in these scenarios.
Likewise with investment portfolios we want to have a mix of stocks, bonds, commodities, REITs and Cash. None of these investments perform well all of the time. Bonds underperform in rising interest rate environments. Commodities and stocks are heavily impacted by economic conditions and market sentiment although they tend to move differently over time. REITs and Commodities tend to both hold up well in inflationary environments, although REITS tend to be less subject to stock market conditions. Within our models we want to make sure that we are adequately diversified but at the same time flexible enough to take advantage of favorable market conditions and protect during unfavorable conditions.
"Risk comes from not knowing what you are doing."
- Warren Buffett -
How do you determine your investment mix in the different models?
The investment mix in the models is developed to provide the least amount of risk (volatility) given the level of return we are targeting to achieve. You could also say that we are looking to maximize the level of return given the amount of risk (volatility) we feel clients in those models are prepared to handle. As we noted above, by diversifying the portfolio into different types of asset classes that move somewhat independently from one another we can reduce the overall portfolio volatility. We will underweight asset classes that we feel are positioned to underperform due to valuation metrics, outside factors or current trends. Likewise we will overweight asset classes that have favorable trends, are undervalued in our assessment or are due to be impacted favorably by outside forces. We rely on internal research, research from asset managers we work with as well as newsletters and other research publications to which we subscribe in formulating our assessment. We are constantly reassessing our outlook based upon the ever changing investment climate. The risk profile in the unfavorable period from May through October is quite a bit more conservative in all models than it is during the favorable period. Our exposure to equities, commodities and other more volatile holdings is typically reduced by 20% or more in all models during the unfavorable period.
What do you look for in mutual funds to be included in the mutual fund investment models?
We have two criteria for mutual funds we consider to be included in our models. We look for strong long term performance numbers and low downside volatility. We typically only consider funds that have at least a 10 year track record and can be found consistently within the top decile (10%) in their category. More importantly, we look to minimize the downside volatility by choosing funds with low downside volatility as measured by the Ulcer Index. The Ulcer Indexis a stock market risk measure devised by Peter Martin in 1987, and published by him and Byron McCann in their 1989 book The Investors Guide to Fidelity Funds. It's designed as a measure of volatility, but only volatility in the downward direction, i.e. the amount of drawdown or retracement occurring over a period. Other volatility measures like standard deviation treat up and down movement equally, but investors typically do not mind upward movement, it's the downside that causes the stomach ulcers that the index's name suggests.
We are most interested in those funds that have the best risk adjusted rates of return by combining these two criteria. We measure these funds by calculating the Ulcer Performance Index typically over a 10 year period which tends to include both good and bad market periods. This Ulcer Performance index is very similar to the more frequently used Sharpe ratio in determining risk adjusted returns of funds over given periods of time, however instead of using the standard deviation of returns over time in the equation, the ulcer index is used. This allows us to keep those funds that may move aggressively to the upside but tend to protect investors during downdrafts in the market.
Why is it that some of the funds that you recommend are not as favorably ranked by Morningstar?
We have no quarrel with Morningstar and own many funds that are currently five-star rated funds. On many occasions, a select group of five-star funds have been among the top performers. Clients who have been with us for a number of years are fully aware that we have recommended more than our share of five-star funds, but each market cycle is different. We believe that selecting funds in asset categories that may have relatively few five star funds is sometimes necessary to provide proper diversification in our models and will allow us to reduce the risk (as measured by the downside volatility or Ulcer Index) of the portfolio over time. Usually, a new bullish cycle is accompanied by a change in leadership; for example, large cap growth may outperform small cap growth, or small cap growth may produce better returns than large cap value. The winning sectors from the previous bull market are often replaced by a new group of funds. These funds are rarely five star funds when they begin outperforming their peers.
Why would we want to own global investments considering the uncertainty in Europeor own REITS considering the state of the Real Estate market currently?
As we explained above, we want to make sure that we have enough inventory in our "store" to be able to weather storms and cold periods in the markets. Likewise many times the best times to invest are when the public opinion is most pessimistic. As they say "it is always darkest just before the dawn." When people are most pessimistic, we are many times able to find the best values for those investments we want to own. We typically want to wait until the opportune time and all the "weak hands" have thrown in the towel, but we very rarely time our entries perfectly. We are almost always a little too early or too late, but as Warren Buffet likes to say, we like to "be greedy when others are fearful and fearful when others are greedy." A timeless article (written in 1979) to read on this from Warren Buffet is entitled, "You pay a very high price in the market for a cheery consensus."
Please explain your "sell discipline"?
Our sell discipline operates much like our buy discipline in reverse. We base our sell discipline on three primary factors.
The first factor would be a change in the market. As we have noted extensively in previous letters, we like to be more conservative when the market is in its "monsoon season" and more aggressive when the market is in its "sunny season." We will reduce our equity holdings, commodity holdings and other various holdings when we move to a more conservative stance looking for treasure hidden among the rubble when the storm has likely passed. We base much of our rebalancing and repositioning on market seasonality but look for confirmation that the winds have shifted before we adjust our sails.
The second factor is a change in the fundamentals or the attainment of a price target for one of our holdings. As we noted before, if a stock hits our price target, we will start looking to liquidate this holding, especially if market conditions are deteriorating. We will be more aggressive in reducing the exposure to any holding which we feel are more expensive compared to its true worth but will typically wait until the charts start to show us that the trend is changing.
The last factor would be a change in the current trends for a given asset class or an individual holding. If an asset class like commodities or emerging markets looks like it is losing steam or starting to falter, we will reduce that holding. Likewise with individual equity holdings, if we see the chart start to exhibit unfavorable characteristics we may start looking at reducing these holdings or selling the entire position. If the chart shows a clear change in trend or the stock falls below our "mental stop" and this is accompanied by a change in the fundamental picture of the company, the market looks weak or the stock has already attained our price target, we will typically sell.
As noted above, a breakdown in the charts may be cause for the sale of a security, trumping our assessment of how inexpensive it is. We typically reassess all securities which break down below our mental stops to determine if we may have purchased too early or we did not adequately assess all information available concerning the given investment security.
Most investors do not like to take losses, even small losses, but unfortunately every investor and money manager alike will, at one time or another, invest in stocks that turn out to be losers. It is very important to realize in advance that anyone who invests in the stock market will end up with a percentage of losing stocks. The big difference between successful investors and unsuccessful investors is how they react to being invested in a losing stock or a losing group of stocks. A successful investment program usually involves taking a number of small losses. The bulk of your profits will come from a few big winners. If we look at our investments like a stable of horses, we want to keep our champions and prize winners, selling or putting out to pasture those that do not perform. We prefer to hold a company for a long period of time. However, if the market is offering us exorbitant prices for one of our holdings, we are more than happy to sell to those who we feel are overly optimistic.
We love small losses but hate large losses. As Doug Kass puts it, "Taking small losses is part of the game. Taking large losses can take you out of the game."
Why would it be better to adjust the investment models to a greater percentage in bonds rather than just going to cash during rough periods?
We like to earn money while we wait rather than moving completely to money markets. Sometimes we may be primarily allocated in short term bonds and at other times we may want to continue to hold certain assets to protect from the market downdrafts in one part of the investing world but still benefit from what we see as an opportunity elsewhere. As one investment pundit who shall remain nameless likes to say, "There is always a bull market somewhere."
That said, we like to err on the side of caution and move to a more conservative stance more readily than not. However we prefer to earn more than a fraction of one percent while we wait for conditions to improve.
"When one door closes, another opens. But we often look so long and so regretfully at the closed door that we do not see the one which has opened for us."
- Alexander Graham Bell -