“It is a tale
Told by an idiot, full of sound and fury,
Signifying nothing.”
- Macbeth, Act V, Scene V, William Shakespeare

We took the week off to enjoy the 4th of July holiday and to build our next portfolio tool (which we will explain at the end of the post). While we did so, the markets staged a bit of a bounce. In fact even a laggard like the Spanish ETF (EWP) was up 12% for the week, perhaps foreshadowing the result of the World Cup.

However, if you check your statements, you will realize that very little has happened since the end of April. There has been plenty of volatility, but precious little direction. In some of our portfolios, cash is starting to show up in the top ranked asset classes. This is not a good market for making bold bets or gaming the latest datapoints on US unemployment.

For equity investors, the main indices are telling a pretty drab story.

Fixed income did better as investors place their bets firmly on slower global growth.

And commodities, except for Gold, which trades on the same “Fear Factor” as US Treasuries, confirm the negative economic outlook. The weak base metal ETF is a concurrent indicator that weakness in China is not a fluke.

Unfortunately both the system and common sense suggest that nothing significant is likely to change in the coming few weeks. Since you will not get rewarded for exposing yourself to excess volatility, the best bet is to keep money in low volatility assets until a clear direction emerges. Even a long short portfolio within a single market is unlikely to lead to pleasant results as the whipsaw effect takes its toll. A prime example is our Taiwan Long Short Portfolio which has taken whipsaw losses in an effectively directionless market. Our Asian Index Long Short Portfolio has done a bit better primarily on the back of the China Short call.

New Portfolio Tool

After much wrestling with the code, we are ready to test our Portfolio Selector. This will allow you to experiment with the core functionality of the IRP system. A number of our users have asked for something more interactive than the portfolios we present here. In order to work the major bugs out, we would like to ask for volunteers to test the application so that we can launch it to all our registered users by the end of this week as a beta. If you are interested, send us an email.

A fun piece came into my email box about analyst coverage of BP after the Deepwater Horizon. The article, by The Reformed Broker, is a rant about fundamental analysts. It is a good fun read for those who enjoy some schadenfreude (a guilty pleasure at viewing other’s misfortune). Yes, the analysts did spend too much time with their DCF (Discounted Cash Flow) models and not enough time studying up on how Exxon became part of Exxon Mobile (XOM). If you listened to the analysts, you might have lost close to 50% of your investment in very short order. Let’s try to learn something by looking at this strange disconnect between the analysts and the events playing out in the Gulf of Mexico, Washington DC and London.

First, Ask What Went Wrong?

Start with the obvious: How could almost all the key institutional analysts have gotten the call on BP so wrong?

There are two reasons:

1. Analyzing what is visible; overlooking what is invisible
   Each call was based on extrapolations of existing accounting information and models of potential liabilities based on the Exxon Valdez oil spill in 1989. The analysts were focusing on the visible data: historic financial data and an accident that happened on the surface of the water near the coast of Alaska. All good and well but the market decided to focus on two problems that are invisible (or at least very opaque).
   First, the blowout is located 5,000 feet below the surface of the Gulf of Mexico. It is literally invisible. The most modern US nuclear submarine would not be able to get to half of that depth before being crushed by the pressure and almost all light cuts out below 650ft. In the case of the Exxon Valdez, both the US Government and the management of Exxon were clear about how much oil was being carried on the ship. This time, no one has a clue about how much oil will eventually spill into the water.
   Second, no one can say for sure how much new regulation will be imposed on the offshore drilling industry as a result of this disaster. These two invisibles have been driving the stock price, not DCF values.
2. If you liked it at that price, you are gonna love it now!
   OK, that may be a bit of exaggeration. We are not talking about kitchen appliances (or gold coins) on late night TV. But the hyperbole highlights the frame of reference problem. The analysts who liked BP at $60 were in the wrong frame of mind when it was marked down to $50 then $45, $40 and so on. If they thought fair value was north of $60 before, how could they not get excited about a clearance sale? But it wasn’t a sale. The frame of reference changed because the market was in the process of digesting the steadily worsening picture in the Gulf. Sometimes, the market is trying to tell you something. It might be a 20% off sale but at the very least, you should be willing to challenge your assumptions.

Next, ask if you should even be here?

For this frame of reference, we should question where the energy sector belongs in the greater scheme. It is fascinating to follow the reports and learn about how oil companies drill for oil a mile under water. But what does that have to do with your investment portfolio today? How much should one be investing in energy companies today with the global economy just barely out of the Great Recession? The answer is not difficult or complex. Taking IXC as a proxy (IYE if you would like to limit yourself to US only), you have not missed much by ignoring the sector over the last 6 months (both before and after the blowout). If you look at the medium term prospects of IXC (click here), the System is telling you that your money is better off elsewhere. Does that make sense? Before the blowout, low industrial capacity utilization and the prospect of a cooling Europe and possibly China signaled caution. After the blowout, the case for underweighting energy is even stronger when you think about how much more it will cost to drill for oil once the US Congress finishes passing new laws and President Obama finishes issuing executive orders. The time to look at this sector is when all the bad news is public and the economy looks ready to demand fresh sources of oil. We have reached neither of those conditions at present.

What can we conclude?

Bottom up research can be risky business. The conclusions can be undone by factors that are hard to fathom (or in this case, are invisible) and the analysts themselves are often too close to their subjects to offer good perspective. The next time you see a hot tip like BP at $48 on your favorite blog, ask yourself if all the bad news is really in the market and what would happen if another shoe were to drop. BP’s management may have been able to deal with a blowout leaking 1,000 barrels of oil a day but at 60k a day, the company’s prospects look very different.

By having a top down framework, which has been telling you that energy is at best a lagging sector right now, you can avoid investing in these “hot opportunities”. Picking a good sector in a broader index or a solid stock in a promising sector is a far easier way to make money in the long term.

Where are we this week?

The System shows us in much the same place as last week. Although the markets did perk up a little, most risk assets are still sporting low or negative scores. One issue looming over the equity markets is the huge number of large equity issues crowding the gates in Hong Kong and Shanghai as Chinese corporates clamor over one another to issue new shares. The expected valuations look rich compared to what investors seem willing to pay, the potential cash call is significant and any hiccups might generate bad news that could reverberate around the world. Perhaps the G-20 meeting isn’t the only reason China has announced a further revaluation of the RMB.

Try our new tool

Check out your favorite stock, ETF, index or Mutual Fund on our “Steam Gauge“. If you click this link or the picture below, it will take you to a page with the S&P500 ETF loaded into the ticker window. You can hit the “Try Me” button or enter your own ticker. After you get the result, the reset button will give you a blank window to try other tickers. We will be rolling out a more advanced tool for our Gold Members that will allow you to put in multiple tickers and see how they compare to each other.

Riskier assets have taken a pounding in the last month or so as investors calibrate the extent of the damage in Europe. Whether a Greek default will happen is almost irrelevant at this point because almost three quarters of investors think that a Greek default is highly likely. That is why Developed Europe is at or near the bottom of all the representative portfolios that we monitor. In the ETF Long/Short Portfolio, the Short EAFE ETF (Europe, Australasia, Far East or EFZ) is now joined by the Short Commodity ETF (DDP) at the top of the list. Please note that the readings for short products can change quickly so unless you are willing to follow those trades closely, the Long/Short Portfolio may not be for you.

However, the implications are important for all investors. As we have mentioned in the past few newsletters, the global “liquidity bathtub” has been tilted towards the US dollar. Most of the new money flooding into the US dollar is going into short term US Treasuries rather than equity, property or other assets, so it is short term in nature. On the equity side, money is flowing from the Big Caps to Small Caps. The reason for the small caps preference can be traced to the relatively large proportion of earnings that come from overseas in indices like the S&P500.

A strong US dollar does not bode well for export-led recoveries in the US or in most of Asia (where currencies show a “high correlation” to the US dollar). Copper prices had a bit of a bounce (an important leading indicator for construction and manufacturing in China), but commodities are generally still soft across the board. The only exception is Natural Gas (UNG) which is probably due to the continuing disaster in the Gulf of Mexico.

All of these developments send us scrambling to our favorite economic indicator, the ECRI Weekly Leading Index. A critical question in investors’ minds is the likelihood of a second dip into recession. Although the WLI has not signaled an upcoming recession yet, the trend is definitely not comforting. Like any leading indicator, major equity indices are going to have a weighting and certainly much of the drop from 12% in May to -3.5% in June is due to the sharp correction in major market indices. We will have to wait a few weeks to see how much a market bottoming will impact upon the numbers.

Source : ECRI

Will we go into a double dip recession? There is no doubt that GDP growth rates and corporate profits will slow for the rest of the year. Looking at a new set of indicators developed by Richard Davies at Consumer Metrics Institute, which uses a modern, updated approach to gathering sales data from the US economy, consumer demand is turning negative. Although these data series have not been around as long as ECRI, the approach is very interesting, the series leads GDP figures and the conclusions are also not positive.

Source: ConsumerIndex.com

So, what is the answer? Bear or just a correction?

Unfortunately, the jury is still deliberating. The System is designed to favor cash and cash equivalent asset classes when everything else is falling. We are not there yet and the risk of getting out of the market at a short term bottom is high when sentiment is as negative as it is now. Overall, our system is still showing a preference for some classes of equity over money market related investments although the readings are approaching a turning point. One sector which has fallen out of favor is the Biotechnology both in our mutual fund and ETF portfolios. But US stocks remain at the top of the portfolios with a skew towards small caps.

New research tool

For intrepid readers who are interested in seeing how some of our numbers are put together, we have developed an application which is still in the testing stage. Try it out here. For now, it only works with US equities, ETFs and Mutual Funds and you need to know the ticker (which can be found on Yahoo Finance). We would appreciate any feedback might have; please that you send it here.

Check out this New York Times article, The Impact of the Irrelevant on Decision-Making, by Robert Frank.

Make sure that the “madding crowds” don’t convince you to make a trade you might regret later.