Archive for April, 2010

Greed and Fear

It’s time to take a reading of where we are on the Fear and Greed curve. If we want to be better investors, it is critically important to take stock of where we are in the cycle from time to time.

Fear and Greed Investment Cycle
Source: Investment Postcards Blog

This week, I am borrowing the chart shamelessly from Prieur du Plessus who runs a very informative investment blog from his base in Cape Town. If you would like to receive his thoughts, he offers a free email subscription (follow this link).

The Fear and Greed Cycle is a classic and has been around for decades at least.

What is a classic?

According to Mark Twain, a classic is “Something that everybody wants to have read and nobody wants to read.”

OK, many of the “classics” we were forced to read in school were pretty dry but that’s not the reason we ignore the Fear and Greed cycle. We ignore it because it reminds us that our emotions play a strong role in our investment decisions. When the market is low, so are our emotions and we fail to buy (or worse, we dump at the bottom). When the market is at the top, our emotions are bubbling over and we fail to sell (or worse, we buy more). Since this is the core argument behind the IRP System, we won’t belabor the point here other than to say that we believe emotions are the key driving factor behind price movements.

So where are we today?

Globally speaking, we are in the middle of the left hand side of the curve, somewhere in the region of Caution. Some markets are more confident than others but there are many investors who still bear the emotional scars of the Global Financial Crisis. We are edging in on Enthusiasm but we are a long way from Conviction.

One of the interesting features of this recovery is the unevenness of it. Because the Global Financial Crisis was largely a G-7 event, the normal order of recovery has been scrambled. Usually, the global heavyweights in the developed markets lead the market recovery followed by smaller caps, emerging markets and exotic themes. This time, the financial markets were led out of the woods by the BRICs (Brazil, Russia, India, China) economies that were able to sidestep the worst of the recession. Countries like Poland did extremely well by not falling into recession at all. So, our normal “rules of thumb” may be a bit stretched but the emotional state driving investor decisions remains the same. Therefore, when we point out that US Consumer Discretionary Spending stocks look promising (VCR & XLY) while China (FXI) Brazil (EWZ) and India (EPI) have come off the boil, it should be noted that market sector leadership was very different this time around.

So what can we expect?

Given the ferocity of the bounce from last March, it is tempting to conclude that this trip up the left side of the curve will happen very quickly. In economic terms, that would be anticipating a double dip recession or W shaped recovery. That outcome is still quite possible but we are preparing for a longer, messier, uneven recovery similar to what we have experienced over the last 12 months. Economically, this more likely but messier scenario would see growth returning in fits and starts around the globe. On the Fear and Greed curve, it would leave us struggling between Caution and Optimism for the next 12 to 18 months.

What should we watch out for?

One should be on the lookout for signs of hubris and in the case of China’s recent property bubble and the potential bubble that has built up in Sovereign Debt, those signs of overconfidence are already here. Bubbles in one or two asset classes are not a sign of the end and with all the stimulus cash sloshing around the global economy, it is to be expected. However, when the majority of asset classes look bubbly, it will be time to look for the exit. We are not about to embark on a 20 year bull run in asset prices, not at these starting levels anyway.

What looks good this week?

This week, our international portfolios are still positive on Emerging Europe (GUR/GMM), India (EPI) and Japan (EWJ). Our mixed US/International portfolios are positive on Consumer Spending (VCR & XLY), Biotech (XBI), Pharmaceuticals (XPH), US Small Caps (VB, IJR & IWM) and Homebuilders (XHB).

New ETF Pages…

We are building up our ETF information pages (starting with AWCI) so please click through and check them out. Any suggestions (ETFs you would like to see, different presentation or any other comments) would be most appreciated.

Caveat Emptor

“Let the Buyer Beware”

is the first lesson any investor should learn. The SEC complaint against Goldman Sachs with regards to a synthetic CDO deal is only the latest reminder of why this old Latin phrase still has instructive powers today.

But, don’t expect much commentary on Caveat Emptor in the coming weeks. Why? Because it is human to get a guilty pleasure from watching the misfortune of others. The Germans even have a proper term for it: Schadenfreude.

One cannot blame the financial media (newspaper, magazine, television, blog) for feasting over every little detail. This story has only just begun. As Professor Bill Black points out in a series of YouTube videos, there were over a thousand criminal convictions in the wake of the Savings & Loan Crisis that wiped out an entire segment of the US financial industry in the late 1980’s. The most stunning statistic to date is that there have been no convictions in the wake of the much bigger and more widespread Global Financial Crisis despite the widely reported fraud that occurred at many levels of the subprime and Alt-A mortgage origination process. Now that the SEC has fired an opening shot at the biggest target on Wall Street, State Attorney Generals will jump on the band wagon. Unlike SEC officials, AGs need to run for reelection. Pursuing the alleged perpetrators of the crisis that has pushed millions of homeowners into negative equity and driven the underemployment rate to 16% will prove popular amongst the voters for several years to come.

Sure, it is fun to watch the mighty fall (or at least get in deep trouble). But, if you want to become a better investor, you need to tear your eyes away from the media circus and learn an important lesson from this affair. The lesson is that “Wall Street” or if you prefer, the sellers of financial products, are not necessarily on your side.

That statement needs to be looked at very carefully. It does not mean that the sellers of financial products are always out to cheat you. It does not mean that all financial markets are a zero sum game where every winner must have a loser on the other side of each transaction. However, it does mean that the firms and the employees of the firms who sell you financial products have priorities that may not always align with yours. It’s called agency conflict.

How does this conflict arise? We need to divide it into two batches:

In the olden days when brokerages and fund managers primarily made their money from selling products and gathering assets, the agency conflict largely arose because financial professionals were compensated by moving product. While the vast majority of investment professionals enter the business to help their clients make money, compensation systems are not set up with that goal in mind. That conflict between the need to make money for the firm and the hope of making money for the client was largely but imperfectly bridged by prospectuses, disclosure, regulation and professional standards. The theory was that transparency should allow investors to make informed choices. In practice, greed and laziness (and sometimes darker motivations) overcame good intentions from time to time.

More recently, however, the large investment banks have come to depend more and more on proprietary trading to pay the bills. This has set up a more serious agency conflict because it is now in the bank’s direct and immediate financial interest to trade against its clients. The relationship runs the risk of turning into that of the casino owner and his customers. And, where prime brokerage relationships allow the “house” to peek at the customer’s cards before placing its bets, the odds appear to be unfairly stacked in favor of the “house”.

Will new regulations fix the problem? Agency problems exist wherever there is a market. Unless the new regulations do away with markets, the answer is no.

What can an investor do?

That brings us back to the title of this article. The lesson of this “train wreck” is that investors must constantly strive to make themselves aware of what is really going on. Investors must not abdicate responsibility for their investment decisions whether for reasons of laziness or greed. The investor must be aware of the risks involved both at the individual asset level and in the portfolio as a whole.

We think the best way to achieve this is to develop a systematic approach to investing. A systematic approach should include at the very least a robust and unemotional investment screening process and a regular review mechanism. The investment screening process is critical to choosing investments based on rational criteria rather than the latest rumor, hot tip or “gut feel”. The review process is equally important because markets are cyclical and even the best investments go down sometimes.

The Fund King System is designed as an asset selection system with a built in review process by investment professionals who have dealt with agency conflicts for several decades. Unlike less independent research operations, we do not have a financial interest in the recommendations of the Fund King System. The system works with your investment universe to unemotionally select assets that have the most likely chance for outperformance in the medium term. Because it refreshes on a weekly basis, mistakes (and there will be mistakes) are caught before they do too much damage to your portfolio. Your assets are regularly redeployed away from underperforming assets and towards those with the best prospect of performing. At the end of the day, that is what investing is all about…positioning your assets so that they can work hard for you.

How does that help you with agency conflict? When you are in control of the asset selection and review process, the Financial Industry’s role is reduced to that of a product and execution services provider. Agency conflicts still exist but the opportunity for abuse is reduced.

If you would like to learn more about how the System works, there is information on this website or you can contact us directly with any specific questions you might have.

A Clean Sheet of Paper

I once asked a brilliant strategist how he did it. How did he come up with insightful equity strategies month after month? How did he know we would recover from Asian Financial Crisis so quickly and that we could make so much money in Indonesian Banks? How did he know that the NASDAQ (and with it, the entire Asian Technology Sector) was going to roll over soon in 1999? The answer was simple, according to him: toss out your previous conclusions, take out a fresh sheet of paper and take stock of where you are today.

Raymond Foo’s strategy hinged on ordering all the available indicators into three batches: Leading, Lagging and Concurrent. His brilliance lay in recognizing that these indicators could change from Leading to Lagging to Concurrent. Past categorizations were not allowed to influence current ratings. He had to prove an indicator was still a leading one before he would use it.

How does that help us today?

Rather than troll through hundreds of indicators and assign one of three values to them, we can get similar results by objectively looking at the asset classes we have available for investment. There are two approaches, a mathematical and a more empirical approach.

The Fund King System takes a mathematical approach and the results are available on the website. Broadly speaking, in the last two weeks the Fund King System’s signals have been slowly recovering from very neutral 1st quarter readings. The picture is brightening but we are certainly far from broad bull market territory in risky assets. There are opportunities which are worth taking: Emerging Europe, India, Biotech and even Japan are coming out at the top of our mutual fund rankings. In the ETF space, Pharmaceuticals, Biotech, Russia and Medical Devices look promising on a global perspective while the small cap space looks like it is heating up in the US only portfolios. Consumer Discretionary is still close to the top of the lists but momentum is starting to fade.

From a more empirical point of view, we can start filling up our clean sheet of paper by dividing the world into four asset classes: Equity, Debt, Commodity and Property.

Equity is not cheap.

Whether measured on a Price/Earnings, Dividend Yield, Price/Book or an earnings growth measure, equity markets around the globe are not cheap on a historical basis. Following a Buy and Hold strategy from these levels will yield a pretty poor return over the long run as valuations are likely to fall rather than rise from these levels over the next few years. But, there are short and medium term opportunities that should not be overlooked. As excess liquidity sloshes around the globe looking for returns, opportunities will continue to pop up in equity assets.

Bonds are not cheap.

Even Greek bonds are not paying enough to compensate for the real risk of default. While all markets are subject to the laws of supply and demand, the bond markets in general and the US Treasury market (which provides a leading benchmark) in particular have seen outsized demand during the Global Financial Crisis. Those dynamics will change although more slowly than some of the bond bears think. One area that continues to show strength is the High Yield space. Many Corporates are managing their balance sheets with the same care as newly chastened consumers (and in stark contrast to many governments).

What about commodities?

Most commodities are not long term investments by definition. Because of substitution and demand elasticity, commodity prices can only rise so much before new supplies sources become economical and customers substitute cheaper alternatives. Alternatively, prices can only fall so much before mines are mothballed or new demand pops up to soak up the excess supplies. As cyclical markets, though, that does not mean that one should not include commodities on your investment radar screen.

Gold is a special case because of its historical role as “hard money.” Supply, demand and substitution do not impact the price as much because gold is almost never actually consumed. Most gold is held as an idle(non-income producing) store of wealth so the price of gold is largely determined by emotions. Gold quadrupled from under $300 (early ’02) to $1200 an ounce (Dec ’09) because investors lost faith in fiat currencies like the US dollar. But, how likely is Gold to double from current $1,100 levels? It may rise back to $1,200 or find a new high at $1,300 but there is also the risk that it could retrace 30% like it did from March to October 2008 (hardly a time of optimism).

And property?

Despite the efforts of Professor Shiller at Yale, property is still not a tradable commodity. Property prices have fallen in many parts of the world but that was from bubble levels. Affordability indices suggest that housing is still overpriced in many desirable locations in the US and Europe. In Hong Kong and China, there is a reflating bubble as China’s heroic stimulus efforts have funded a massive property rush. That said, there are several studies that show property markets decoupling from one another suggesting that some well researched REITs will once again add non-correlated returns to your portfolio in the not too distant future.

The conclusion?

Many of the “Buy and Hold”, “Buy the Dips”, “Property Always Goes Up” and “Stocks for the Long Run” ideas that we grew up with in the great asset bull markets of 1982 to 2006 need to be tossed and replaced with a more opportunistic trading strategy.

How should you start to formulate that strategy? One way is to secure a good supply of clean sheets of paper. It is not easy to let go of previous assumptions, especially if they have worked out and made us some money. But, if you can approach the market with a fresh attitude each time you evaluate your portfolio, those sheets will come in handy over the next few turbulent years.

The Fund King System is a web based way to achieve the same goal. If you need more information about how the Fund King System can help you invest more efficiently, let us know how we can help you use it for your portfolio.

Time to Check Your Bonds

With the 10 year US Treasury Yield flirting with the 4% mark once again, some commentators are calling the end of a three decade long bull market. The US Government looks set to grow borrowings for the foreseeable future as it steps in to take the lead in the Debt Supercycle Buildup. With total debt at unprecedented heights and growing at rates not seen in several generations, either bond buyers start demanding higher interest rates soon and/or the US “restructures” the terms of the debt by inflating or monetizing (which will in turn force nominal interest rates higher later). When interest rates rise in the market, assets with fixed rates of return (like bonds) generally fall in value.

The Debt Super Cycle

Source: John Mauldin

What will cause things to crack?

Inflation, demand for capital and/or a buyers’ strike are the common culprits. While inflation and demand for capital don’t look like a problem today, the risk of a buyers’ strike in the not too distant future cannot be ruled out.

Of course, this doesn’t mean that everyone agrees. Bond Bulls argue that interest rates aren’t going to fall much from this point but they think a continued weak economic recovery will keep interest rates from rising. The best example of what they expect is the Japanese Government Bond (JGB) market which has delivered razor thin interest rates year after deficit spending year. For nearly 20 years, JGB bears have scorched their fingers betting against the bond market. (for more read Alicia Ogawa’s piece in the Wall Street Journal)

So who is right?

The answer lies in what is different about the two markets rather than what appears to be the same.

To start with, the US dollar is the global reserve currency. The US dollar is used to trade commodities (especially Oil), settle trade accounts between non-US parties, and even as the legal tender in several smaller countries around the world. The Japanese Yen, while fully tradable, is not really of much use outside of Japan.

Next, we look at the decades’ long current account surpluses in Japan vs. deficits in the US. The result? The JGB market is largely a clubhouse affair. Only a very small proportion of the bonds are held outside of interlocking government agencies and the big Japanese banks. Despite the best efforts of the US Government to turn money center banks into the willing tools of US financial policy (and the latter’s willingness to be so co-opted), the US Treasury and the Federal Reserve will never enjoy the captive audience that their Japanese counterparts do.

So who will trigger the next move?

Perhaps the largest single holder of US paper? Actually, that is not likely. A Chinese clearance sale of US Treasuries and Agencies is a pretty remote possibility at this point in China’s economic and political development. Although no one likes to talk about it, the value of China’s currency (the RMB) is directly derived from the pile of US treasuries sitting in Chinese Government accounts. How about a buyer’s strike? That is more likely only because China’s current account surplus is shrinking and may even show a few monthly deficits this year.

The trigger will probably come instead from Europe. As the Greek crisis has shown, European banks are very well exposed to the government debts of the PIIGs (Portugal, Ireland, Italy, Greece) markets. Part of the Global Solution to the Global Financial Crisis has been to pretend that credit assets (loans, bonds, MBS, CDO’s, real estate collateral, etc.) are worth face value while opening up a central bank arbitrage window to allow banks to quietly rebuild capital bases. If the Greek crisis gets much worse, we could see European banks selling off treasuries not because they have lost faith in the paper but because US Governments and Agencies can still be sold at something approaching the values carried on the books.

Look for US interest rates to rise and all financial markets to get more volatile as a result.

Sources: Stock and Investment Postcards Blog