Archive for February, 2011

Does Why = When?

As most of our longer term readers will know, we have issues with the Efficient Market Hypothesis and Modern Portfolio Theory because while elegant, they do not explain the actual market very well. Recently, we were challenged by one of our readers to really dig down and explain what bugged us the most about these two cornerstones of modern investment management.

Our conclusion? The concept that gets under our skin is the conceit that the current market price reflects all the available market information or, to state it simply: the price is always right. We call it a conceit because it assumes that the “Why” is always equivalent to the “When.”

How does this work in practice? If one assumes that the timing behind an investment decision is completely dependent on the reasons why one is making the investment in the first place, the process of making those investments is greatly simplified. One needs only to spread one’s bets widely across a broad range of investments and wait to see what the market delivers.This is the essence of “Buy and Hold.”

In a broadly rising market, waiting for the “rising tide to lift all boats” is a viable strategy. However, since we do not think financial markets are likely to deliver such benignly bullish conditions in the near or medium term, we feel compelled to look more closely at the issue.

Why is there so much emphasis on the “Why?”

Going back to basics, there are a number of questions one could reasonably pose about any investment or investment program. Who? What? Where? Why? How? and When? are all logical starting points.

But most financial media and investment research operations are geared to answer the question “Why?” to the exclusion of all others. Why did the market go up (or down)? Why did this investment soar/crater? Why did this quarter’s earnings miss/exceed analyst forecasts?

And frankly, first prize goes to the simplest explanation while second prize goes to the one who can repeat the explanation to the widest possible audience. The simple explanation, rather than the best explanation, is what investors pay for (through commission dollars, subscription fees and audience share numbers on cable networks). Perhaps that is why much of what passes for analysis on the airwaves, the internet and in our email inboxes feels like “empty calories.”

The hope seems to be that the “Why” will incorporate all the other questions one could ask or that by the time the “Why” explanation is examined closely, attention will have shifted elsewhere.

But like potato chips, these empty calories certainly satisfy the need for instant information gratification but do not necessarily leave one better informed about the state of the market.

Why vs When

“Why” looks backwards

In addition to the race to the simplest explanation, the other problem with the relentless search for “Why” is the rear-view nature of the quest. While we might intellectually recognize that all potential profits and losses actually lie in positioning ourselves correctly for future movements in the financial markets, emotionally, we are obsessed with the need for vindication.

So, as one confronts the daily tide of financial market information, one needs to ask: does this particular nugget of information or analysis merely feed my need to be right or does it actually tell me something new about the lay of the investment landscape?

“When” looks forward

Going back to our starting point, we think that asking the question “When” can help keep us focused on the timeframe which will actually deliver investment returns: the future. The purpose of investing is to fund future liabilities. Obviously knowing what you are investing in and how different factors have impacted the investment in the past are important components to help gain a more complete understanding. But “When” forces us to grapple with the actual forces which determine the price of assets in the financial market. “When” also compels us to think of exit strategies as well. If an investment is attractive to us at the current price, what will make it attractive at some point in the future so that we can reasonably expect to book a profit.

How does all this help us as investors?

Although Financial Markets are driven by the sum total of the emotions of participating investors, the market itself is devoid of any sympathy or emotions. Relying entirely on backward looking explanations to satisfy our emotional need to be right is probably not the best way to extract the returns we will need over the longer term to fund our future liabilities. By recognizing which questions will lead us to unemotional decisions, we can cut through much of the information overload and follow strategies that are not already completely discounted in the marketplace.

To answer our original question: does “Why” = “When”? We don’t think so. We think that the two different lines of inquiry yield different and sometimes conflicting answers about the state of the market. Since time and resources are limited, we would concentrate on answering the forward looking “When” question while the vast majority of investors remain obsessed with the backward looking “Why”.

What are the various Systems telling us?

Broadly speaking, the systems that we follow are showing strength in Energy, Technology, the US market and Small Caps. In the commodity space, we continue to see strength in Agriculture (DBA, JJG, DBC and COW), Energy (UHN) and Silver (SLV). The markets are pointing to a continued recovery in demand and investment in the sluggish US economy and the risk of inflation is a very real concern. Although many of the particulars are different, with two unfunded (by current tax revenue) wars and a massive domestic spending program, one should perhaps start flipping back to the history books to see how the economy developed through the late 60s all the way through most of the 70s. But the risk of stagflation is a big enough subject to warrant its own post.

How Do We Interpret Information?

Rose Colored Glasses

What if the latest data seriously conflict with your investment thesis?

Do you follow John Maynard Keynes who once famously quipped when accused of changing his position on monetary policy in the Great Depression: “When the facts change, I change my mind. What do you do, sir?” (Source: Wikiquotes)

Or, do your actions sound a bit more like this passage…

Investors’ desire to align their behaviour with their beliefs causes them to interpret the information they receive in a way that leaves those beliefs intact. …We will choose to discredit, downplay or even ignore any inconvenient signal for reasons that have nothing to do with our belief in the methodology or, heaven forbid, profit maximisation.

If you suspect the latter quote describes your system of interpreting information, perhaps you should read the entire article, Self-Fulfilling Destruction, found here. It is a short passage but really nails down one of the biggest issues we face as investors: how do deal with information that doesn’t support our current investment thesis.

What does this have to do with the Fund King System?

The truth is that we do not invest with perfect knowledge. However, even if one were so deluded, that assumed perfection would melt away when the first piece of new information became available. An investment system is a tool to help overcome our natural desires to enthusiastically embrace confirming data while quietly ignoring conflicting data.

Silver and Gold

As long time readers will know, I have a particular fondness for Silver. I was fortunate enough to buy a small stack of one ounce silver bars as a kid just before the Hunt brothers tried to corner the market. The story even has a happy ending as I managed to sell most of my stash very near the top at $42-45 an ounce (my average price was around $12).

So, it did not take too much encouragement from the feverish doomsayers to get me to dabble in Silver once again last year. Rather than loading up on coins or bars, I decided to participate in the shiny metal this time by buying the SLV ETF.

For those of you who do not spend too much time on the internet researching investment ideas, SLV has been at the center of an email, newsletter and pundit campaign which sees dark forces (JP Morgan was assumed to have been over-exposed on the short side of the futures market) surrounding the market for silver. I remember reading several reports from otherwise credible websites that cast doubt on whether there was actually much silver backing the ETF.

So how did it work out and why?

Obviously, Silver went up alot last year. SLV closed 2009 at $16.54 and finished 2010 at $30.18. I did not pick up until about halfway through the rally (I was using the discipline of the System) but that still left me with a smile on my face. If you check out SLV on the Steam Gauge, it is still ranking pretty highly. The question one should ask is why?

Relationship with Gold

Both Gold and Silver have served as money and store of value for thousands of years. Their value as precious metals for jewelry goes back even further. And, often Silver is found as a bi-product of Gold mining (as well as copper, lead and zinc mining). However, there are also important differences. The first is that gold is nearly indestructible despite its industrial applications. Almost all of the gold ever mined in human history can still be accounted for. Silver, while much of it is recycled over the centuries, has many industrial uses that cause it to be used up.

For investors the question is: what is the “fair” or “proper” relationship between Gold and Silver? While most of the research that I have read argues persuasively for a 30:1 price relationship, the fact is that over the last 100 years, the ratio has fluctuated between 100:1 and 15:1. Whatever the proper relationship, there is no question that most of the performance last year came from a rerating of Silver vs. Gold. In the chart below, we have charted the price of GLD divided by SLV over the last two years. Remember that GLD is meant to represent 1/10th of an ounce of Gold vs. a full ounce of Silver for SLV.

GLD price divided by SLV price

Will it continue?

There is probably a bit more left in Silver because it has two drivers. The stronger driver is the relationship to Gold (which will rise in conjunction with general investor anxiety and fall if confidence in economies and currencies returns). If Gold goes up, Silver will follow. Silver may close the “valuation gap” a bit more this year but most of the revaluation is history now. The lesser but still significant driver is Silver’s role as an important industrial metal. Like Aluminum, Copper and Zinc (which one can gain exposure to through DBB), it may rise in line with general inflationary pressures.

System Numbers Flattening

As we pan across our portfolios, we notice a definite lowering of the numbers that the System is throwing out in the rankings. The last time this happened was in April/May of 2010 and it definitely foreshadowed a weak stretch for assets at the higher range of the risk spectrum. The numbers remained flat through the summer and started to recover in September of 2010, which coincided with a strengthening of sentiment that carried through until recently.

But what about all the reports of bullishness?

There have been a number of recent articles in all the right papers which have pointed to a general bullish sentiment in the market. These reports are couched in caveats but generally reveal that asset allocators are overweighting equities and bonds and underweighting cash. But the market is not all one way; there are still magazines to sell and as we approach the second anniversary of this strange bull market, we get think pieces like this in Barron’s. Unfortunately, the thinking is not terribly original or prescient.

The problem with these approaches is that they either measure what people say (asset allocation intentions, bullish/bearish sentiment polls) or the way they think things should be (articles bemoaning the historically high CAPE, the Cyclically Adjusted Price Earnings ratio or why Gold should be trading at $5,000). They are not measuring what people are actually doing with their money.

Let’s think about how this works. If one owns equities (or property, or bonds, or gold bars), one is by definition bullish. But this is a lagging indicator because the actions surrounding the bullishness have been taken in the past and are unlikely to contribute to further upward price action in the short and medium term (unless the market has been cornered). So, after a run up, which by definition must mean a bunch of new investors have been bidding up prices and filling their portfolios with the asset-du-jour, one would hardly expect those avid collectors to “talk down” the price of their newly acquired assets. The trend can continue only with new money being attracted to the asset in question. That money can come from other asset classes, from the real economy via savings or, in the case of QE1 and QE2, from credits which materialize from FED activity on bank balance sheets. Once the new buying abates, the market pauses and often corrects.

While we make no claims that the Fund King System has any “crystal ball” properties, one of the things it will measure is the momentum of money as it flows into and between the various financial asset classes.

In this week’s survey, the assets still attracting investor favor are Energy, the US, Small Caps and Agriculture. Silver appears to have topped out after rushing to catch up to a more traditional valuation against Gold. It still ranks highly in some of the longer term portfolios but it has been dropping down with Gold on the shorter focused portfolios.

Our advice? It is time to watch the numbers a bit more closely than usual. We could be at the start of a larger correction in risk assets or it could just be a pause to see how some of the latest events turn out. The big issues are, in order of importance from an investment point of view, the level and sustainability of growth in the US, the risk of a slowdown in China induced by inflation fears and an ugly resolution to the Egyptian unrest which would upset the balance of power, peace and trade arrangements in the Middle East.

Inflation Sneaking In?

While trolling through the 24 hour news channels, one thing to watch out for is the quiet risk of inflation. The fact that the best looking assets are in the energy, agricultural and materials sectors leads one to conclude that there is more inflation running through the system than government statistics might suggest. There is no way to properly quantify how much inflation because the two most common measurements (Government Statistic and Personal Observation) are both flawed. The former is flawed because Governments collect and report the data which they use as a yardstick of successful governance. There is no question that the BLS has changed the rules over the past few decades to make the data as flattering as possible. The latter is flawed because our personal viewpoint is too narrow and we tend to focus on the things that are causing us the most anxiety. We tend to overlook those prices which are going down (unless it is our salary or house).

But how can we have inflation if growth is only in the 3-4% zone? Most of us have been schooled on the idea that inflation can only come about when the economy gets overheated (too much money chasing too few goods). When the economy is well below potential, there is little risk of inflation creeping in, right? That is the crux of the FED’s stimulative policy argument. But there is more than one way to create a bit of inflation. If we look at Zimbabwe, for example, its bout of hyperinflation did not come about from extremely robust economic growth. It came from printing up too many pieces of paper (too much money chasing too few goods).

One might be tempted to take comfort in the relatively low yields on long dated US Treasuries. But then again, one needs to look carefully at who is buying the paper. The FED is hardly going to demand an inflation premium on the US Treasuries it is buying with newly created money it created when one of its two mandates is to maintain price stability. I am not accusing anyone of “window dressing” but there is little incentive for the FED to haggle for the best price while it fills its shopping cart with long dated Treasuries.

Shadowstats Alternate Inflation MeasureShadowstats has an interesting take on inflation by taking the 1990 methodology and contrasting that with the current BLS methodology. There is no doubt that some spending patterns have changed since 1990 but it is interesting that the adjustments to the methodology have served to consistently show the US inflation picture in a flattering light.

Risky Business

After 30 years of a mummified political existence, the Egyptian political scene exploded into protests and unrest last week, threatening to destabilize the Arab world’s largest country.

Although the Egyptian financial markets barely register from a global perspective, the unrest reminded investors that the world remains a risky place. The US dollar rose, gold perked up and oil, which is not a big Egyptian export, was back on the rise.

If you read’s excellent coverage of the crisis, you will note that the most likely outcome for this crisis is a fresh face from the military who will rapidly move to:

  1. close down the Muslim Brotherhood,
  2. shore up the US alliance, and
  3. quietly assure Israel that the 1977 Peace Deal is still in effect.

But the fireworks along the Northern bit of Africa are not the only worry in the world.

US Growth

In a detailed letter this week, John Mauldin takes apart the latest US GDP numbers and finds that there were more statistics than recovery in the numbers. It makes for interesting reading, especially when one considers how the inventory numbers change because of the change in oil prices over the quarter. The issue of US growth is tremendously important because much of the world’s monetary policy (in particular, the fast growing developing markets like China) are tied to the FED through fixed or nearly fixed exchange rates. Weak growth means that the FED will continue to err on the side of accommodation, which means that US interest rates will remain low until the bond market rebels and/or inflation becomes too obvious to hide.

The US economy is starting to pick up but at a growth rate well below that of previous post recession recoveries.


Related to the sluggish US growth rates and resultant accommodative monetary policy, it looks like we will see commodities surge ahead once again. In this week’s rankings, Silver (SLV) and Food (DBA) score highly with Base Metals (DBB) and Oil (OIL) putting in lower but respectable scores. Commodity Related ETFs like Russia (RSX), Global Energy (IXC), and Fidelity Funds like Select Energy (FSENX) and Natural Resources (FNARX) are also near the top of our various portfolio lists.

The strength is due to the solid demand for these commodities which is driven in no small part by the massive supply of dollars floating around the globe. The desire to turn the seemingly unlimited supply of dollars into more supply restrained commodities looks set to remain a theme for the foreseeable future. Higher prices will eventually entice more suppliers onto the market but the lag should be prolonged enough to make some money from the next leg of the commodities rally.

Sovereign Debt Crisis: Japan

Another story that should have caused more concern than it did was the downgrade of Japan’s long term debt by S&P. The rating drop from AA to AA- doesn’t seem momentous compared with some of the sovereign crises we have experienced over the past couple of years. However, two things bear watching. The first is that ratings agencies historically have been behind the curve in downgrading sovereign debt. If S&P is downgrading now, this may be the start of a more serious cycle. The second question to ask is: “Who will buy Japanese debt?” In the past, this was not a terribly interesting question because the bulk of JGBs (around 94%) were absorbed domestically. With the aging of Japan, it is not unreasonable to expect that the robust savings rate, which allowed Japan to self fund its government debt, will shift into reverse. Last year the Japan Post Bank (the biggest owner of JGBs at more than 20% of the total) announced that it would no longer be a net buyer from 2011. According to the Economist, gross debt to GDP is an eye watering 190% and rising (although other sources already quote figures in the 200% plus range) so having a major buyer like the world’s largest bank (by deposits) pull out of the market is not a small issue. The pricing mechanism for JGBs looks set to change as foreign investors are asked to bid for bigger slices of Japanese debt. On the negative side, it will not take much of an interest rate hike to overwhelm Japan’s fiscal budget with interest expenses. On the positive side, the pressure from the bond market could be enough to spur Japan to enact much needed but unpopular reforms that could set the stage for an escape from two lost decades. However, any good news will only come after a period of painful adjustment.

So what should an investor do?

We think the best approach is not to run away from risk but to manage it. The recovery from the Global Financial Crisis has been rocky and looking around at some of the overheating in China, the rolling sovereign debt crises along the rim of the EU and now the turbulence in the Arab world, it is obvious that some of these trends will lead to trouble down the line. We think the solution lies in identifying and monitoring a fairly broad universe of asset classes and recognizing that the institutional money in the market will be draw towards and scared away from different asset classes at different times. By deploying one’s investment funds in the asset classes that are benefitting from the rising tide and avoiding those where sentiment is draining away, we think one can achieve a solid return on one’s portfolio despite the generally directionless but highly volatile overall direction of the financial markets.

CIVETS anyone?

We have received a number of questions about the CIVETS market (Columbia, Indonesia, Vietnam, Egypt, Turkey and South Africa) and how they compare to the previous emerging markets grouping, the BRICs (Brazil, Russia, India and China). We decided to see how far along in the cycle we might be by using the System to pick when and where to invest in each grouping.

CIVETS markets

So, if you were wondering if it was too late to jump on the bandwagon, this chart suggests that there is still some money to be made in CIVETS.