Archive for March, 2011

Managing Uncertainty

Now that some of the dust has cleared from the international markets, it is a good time to assess the real impact of Japan’s triple disaster on your actual portfolio.

Why? Because it is sometimes important to look back and recognize that for most investors, the damage was in the 2%-4% range. It may seem cruel that financial markets can rebound so quickly after a massive earthquake, a tsunami and partial core meltdowns but, except for Japanese fund managers and the people who are suffering in the affected areas, the news cycle is about to leave the story behind.

The urge to “Do Something”

When we invest, we bring all the skills we have acquired in the non-investment world, especially those which have worked so well for us.

One of those skills is the ability to quickly react to stimulus. Our ability to survive in the world depends on quick reactions. Whether driving, walking, making decisions at work or social situations, our ability to react to our environment is critical to success. We actively seek to hone our reaction skills through education, training and experience. Some of our reactions are “hardwired” and so quick that when we put our hand on something red hot, our nervous system reacts even before sending the message to the brain. By the time the brain becomes aware of the incident, the hand has already jerked away from the hot surface.

What works well in the physical world does not always work as well when it comes to investing. For the short term professional trader, lightning fast reflexes may be important. But for the rest of us, letting the new information get all the way to the brain where it can be judged against the existing investment strategy is the way forward because trading, while cheap these days, is not cost free.

As the markets regain their pre-triple disaster pose, it is clear that “doing something” just for the sake of reacting to the news is not the best investment posture to strike. As the Nuclear plants are brought under control, we should see iodine and salt prices returning to normal, even in Mainland China.

What does Japan mean to the Global Economy?

Most observers reckon that Japan was either in or about to enter its next recession even before the triple disasters struck. That means the 4%-4.8% global growth rate that many economists are looking for this year did not rely heavily on a strong Japanese contribution.

What about Japan?

Although our initial reaction was that Japan’s financial prospects have not changed significantly as a result of the triple disaster, there has been one movement which bears further observation: the Yen.

The world’s Central Bankers are coordinating efforts to clamp down on the surge in the Yen that occurred in the aftermath of the quake (82.9 on March 10th to 76.25 on March 17th) as Japanese firms and individuals scrambled to bring money back onshore. Given Japan’s high level of indebtedness, one might expect the Yen to weaken as the scope of the disaster became clear. But, that would ignore the investment situation from the local perspective. Japanese individuals and institutions have spent the last two decades funneling money offshore to capture more promising returns than were available onshore. With a massive rebuilding program on the horizon, it would appear that investors are voting with their offshore accounts that there will be some attractive opportunities in the not too distant future. Japan has often only undertaken comprehensive restructuring as a result of Gaiatsu (outside pressure). Although usually a term reserved for foreign political pressure, the triple disaster comes at a time when Japan has largely exhausted its biggest source of finance (individuals saving through Japan Post Bank). That pile of savings is still very large but is more likely to be drawn down than grow given the aging of the population. Whether the rebuilding effort will be large enough to spur the economy out of its “Lost Decades” is something to watch for over the coming months. To succeed, a certain amount of intestinal fortitude on the political side will be required to allow for economic restructuring in addition to just reconstruction. The dramatic movement of the Yen suggests that the possibility exists.

So, how do we manage in such uncertain times?

There is no “System” that will predict an earthquake (large or small) or any other “Black Swan” event that might trip up the financial markets. Fortunately, the financial markets are more resilient than the 24/7 cable talking heads suggest. The problem with Black Swan events arises when one invests without a plan. Because, without a plan, all one is left with is panic and reaction. Unfortunately, with High Frequency Trading systems trading 50-70% of the daily volume in the US on timescales that are a tenth to a hundredth of the time it takes to blink, the reaction game is one in which an individual investor has no competitive edge.

The trick is to change the parameters of the game to play to your strengths. By taking a longer viewpoint, most of the market noise (intraday and intraweek volatility) cancels itself out. The remaining movement can be analyzed in terms of shifts in economic or financial fundamentals or investor perceptions of the same. This is an area where astute observations and an eye towards risk control can help one capture returns that will build wealth in the long term.

Whether you use the Fund King System or another investment discipline, it is important to keep a level head and make the important decisions (what to invest in, when to buy and when to sell) well before the markets inundate you with conflicting data. Not all of your trades will be winners but having solid parameters for judging winners and losers before the market starts reacting to the day’s events will leave you in a much better position to make astute investment decisions.

Or you can load up on iodine tablets…

What looks good this week?

Across the portfolios, we are seeing a deceleration in the small caps which performed in the first few months of the year. An interesting sector to watch is financials which may be poised for a big jump in top line growth if confidence in the US economic recovery grows. Banks in particular have been in balance sheet repair mode since the Global Financial Crisis started. If the focus switches to market share and revenue growth, we could see a big surge in financial shares in the US. XLF is currently ranking #2 in the US ETF Sectors Portfolio.

Silver (SLV) still looks solid both in the longer term portfolios and in the short term commodity portfolio. Energy looks good both in US terms (XLE) and Globally (IXC) and while events in Libya may influence prices in the short term, the longer term driver is increased demand from G8 economies that are still in the early stages of an economic recovery from the Global Financial Crisis.

The Seeking Alpha Portfolio

Seeking Alpha PortfolioThis week, we bid farewell to Taiwan (EWT) which has been nudged out of third place by the S&P 500 (SPY).

As noted in the past, the tech sector has shown signs of weakness that suggest either that economic growth for 2011 has been overestimated or that the tech sector is not going to benefit to the same degree as it has at similar stages in economic recoveries of the past. The fact that most of the tech innovation is actually taking place in software rather than hardware (apps vs. a new tablet; software as a service rather than installed applications) may be part of the puzzle as corporate budgets are spent on IT projects that deliver more efficiency rather than just building in new capacity. The system may be signaling that the pricing power lies with the corporate IT departments rather than the tech firms that will be supplying them.

Oil, Food and US Big Caps

With SPY nudging out EWT, we should be on the lookout for signs that confirm or contradict the idea that the US will grow at a solid 4% plus rate. Unemployment will continue to draw headlines as the Republican presidential candidates start to turn Political Action Committees into formal campaigns in the coming few months. However, it is important to keep two things in mind.
1) Unemployment is a lagging indicator of economic growth in the best of statistical times. And
2) US statistical methods tend to understate new employment in recoveries and overstate the situation in downturns.
So, with a double lag effect, investors should not put much weight on payroll releases. By the time they flash “green”, most of the recovery may be finished.

Extreme Money Flows

iShares Japan

My buy order for EWJ was ignored on Tuesday morning. It wasn’t a large order. I was just putting it in to see if I could pick up the ETF on the cheap.

Unfortunately, I got a bit too clever on the limit (previous close less 10%) so I did not get filled. By 10am, I was pretty sure that I had missed the boat.

Why is that important?

Because the market meltdown in Japan and subsequent bounce are not being driven by rational calculations of the damage to the economy…it is just guesswork at this point. Nor is it a rational response to the nuclear power plant disaster. Our only comparable nuclear power accident scenarios happened decades ago.

It was the dramatic movement of money.

Smart Money Investors panicked and stabbed the sell button as soon as they saw their competitors doing the same. No one was waiting to see if mutual funds were going to be redeemed on the back of the shocking pictures and videos that blanketed the airwaves and bandwidth.

But, foreign investors only own about 25% of the Japanese equity market. There was only so much they could do. And once the selling pressure eased off…investors jumped in and bid the market up (both in Tokyo on Wednesday and EWJ not long after the opening bell on Tuesday).

The lesson in all this is that the weight of money can have dramatic effects on the value of assets. Japan’s “big picture” has not changed since last week. This week it is still the world’s #3 economy with an aging population, strong export sector, shocking level of government debt and extremely low interest rates. In the short term, it has sustained a mighty blow from Mother Nature but it has the institutions and experience to deal with the disaster. Fundamentally nothing much has changed. Emotionally, there have been several very big shifts.

What does the Fund King System have to say about it?

Asian IndicesThe System was not built for “Black Swan” events like this. What it can tell you is that Asia leading up to this event had some pretty crummy numbers behind it. Japan was the strongest of a weak bunch but the whole region is under a dark cloud of uncertainty over China’s short term economic outlook.

The first shocks have hit the market and there will undoubtedly be more aftershocks. One of the longer lasting aftershocks will be in the energy sector. As governments around the world (like Germany) take a close look at their nuclear power programs, the demand for oil is likely to rise. With the popular uprisings in Northern Africa and the Middle East threatening to disrupt the supply side, oil prices are likely to remain firm for the foreseeable future.

A Shiny Example

SLV has had a nice run since breaking north of $30 in the middle of February. That is not news but a checkable fact. For those investors who noticed that SLV was at the top of their rankings since July 12th of last year (when SLV closed at $17.62), it was a good opportunity to make money in a relatively non-correlated asset class. The only time it got sticky was at the beginning of this year when the price corrected.

The reason that we bring this up is not to brag. While SLV has done well, other investments that have made it into the top rankings have fared less well. The point is that most of those investments were eventually replaced by new market movers while SLV has hung in at the top of the lists despite the 10% correction that we saw in January. While we may have worried in these posts that the rerating between Gold and Silver may have run most of its course, the System kept pointing out that there was strong momentum behind the asset and that there were not that many more promising assets out there at the weekly measurement points.

My only slight regret…not swapping GLD for SLV a few weeks back when I was adjusting my Seeking Alpha ETF Portfolio. I would have looked very clever. But, in calmer moments, I realize that the regret and the emotion behind that regret is precisely why one should use an unemotional system to help execute one’s investment plan.

So, should you buy SLV now? Well, that all depends. Does it make sense as part of your universe? And, if it does, ask why? Make sure that you are not adding at this point because of past performance. Make sure that it is in there because you think other investors are worried about the US dollar or you think there is a chance that the Biomedical uses of silver are poised to go through the roof. In short, remember to separate the Asset Selection process from the Asset Trading process. And what happens when something better comes along in your universe? That’s easy, switch.

A Tarnished Example

Now that PIMCO has finally gotten it through to folks that, yes, they really are not keen on US Government paper (no link…too many choices), let’s look at how two bellwethers fared in the Fund King System.

TLT (which tracks 20 year plus US Treasuries) has been at or near the bottom of the US Sector ETF Universe since the beginning of November 2010. And less long term TLH (tracking 10-20 year Treasuries) has joined the bottom of the pile in another ETF portfolio since the end of November.

So, whether you were in the “Don’t Fight the Fed” or “Hyperinflation Around the Corner” camp, the Fund King System told you to steer clear of the asset class for the last three months. Even the FED could not buy up enough long dated Treasuries to keep TLT from dropping 10% over the period. Mr. Gross, the head of PIMCO noted in his newsletter that the FED has been buying as much as 70% of the newly issued Treasuries of late.

What does it mean?

There is nothing wrong with SLV , TLT or TLH in absolute terms. Each of these ETFs represents claims on perfectly good assets. The deep meaning to take away from these two examples is that it does not pay to fight the trends. If investors (on balance) are shifting money out of US Treasuries and into hard assets like Silver, there is little point in trying to stand in the way. At some point, the tides of money will change directions and other asset classes will get swept up or down. When interest rates rise a couple hundred basis points, Bill Gross and his PIMCO colleagues will be back on the bid side. Why? Because they are in the business to make money; and money is made by buying low and selling high.

An interesting read

Supporters of Ron Paul can sometimes be a prickly bunch. But, they occasionally come up with very thought provoking concepts.

I like a good bash so when I came across an article entitled: “How to End the Federal Reserve System” by Gary North, I was prepared for a rehash of the old arguments about an evil cabal on Jekyll Island in 1910. But the real strength of the article comes about halfway through when Mr. North analyzes the demise of a government agency which had also been granted monopoly powers: the US Postal Service. He draws some interesting parallels about what technology could do to the Federal Reserve System long before Ron Paul and his supporters in Congress are able to rescind the Fed’s legal mandate.

Basically, the ability to move into other currencies with a few well place computer key strokes or even to develop new mediums of exchange means that even an institution as powerful and influential as the Federal Reserve is not immune from obsolescence.

Part of the appeal of ETFs like GLD and SLV is that they are theoretically redeemable into a fixed amount of Gold and Silver respectively. While pitched as a new idea, the concept of convertibility into precious metals was once the cornerstone of the US dollar’s value (and most other currencies before that). In an interconnected world that can work with services like PayPal, it’s probably only a matter of time before someone reinvents a multinational global fractional banking and payment system backed by gold, silver or some other store of value. If it is tied into Visa, Mastercard and American Express, one need not worry about carrying about sacks of heavy metal to the grocery store. Just as email eclipsed the first class letter (something that was unthinkable as recently as 20 years ago), there is a risk of a new currency system taking the premier spot occupied by the US dollar today.

Just because the risk exists, however, does not mean it will come to pass. The biggest difference between the US Post Office and the Federal Reserve is that the latter is a privately owned, profit seeking entity. Long before we are all paid in PayPal credits or Googles, the Federal Reserve (which is owned by and represents the largest US banks) will feel compelled to take steps to shore up the value of the US dollar. That more than anything else will lead to a change in policy that will likely see higher interest rates in the not too distant future.

While you are pondering your long term investment strategy, make sure to include a plan for higher interest rates.

What happens to Japan now?

The earthquake and tsunami that hit Japan on Friday will impact the country and the economy in ways that are hard to foresee at the moment. Despite the shocking video and photos, however, the natural disasters are unlikely to have a significant long term impact on the economy. As long as the authorities can keep the nuclear fallout to a minimum, the biggest issue will be reconstruction and who will buy the fresh batch of JGBs. That points to another force for higher than near zero interest rates in the world’s #3 economy.

From an investors’ point of view, the Nikkei 225 was the best of a weak bunch (Asia has lagged since November of last year) in our universe of 11 Asian indices as of Friday’s rankings. The earthquake and tsunami do not significantly change the long term public finance fundamentals of the country and most of the familiar exporting names have transferred significant portions of their manufacturing base to locations around the world in the last few decades.

Should you buy? If your universe is only Asian Equities: then perhaps. But, if you are looking at a broader range of asset classes, there are quite a few commodity based ones that look more attractive. As Japan is import dependent for almost all of its commodity needs, there are better places to invest your money.

Energy Issues

When the Energy ETF (XLE) worked its way into the top 3 of the US Sector ETF portfolio in the first week of December, the protests in Tunisia were still almost two weeks away (Mohamed Bouazizi set fire to himself on December 17th).

XLE cracked into the top 5 on November 15th so depending on whether you were buying the top 5 or top 3 of this 20 ETF portfolio, you would have made 25% (top 5 methodology) or 18.5% (top 3 methodology).

At the time, the prospect of higher energy prices appeared to be driven by inflationary pressures, a potentially weaker dollar, seasonal demand for heating fuel in and the usual arguments surrounding Peak Oil.

This was not an isolated incident. In the Fidelity Equity Portfolio, the Energy (FSENX) and Natural Resources (FNARX) funds both jumped into the Top 3 on the December 7th reading, Vanguard’s VGENX the following week, and the S&P Global Energy Index (IXC) popped into the top 3 of the Seeking Alpha Portfolio in the first week of January. The Russian ETF (RSX) which is heavily weighted with Oil and Gas producers has been lurking near the top of its respective portfolios for a while now.

The reason we mention this is not to tout the Fund King System as some sort of crystal ball that was somehow able to read the fate of North African and Middle East dictatorships and monarchies in the late November/early December price action. What we would like to point out is that the seeds for higher energy prices were already planted in the market place when the proverbial “Arab Street” decided to actually pitch tents out on the street. Therefore, even though the rebels in Benghazi are determined to keep the oil flowing and Saudi Arabia has pledged to boost production to make up for any shortfalls in Libyan deliveries, a quick resolution to the protests and revolutions may not solve the underlying market dynamics.

Watch the trends

Therefore, the time to take your trade off may not be the one or two day dip in oil once the Mainstream Media loses interest in the story. The price of energy may be closely related to the inflationary pressure we are also seeing in the agricultural space (DBA, for example). If that is the case, the stronger consumer confidence numbers combined with a massive arsenal of reserves ready to be written into sizzling fast credit expansion may be what is driving investor assets into the energy sector.

What about Gold and Silver?

Silver has had a burst of activity in the last two weeks. SLV closed just over $30 at the end of 2010 and then languished below the $30 line for most of January and the first half of February. Gold, by comparison, has risen much more modestly. Part of the reason is a rerating of the Gold/Silver parity level. In a previous post, we worked through that relationship a bit. But the other factor is that Silver is much more of an industrial metal than Gold. The relative strength of Silver could be a confirming indicator on the more positive numbers coming out of the US.

What else looks good?

To round out the list, US small caps (IWC, VB), mid-caps (IWM,MDY) and Technology (PRGTX), are ranking highly across the portfolios that we watch. The shift from emerging markets to developed markets followed the usual seasonal patterns (ie. January Effect) but there may be more behind the shift in market sentiment. If the gap between developed and emerging markets (particularly Asia) continues to grow in the coming month or two, we will want to watch for a shift back towards Emerging Markets in the mid to late Spring.

What does this mean for investors?

While there are plenty of dark clouds on the horizon and no doubt a number of hot issues that could flare up to spook investors, the market seems to be pointing to stronger economic performance in the coming few quarters. There is nothing wrong with stashing a few gold bars into the safe deposit box but looking at the current readings across the portfolios, one should be looking to maintain and add to selective risk positions.

Seeking Alpha Portfolio

SA Portfolio RankingThis week the portfolio fell 0.94% with EWT the biggest drag on performance. Over the last 15 weeks, we are still looking at a loss of 1.17% (which does include all commissions and other fees).

There were no changes in the ranking this week so there will be no trading on this Monday.

The only thing I am a bit concerned about is the weakness of Taiwan. After breaching the 9,000 mark on the TWSE Index (^TWII on Yahoo Finance) the market has been very soggy. Although first quarter is traditionally a slow period, the system was indicating that this year would be different and a number of sources appeared to confirm that US Corporates were looking to increase their IT budgets significantly this year.

We will continue to watch this closely as it could impact the Technology investments that are ranked highly in several other portfolios.

Disclosure: I own shares in several of the investments discussed in this post (FSENX, FNARX, IXC, DBA and SLV) which I hold by employing the Fund King System across two portfolio universes.