Archive for August, 2011

Do as I say…

Of course, the second half often runs: “…not as I do.”

For many Wall Street operators, it would appear that this famous nostrum has been truer than ever during the financial crisis. While big name financial gurus from blue chip financial firms exhorted the masses to stick with the program (ie. “Buy and Hold”), it seems that many have been implementing a different strategy: “Duck and Cover” perhaps?

This week, one of the Wall Street Journal’s reporters dug around into what some high powered investment types were doing with their money. From this article, it would seem that many big name financial executives do not bother shopping at their own firms for investment advice. It is a good article which could have ended with a well thought out Caveat Emptor.

However, it does not.

Ironically, the most telling line in the article comes towards the end:

“Should our 401(k)s follow Wall Street’s finest into the low-yielding safety of cash and bonds? Not according to the experts.”

It goes on to explain that “they” live in another world where capital preservation is important while you, dear reader, and I had better get comfy with the volatility at the whip end of the risk curve.

What does this mean for investors?

Essentially, it boils down to three choices:

  1. Shut out all the noise and invest in tomorrow’s winners.
  2. Continue to listen to what “Wall Street” says.
  3. Watch what “Wall Street” actually does.

If you know what tomorrow’s winning investment is, by all means ignore the rest of us and get to it. Bill Gates, Steve Jobs, Warren Buffet and George Soros did not amass their billions by broadly diversifying their investments.

Good luck and I may even buy your book in 10 years time.

The only exception to my good wishes is for gold bugs. My email box is full of “Doom and Gloomers” who tell me that Gold is the answer to all my problems mainly because the trade has worked well over the last 10 years. For the more fanciful forecasts ($6,000 an ounce), alot of very bad things need to happen. So, from my own selfish motives, I hope that their vision of the future does not come to pass.

But, if you are like most of the rest of us, you have to be honest and admit that you are not certain what the sure fire investment of tomorrow is.

For the great majority of us, we have to choose from options 2 and 3. We either listen to what the experts say or we watch what they do.

What is wrong with listening to the experts?

When the markets are undergoing a secular bull market (as they were in the 80’s and 90’s), listening to the experts is fine. Everything is going up and we are all making money. That is the point of investing…to make money. If listening to the gurus in a raging bull market gets you to that goal, who can argue against it.

However, we are not in a raging secular bull market right now.

Right now, it is more important to watch what the experts are trading. That is where the gurus are actually placing their bets with real money. Does that make them right? Well, yes and no.

Yes, it does make them right in the short and medium term because most financial markets are dominated by institutional players (from 80% to nearly 100% of daily turnover).

And No, in the long term the herds of institutional investors who have chased the 10 year Treasury bond to 2% (now back to 2.25%) are obviously not thinking rationally about the most likely course of inflation between now and 2021.

The premise of the Fund King System is that it allows you to “see” the strength of the various market sectors today so that you can make a rational investment choice based on where capital is being deployed.

The choice is yours: do as they say or do as they do.

I know what I am going to continue doing.

If you want to see what the system is telling us, go to the ETF Top 20 Page. The financial press will tell you that the “risk trade” is back on ahead of Mr. Bernanke’s Jackson Hole speech. The Fund King System has been telling a different story for several months. There will be a change at some point and we are fully prepared to miss the absolute bottom by a few weeks. But, we have “preserved” a fair amount of capital since the end of April by paying attention to what the system has been telling us.

May You Live in Interesting Times

Despite well telegraphed intentions, the Standard and Poor’s downgrade of US Government long term debt still came as a big shock to most investors. The markets have and will continue to react accordingly. Expect high volatility and no small amount of panic.

Economist CoverWith the US economy barely growing (latest reading at 1.6% for 2Q), the next question is the one which we find on the cover of the Economist this week. The magazine and other sources like ECRI are not willing to say for sure that there will be a second recession but are warning that the chances for a double dip are on the rise. The popular image is of the US economy being like a slow moving bicycle…the slower it moves, the more easily it can tip over. Like most easy images, this one obscures more than clarifies. As the impact of the tsunami in Japan on global supply chains demonstrated, the US economy is far more complicated than a bicycle.

Earnings are pretty good

While politicians are doing their utmost to stymie growth in the US, on the earnings side S&P500 companies have turned in positive numbers. In the latest round of reporting, the earnings have grown at just under 18% or about 5 percentage points better than expected. How can the largest listed corporations in the US be earning better than expected profits with the US economy so close to “stall speed”? The magic trick is achieved by non-US sourced earnings which may account for as much as 50% of the total (up from less than 40% before the onset of the Global Financial Crisis). The developing world continues to develop a middle class that is keen to acquire the trappings of their recently improved status.

Valuations are out of line

The dichotomy between the US economy and its leading corporations is part of the reason why there has been a disconnect in the “Fed Model” which compares the interest yield on the current 10 year Treasury to the inverse of the PE ratio (otherwise known as the “earnings yield”). If 50% of the earnings used in the earnings yield calculation are from non-US sources, comparing that result with a less than free market rate on 10 year US Treasuries (thanks to QE2) is an exercise in GIGO (garbage in, garbage out) financial modeling.

What should an investor do?

In the case of risky assets, one should be watching for short term opportunities at this point. SPY is very oversold (see chart) so even though the long-term outlook is unclear, there will no doubt be a rebound as soon as the panic subsides and cooler heads move in to pick up the pieces.

SPY is oversold

Otherwise, continue to monitor the situation from the sidelines. Gold will continue to move up as investors who are extremely risk adverse will look for havens beyond short term US Treasuries. If one thinks about gold as a low inflation currency, it is not hard to fathom its latest appeal. Of the 100 largest ETFs listed in the US, IAU and GLD remain at the top of the rankings. Health Care, Biotechs and Pharmaceuticals are also found amongst the top 20 but the ratings are far from conclusive at these single digit levels.

Waiting for Godot

It is probably with a cruel sense of irony that my high school French teacher dragged me through a section of French Literature called the Theater of the Absurd (Théâtre de l’Absurde). Samuel Beckett’s play “En attendant Godot” formed a part of that journey for me. The play centers around two characters who are, as the title suggests, waiting for Godot. The play drags on for pages and pages of tedious back and forth between Vladimir and Estragon and a few others who wander along the road. The frequent refrain meant to justify all this nonsense is that, well, they are waiting for Godot. Needless to say, the play ends without an appearance from Godot.

The reason I have channeled this unpleasant memory from decades past is because it helped me zero in on my feelings of frustration. My French teacher sandbagged me with Samuel Beckett’s dreary drama just as the leadership of the US and EU has inflicted the Absurd saga of the twin sovereign debt dramas upon me as an investor. While many will see the congressional action over the weekend as the end of the US part of the play, the one thing I learned in French class those many years ago is that we are only finishing Act 1. After a short relief rally, the market should fizzle as the audience (investors) realizes that there is an Act 2 and that the action is unlikely to prove any more inspiring than Act 2 of Beckett’s play.

The European story is perhaps more depressing because even when the Greek Sovereign Debt Crisis Drama runs out of steam (we are only at August Euro Beach Holiday intermission), there are plenty of other European venues ready to stage the play. Right now, it looks set for a five city run.

Why only the end of Act 1?

Because, if one actually reads what has been agreed (Bloomberg article), the headline figures barely last much past the second paragraph. Super committees will be set up and no doubt overlooked. Automatic cost controls will be established and no doubt ignored. Both sides can declare victory because very little has actually been achieved except for an agreement to allow the Treasury to borrow more money.

What should an investor do?

Probably raise cash into the “relief rally” that will kick off this week. If this weekend deal is the trigger event for the fall rally that we were looking for, then this rally will be a weakling.

Wait for the next boot to drop (which may be a threatened Moody’s downgrade) before loading up on risky assets with the cash you raise in the coming week. The Fund King Ratings are anemic, which is to be expected at this point. However, looking up from the figures, we appear to be stuck in the Theater of the Absurd waiting for this play to end. It will end at some point and not necessarily with a cataclysmic bang that will drive the price of Gold to $5,000 an ounce. At that point, we as investors can get on with our lives.