June Gloom

When the weather is not cooperating in Southern California this time of the year, the natives will regale you with the atmospheric conditions that produce the dreaded June Gloom conditions. If you happen to have just spent the winter in Chicago or Boston, you might be wondering what all the fuss is about.

Gloom hangs over the markets today. The natives are swooning at every jobs figure that does not defy gravity and the European crowd are indulging in dramatic pratfalls that make their soccer (sorry, football) melodramatics look prim and restrained. For Europeans, the crisis that was “Made in America” does not fully explain how Greece ended up in so much trouble. The Europeans are trying desperately to avoid answering the hard questions that are being asked by the voting public and the bond market.

From a macroeconomic point of view, the global economy is still recovering from a severe financial crisis. That recovery has actually been delayed by all the public funds and government projects that have sought to cushion the blow to the economy and its citizens. Throwing more debt on the pile of debt that got us into trouble in the first place has not worked. The Austrian School of Economics was first and most vocal in pointing out that the bad debts had to wash through the system before the economy could return to a healthy basis and start growing again. However, the thought of letting the market clear out the bad debt was a political non-starter in countries as diverse as China, the US, Brazil, France, Germany and the UK.

But now, after three years of pump priming, disaster management and wishful asset valuations, the markets are finally getting a chance to sort out some of the wreckage. The FED has admitted that its monetary stimulus has not produced the desired results and the Germans are starting to talk about how private investors may end up wearing real losses when Greece’s debt is restructured (and/or defaulted upon). The US housing market is still trapped in suspended animation but, with the Case Shiller index double dipping, it should not be long before real solutions are proposed and acted upon.

What does this mean for investors?

In a word: Patience.

Although we mentioned that it looked like another “Sell in May and Go Away” year, we did not take nearly enough of our own advice and our portfolios have suffered accordingly. Investors who joined the rally late (in the early part of this year) will be keen to sell into any rallies now that the markets have “confirmed” their initial bias that risk assets are to be avoided. A quick break to the upside will be smothered very quickly.

On the downside, most of the bad news in the market is actually pretty old news. The problems in the developed markets have been worked over for several major news cycles: American mortgages underwater, sovereign debt issues in Europe and budget deficits almost everywhere. In the developing markets, the worries about inflation, hot money, loose monetary policies and rising currencies are not fresh. All of this means a simple relapse into 2008/9 conditions, while not impossible, are nonetheless extremely unlikely. There is plenty of money swirling around the system to capitalize on any sizable dips in the financial markets.

Resurgence in Biotech

Although it is too early to say for sure how strong the trend is, we have noticed a fairly broad improvement in the biotech (XBI), medical devices (IHI) and health care (XLV) sectors. The numbers are not conclusively high at this point but they are better than most of the alternatives in the market.

Some market observers have cherry picked past data and noted that times of economic distress are often also times of tremendous technological innovation as well. Perhaps the energy released by a Schumpeterian “Creative Destruction” wave is fueling innovation in the biotech and medical devices sectors. Or it could be simple rotation into what could be viewed as a more defensive sector in the US at this point.

There is no question that the medical/pharmaceutical/health care complex in the United States is ripe for innovation. Andy Kessler has explored this area since at least 2007 with the central thesis that the delivery of medicine and health care ought to enjoy some of the liberating innovation and efficiency gains that we have seen in the IT sector since the invention of the integrated circuit. Was he a bit early? Perhaps, although there is no question the cracking of the human genome is just now starting to pay dividends in terms of new medicines and delivery systems wending their way through the drug approval process.

Have some cash ready for Autumn Opportunities

So, we may have some excitement on the biotech front. We will definitely see some frothy IPOs in the social networking space (Linked In, GroupOn, Facebook…) which might help spark some small return of investor appetite for risk. And we can definitely look forward to a good scare on the European sovereign debt crisis and some worries about China’s rediscovery of the business cycle which will frighten investors back to the sidelines. Therefore, until the RSI numbers start to improve into the 20’s, there is no rush to get back into the market.

If the second half of “Sell in May…” hold true, there should be some good opportunities in the fall. Keep a bit of cash available and be ready to rotate into different asset classes after the summer torpor lifts.

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 Stratfor.com’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.

Inflation

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.

Selecting an Asset Universe

The Fund King System is all about promoting systematic investment as a way to reduce the emotional component of investing that so often ends up hurting out portfolio’s performance.

This week, in response to several users’ comments, I am going to outline how to construct an Asset Universe that will suit my needs and also work well in the Fund King System. I fully expect that someone else would follow the same process and come up with a different mix at the end of the process.

I approach the process in a top down manner because my role is to be the Asset Allocator for my investment funds. Other people are going to execute trades, hold the securities and decide which securities will meet their obligations to me. By leveraging off of that expertise (which I am already paying for in commissions, custodian charges and management fees), I can invest in a broad range of asset classes without having to visit a single factory.

To do “top down” correctly, I need to start broadly and then trim down my options to get a portfolio.

The first question to start with is: What do I know? Am I stronger in equities, bonds, commodities, currencies or real estate?

The second question is: What can I learn about? Are there any areas that I could expand into with a reasonable amount of effort?

Third, check for holes. Going forward it is reasonable to expect periods where developed market stocks and bonds may be stuck in a downtrend. At that point, I want to have some commodities, metals and/or currency opportunities to continue making money while more traditional asset classes sit on the sidelines.

This should give us a good list of sectors from which we can build up a shopping list of mutual funds, ETFs and/or ETNs.

Investing in what you know

Most of us have grown up with equity investment but some have cut their teeth on the bond market over the last three decades of almost uninterrupted bull market. Perhaps you have a strong feeling about precious metals as a hedge against paper money. You might think that the world is going to end up paying much more for foodstuffs or maybe you want to buy into real estate.

As an economic participant in the markets every day, you actually have access to a tremendous amount of information. Start building up your universe of investment opportunities with ones that you know well. If the universe starts to get too crowded or you find something more exciting in the next two steps, you can always substitute.

Try to keep things as broad as possible. You may be tempted to start picking individual ETFs or fund families but you will end up with a stronger universe and a better refresh process if you take the time to evaluate a broad spectrum of products, ideas and opportunities.

Investing in what you can learn about

It is unlikely that any one of us will possess enough information to feel equally comfortable with every asset class. However, since we are looking at funds (mutual funds and ETFs) a lot of the nitty gritty details are dealt with by the fund manager whom we are paying with a management fee.

This is where most of us have to step outside our comfort zone. But it is important to remember that we are not going to be auditing Eastern European bank balance sheets, Asian petrochemical refineries and South American airframe manufacturers. The idea here is to find assets that may grow in the coming few years. The emphasis is on “may”. If we pick one or two dud assets in our universe, it will not matter overly much because our trading system will keep us invested in the most promising assets. But we do not want to get too complacent. If we pick too many similar or underperforming assets, the system will just be choosing between mediocre investments. As any chef will tell you, no amount of culinary skill will make a great meal out of lousy ingredients.

If we have been primarily US bond investors, it is time to venture into equities (domestic and foreign), emerging market debt, commodities and perhaps even currencies.

What if I don’t like junk bonds?

I don’t like JNK…do I have to include it? No. In fact, decide to actively exclude it. What do I mean by actively? Just admit you don’t like JNK and move on. When your neighbor brags about how he made money one week in the future trading JNK on margin, you can nod politely and imagine all the loss making positions that he neglected to bring up with you. The idea is to make money on the whole portfolio. The actual assets are just tools towards that goal.

If you have a bag of preconceptions that you have brought to the investment process, this is the one place where you can unpack and use them. It may make sense for you to include Russian Equities or a soft commodity ETF in your universe from a pure asset allocation point of view. However, if the idea of dabbling in commodities or investing in Russia makes you uncomfortable for whatever reason (logical or otherwise), then it makes sense to exclude them from consideration at this point in the process.

As a live example, I included home builders (XHB) and Spain (EWP) in my universe as the Global Financial Crisis started on the logic that they would fall sharply and then have some sort of recovery. Both eventually staged rebounds significant enough to be ranked in my System. But because I had strong negative feelings about the underlying assets, I not once but twice (because the rebounds happened at different times) hesitated to buy when the signal came up, kicked myself and bought just as each was peaking and did not cut my losses immediately when they fell back into the general pool. As a result, I allowed my emotions to interfere with what was otherwise a pretty decent investment strategy designed to capture a meaningful rebound in two bombed out assets. After these two helpings of humble pie, I decided to eject the offending ETFs from my universe. There was nothing wrong with the ETFs or the way they performed. The problem was me. So, with plenty of other investment fish in the sea, I took my lumps and moved on.

Leveraged ETNs may be a good category to exclude in the beginning. The reason leveraged ETFs cause trouble is not because they are inherently bad investments but because most retail investors do not understand how to use them and do not have the time (or inclination) to watch them throughout the trading session.

Where are the holes?

We have all heard about diversification and its benefits. Those benefits exist but they were a bit oversold during the “Great Moderation” in the 80s and 90s when most asset classes were in a bull market. We approach diversification in a different way. Rather than holding a diverse basket of assets, we concentrate our investment dollars on the assets that look the most promising. However, to do that, we must consider a broad range of assets in the first place, rerank our universe regularly and invest according to the system (ie. do not let “gut feelings” intervene). Diversification for us means having enough different assets to prepare for the different market conditions that are likely to crop up over the medium term (3-5 years).

So, look for holes in your list of potential assets. You do not need to add a lot of currencies but if you are US based, why not add the Japanese Yen or Euro? You do not need to aspire to becoming a pit trader in Chicago to include some precious metals , industrial metals or a soft commodity basket. And, although you may fancy yourself as a risk taking equity person, there is no reason not to include some short and medium term government bond funds for those times when no one is making money in equities no matter how aggressive your trading stance. Also, you might want to consider some sector funds. While the market has been volatile, the overall direction has been neither particularly positive nor negative over the last decade. Investment flows have become “rotational” as professional investors seek to eke out performance by chasing down the next hot sector.

OK, now that you know where to look, how do you find the funds and ETFs that meet your criteria?

The first place to look is your online broker. TD Ameritrade, Schwab, Fidelity, Vanguard and all the other providers all have excellent tools which can help you zero in on funds and ETFs that match your shopping list.

You want to check beta vs. the index, and if you can see it, the top 10 holdings (just to make sure that what you read on the label of the fund is what you think should be inside). For ETFs, you should check the daily volume. If you are going to be a major (over 5% of daily volume) trader by placing a buy or sell order, you might want to look for a more liquid alternative. ETFs have a bid-ask spread which can get unacceptably wide if the Similarly, you should also make sure that any mutual fund you invest in has a decent amount of Assets under Management (AUM). You do not want AUM to drop to a point that the fund manager decides to close the fund or merge it with another. Nor do you want to be in a position where one large redemption will impact your interest.

ETNs have one more level of due diligence since they are senior obligations of the bank/sponsor that issues them. Whereas the assets in a fund belong to the share or unit holders even if the management company goes under, the assets of an ETN are part of the bank balance sheet that has to satisfy all creditors. If we had not just gone through the Global Financial Crisis, most people would not care about the difference. Now that we know better, just make sure that you are comfortable with the counter-party risk. If in doubt, leave the ETN on the cutting floor and move on.

How many assets to you want to watch?

Try to whittle the list down to 20. Why 20? Because this is an active process and trimming the list to just 20 assets will force you to think carefully about each one. What if you chose a mid cap value ETF over a mid cap growth? If the equity markets are not in a cooperative mood, the System will tell you not to hold either.

Remember, more does not always equal better. If you have 5 tech funds in your universe, they will all move pretty much together relative to non-correlated assets like Silver or Treasuries.

If you are stuck for ideas, ETFdb.com has just put out a page with a number of useful sources that can help you. Check out this page of 50 free ETF tools.

So what is the final result?

For my “Seeking Alpha” Portfolio, I have come up with this. Is this the end of the process? Hardly. I plan to review this list once a quarter to fill holes and make sure that I have all of my investment bases covered. For example, I might want to drop one of my developed and one of my emerging markets and replace them with a Real Estate and another Fixed Income choice. That would add better balance to the universe.

Equities

Developed Markets
SPY – US Equity Market
FEZ – European Equity Market
EWH – Hong Kong Equity Market
EWY – Korean Equity Market
EWT – Taiwan Equity Market
Sectors
IXC – Global Energy Sector
IXG – Global Financial Sector
XPH – Pharmaceutical Sector
Emerging Markets
EWZ – Brazilian Equity Market
RSX – Russian Equity Market
EPI – Indian Equity Market
FXI – Chinese Equity Market
EWW – Mexican Equity Market
TUR – Turkish Equity Market

Fixed Income

TLT – 20+ Year US Treasuries

Currencies

FXY – Japanese Yen
FXE – European Euro
FXA – Australian Dollar

Commodities

DBA – Agricultural Futures
GLD – Gold
Weekly Ranking of the Seeking Alpha Universe

The Seeking Alpha Portfolio

As mentioned in last week’s post, we switched out of 370 shares of EPI (Indian Equities) to invest in 320 shares of DBA (Agricultural Commodities Basket). The EPI netted us $9190.25 (and a short term capital loss of $710.95) and we bought the DBA for $9371.15. Our cash balance falls to $345.95.

Last week, we participated in the general rebound to the tune of +4.11%. Overall, we are still down 3.53% from our starting point on November 15th.

There are no changes in the ranking this week so we will see how our portfolio of Hong Kong, Turkey and Agriculture fares in the choppy markets that seem destined to persist for the foreseeable future.

One final note

Just to follow up on an issue we explored earlier, it seems that hedge fund performance has generally not lived up to expectations (Bloomberg article). This might lead to some sell off in some of the favorite names. One of the biggest, AAPL, may be in for a bit of profit taking as the year closes and redemptions need to be paid out. We do not hold AAPL (long or short) nor are we suggesting that you should take any action. We are using the stock simply as an indication of the magnitude of the Hedge Fund redemptions.