Invest with the Best?! (Saut)

Tuesday, August 14th, 2012

Invest with the Best?!

by Jeffrey Saut, Chief Investment Strategist, Raymond James

August 13, 2012

“Finding the best person or the best organization to invest your money is one of the most important financial decisions you’ll ever make. It’s also one of the toughest. The right manager for someone else may not be the right manager for you, nor can you reasonably expect to find many objective, or even reliable, sources to help you narrow your choices. You will be bombarded with figures, charts, and statistics that seek to sell you on each adviser’s services … the sad fact is that too often you cannot even believe what has been presented to you.”

… Claude N. Rosenberg, Jr.

I have been a “fan” of the astute Mr. Rosenberg ever since hearing him speak back in the 1970s. Many will remember him as the founder of the San Francisco-based money management firm that used to bear his name, Rosenberg Capital Management, before changing its moniker to RCM Capital Management. Others will remember him as the author of numerous books on financial matters, one of which was Investing with the Best, which holds the above quote and deals with the daunting task of selecting an investment manager. Given the plethora of investment managers, each with their own investment philosophy and style, picking a manager is difficult. That’s why many individuals’ selection process consists of nothing more than looking at a portfolio manager’s track record for the past few years. We think such a simplistic approach is a mistake.

Apparently, Jeremy Grantham, eponymous captain of the money management firm Grantham, Mayo, Van Otterloo & Co., agrees. To reprise some of his thoughts: “Ninety percent of what passes for brilliance, or incompetence, in investing is the ebb and flow of investment style (i.e., growth, value, foreign vs. domestic, etc.). Since opportunities by style regress, past performance tends to be negatively correlated with future relative performance. Therefore, managers are often harder to pick than stocks. Clients have to choose between fact (past performance) and the conflicting marketing claims of various managers. As sensible businessmen, clients usually feel they have to go with the past facts. They therefore rotate into previously strong styles, which regress [to the mean], dooming most active clients to failure.”

This is where Raymond James’ Asset Management Services (AMS), as well as our Mutual Fund Research Department, can help. As unbiased intermediaries, these departments are committed to aiding clients in the hiring of an investment manager who most closely aligns the manager/mutual fund with the client’s views on the various markets, as well as their risk tolerance. To this point, I journeyed to the cooler climes of Boston last week to escape the Florida heat, speak at a national conference, and visit with over 20 portfolio managers (PMs). My first visit was with the folks at Pioneer Funds where I met with Marco Pirondini (Head of Equities) and his team, as well as Ken Taubes (Chief Investment Officer). I have spoken with Ken a number of times and find his wisdom both on stocks and bonds to be invaluable. Because of his long tenure as a bond manager, I was surprised when he opined that interest rates should bottom between now and year end. Given that “higher interest rate” view, I was particularly interested in speaking with Jonathan Sharkey who manages the Pioneer Floating Rate Fund (FLARX/$6.88) and the Multi-Asset Ultrashort Income Fund (MAFRX/$10.04). In a rising rate environment these two funds should fair pretty well. I discussed Jon’s investment style/strategy over dinner and found it to be closely aligned with mine. I was also interested in the Pioneer Research Fund (PATMX/$10.64) and will be vetting it, along with other Pioneer funds, over the coming months.

After a few more meetings with hedge funds that afternoon, I spent most of Wednesday with Fidelity. My first meeting was with Jurrien Timmer, co-portfolio manager along with Andrew Dierdorf, of the Fidelity Global Strategies Fund (FDYSX /$9.18). To me, FDYSX is tantamount to a global macro fund because it can “go anywhere” and “do anything.” That means it can invest in just about everything. Moreover, I like the fact that the fund has a technical analysis overlay to it, as well as a tactical leaning, since tactical is what has been working in this manic depressant market. Next was Charles Myers, captain of the Fidelity Small Cap Value fund (FCPVX/$15.27). Chuck told me that while he is really good at picking stocks, he is less confident with his market timing and sector selection abilities. Accordingly, he spends his days looking for good companies and thinking about portfolio construction. Indeed, he adds value to the investment equation through portfolio construction. He does run a concentrated portfolio (~70 names) and does adjust his turnover rate to take advantage of when the markets are more dynamic.

Fidelity Select Health Care Fund (FSPHX/$136.14) is managed by Edward Yoon and has provided very good risk adjusted returns over time. My meeting with him was informative as he thinks insurance companies and PBMs are part of the healthcare solution. Strategically, Eddie thinks the healthcare system has never let customers know what things cost, but that’s changing because employers are moving healthcare risks from their balance sheets to the employee’s balance sheet. This should be a boom for companies that provide consumers with the ability to analyze price competition between vendors. He also suggested there is going to be a shift from public to privatized Medicare. A couple of names he mentioned covered by our fundamental analysts were: Cerner (CERN/$71.12/Outperform) and Nuance (NUAN/$23.53/Strong Buy). My last meeting was with Steve Wymer, who told me the S&P 500 investment style is too conservative for a growth fund and the Nasdaq Composite Index is too aggressive, so he runs The Fidelity Advisor Growth Opportunity Fund (FAGOX/$40.87) somewhere in between. He thinks we are somewhere in the mid-cycle of a recovery provided Euroquake doesn’t derail us. Dinner Wednesday was with the good folks from Fidelity.

The next morning I arrived at MFS, which is an active global asset manager that employs a uniquely collaborative approach to build better insights for our clients. Their investment approach has three core elements: integrated research, global collaboration, and active risk management. Of course, “risk management” is a big thing with me for the essence of portfolio management is the management of risk, not the management of returns. My meeting was with Jim Swanson (Chief Investment Strategist) and eight PMs/analysts. Jim began by stating that people he meets in everyday life talk about how bad the stock market is. He then “closed” that comment by noting the S&P 500 is up nearly 12% YTD, while the NASDAQ Composite is better by ~16%. Moreover, when you impact those returns for the almost non-existent inflation, the “real” returns are awesome. The rest of the conversation was about the topics du jour (government, Euroquake, the fiscal cliff, etc.). Regrettably, I did not have the time to meet with my friend Thomas Melendez, who manages my favorite international fund, MFS International Diversified Fund (MDIDX/$13.27), or the PM of the MFS New Discovery Fund (MNDAX/$20.15), but that will happen next trip.

My final meeting was with Putnam to reconnect with Bill Kohli, portfolio manager of the Putnam Diversified Income Trust (PDINX/$7.65) that has so often been featured in these comments. It is one of only two bond funds I have featured over the years because I think PDINX is positioned for a higher interest rate environment. The fund has a 5.8% yield with zero duration. The fund employs 70 – 80 different strategies to pursue a diverse range of opportunities. For example, the fund is “long” non-agency RBMS (Residential Mortgage Backed Securities), but hedges that position with agency IOs (Interest Only). Hence, to lose money on those positions would require home prices to collapse over 50% from their already depressed prices. And then there was David Glancy and his Putnam Equity Spectrum Fund (PYSAX/$28.04). Hereto David thinks a lot about portfolio construction and combines stocks, bonds, bank loans, convertibles, opportunistic short-selling, and cash to produce returns. To this cash point, I was taught early in this business that cash is indeed an asset class for to assume the investment “opportunity sets” that are available today are as good as those presented next week, next month or next quarter is naive; and, you need to have some cash to take advantage of those opportunities. Evidently David thinks that as well because his cash position has varied from 44.4% in 2Q09, to 14.8% in 3Q10. David loves stocks and I could talk individual companies with him for hours. As always, all of these mutual funds should be vetted before purchase.

As for the stock market, not much really happened in my absence as the D-J Industrials (INDU/13207.95) experienced their tightest weekly trading range since January 2007. Of course, that was not the case a year ago when our sovereign debt was downgraded and equities collapsed 6.66% (the mark of the devil as well as the intraday low of March 6, 2009 where the new bull market began). Indeed, what a difference a year makes. Nevertheless, the rotation away from the defensive sectors and into Materials (+2.83%), Energy (+2.34%), and Technology (+2.10%) is an interesting observation because when the defensive sectors lead it is not indicative of a healthy and sustainable rally. Said rotation reinforces my belief that the upside breakout above the 1360 – 1366 level is for real and suggests we are finally setting up for another push to the upside. The real battle should be waged at the April highs of 1422. That said, the rally that began on June 4th has left ALL of the macro sectors overbought in the short term. It has also left the SPX at the top of the parallel chart channel (read: resistance) referenced in last Monday’s letter. Consequently, a pause or pullback attempt is not out of the question. Support remains in that 1360 – 1366 zone for the SPX.

The call for this week: The good: stocks are hanging in pretty well after an 11% rally from the June 4th low, earnings are still beating estimates by ~60%, earnings revisions are rising again, economic reports are strengthening, European equities have rallied while their sovereign yields have declined, the SPX continues to track the typical election pattern (see chart from the sagacious Bespoke organization), and there was a rare “buy signal” from the Bob Farrell sentiment indicator. The bad: all sectors are overbought, companies are beating revenues estimates by only 48.3%, the number of new highs is shrinking, upside momentum has waned, we are at the top of a parallel channel in the SPX chart. The ugly: forward earnings guidance is negative by 5.5%, the presidential election rhetoric is getting nastier, commercial hedgers have moved close to their most extreme short position in years, the Volatility index (VIX/14.74) is below 15 (read: no fear), gasoline had its largest two-week rise this year (+$0.18), and the list extends. Nevertheless, I think this is the pause that refreshes and not the start of a big decline.

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Tags: Capital Management, Chief Investment Strategist, Claude N Rosenberg, Daunting Task, David Rosenberg, Ebb And Flow, Financial Decisions, Gluskin Sheff, Grantham Mayo Van Otterloo, Investment Manager, Investment Managers, Investment Philosophy, Investment Style, jeffrey saut, Money Management Firm, Moniker, oil, Portfolio Manager, Raymond James, Relative Performance, Reliable Sources, Rosenberg, Rosie, Sad Fact, Saut, Simplistic Approach
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Is Dodd-Frank the Death of Preferreds?

Wednesday, August 8th, 2012

by Mariela Jobson, iShares

Investors typically don’t like uncertainty, and regulatory uncertainty is no exception. So it’s not surprising that our sales team has been fielding a lot of questions from clients about the iShares S&P US Preferred Stock Index Fund (PFF). Clients are wondering what impact regulations put in place after the 2008 financial crisis might have on PFF specifically and preferred securities in general.

As the portfolio manager for our preferred stock ETFs, I spend a lot of time with our sales team and clients, helping them to understand the complexities of these products. Here, I’ve recapped the two main conversations I’ve been having with investors about the effects of these regulations on preferreds:

Q: Will regulatory changes deplete the supply of preferred stocks?

A: First, it’s important to understand what the regulatory changes are, and how they assumedly will affect preferreds. The preferred market is going through a significant transition driven by the Dodd-Frank (D-F) legislation. Under D-F, the Tier 1 capital treatment of hybrid and trust preferreds from bank holding companies will be phased out at 25% per year from 2013 until 2016. The fear is that the law will change the preferred market and could shrink the market size over the next few years. As of 8/4/12 approximately 22% of PFF’s holdings were trust preferreds that would be affected.

So what does this change really mean for preferred stocks? First, it helps to remember that the change does not actually forbid the issuance of trust preferred securities. Even after D-F goes into effect, banks may still choose to issue trust preferred shares, and they can simply opt to exclude them as part of their Tier 1 capital calculation. One reason they may choose to do this is because the interest is tax deductible.

In addition, this change is only aimed at hybrid and trust preferred securities — not the entire asset class. Companies are still issuing and should continue to issue perpetual preferred securities (see chart below). Preferreds are typically a more cost-efficient cost of capital than common equity, and as such they have been an attractive source of financing for companies.

Q: With the onset of the Dodd-Frank Act, will large volumes of preferreds be called?

A: In response to the new rules, banks can either call their preferred securities and replace them with another form of capital if needed, or they can let them continue to mature. The current low rate environment is increasing the possibility of securities of being called similar to any other security that has a call option, and in some cases, banks have the option of calling the securities even prior to normal five-year call protection.

But at this point, we believe it is highly unlikely that banks would call all of their trust preferred securities. Many of them have publicly stated their intention not to – for example, JP Morgan only plans to call half of their trust preferred issues. Instead, we believe banks will call their preferreds over time. While it is always difficult to predict what decisions management will make, we believe the chart below – which illustrates expected call dates for preferreds within PFF if prices remained at current levels and issuers were solely motivated to call based on trading prices – shows a more likely scenario.

The bottom line is that despite these regulatory changes, investors can still consider using preferred stock as part of a diversified income-oriented portfolio. While Dodd-Frank may change the treatment of trust preferred securities, we do not believe it will curtail the supply of preferreds, and as new preferreds are offered, they should continue to make their way in to PFF.

Sources: BlackRock, Bloomberg as of 6/30/12

Mariela Jobson, Vice President and portfolio manager in BlackRock’s iShares Index Equity Portfolio Management Group.

Ms. Jobson’s service with the firm dates back to 2006, including her years with Barclays Global Investors (BGI), which merged with BlackRock in 2009. At BGI, she was a portfolio manager for the index equity team, focusing on iShares and taxable accounts. She was responsible for managing U.S. and global portfolios, including preferred equity. Prior to joining BGI, Ms. Jobson worked as an equity research analyst in the asset management group at ING Investments in New York and at Wedbush Morgan Securities in Los Angeles.

 
Diversification may not protect against market risk. In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Preferred stocks are not necessarily correlated with securities markets generally. Rising interest rates may cause the value of the Fund’s investments to decline significantly. Payment of dividends is not guaranteed. Removal of stocks from the index due to maturity, redemption, call features or conversion may cause a decrease in the yield of the index and the Fund.

Tags: asset class, Bank Holding Companies, Complexities, Dodd, Financial Crisis, Ishares, Issuance, Jobson, Mariela, Pff, Portfolio Manager, Preferred Market, Preferred Shares, Preferred Stocks, Regulatory Changes, Regulatory Uncertainty, Stock Index Fund, Tier 1 Capital, Trust Preferred Securities, Trust Preferreds
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Rethinking Asset Allocation (PIMCO)

Wednesday, July 18th, 2012

by Curtis Mewbourne, PIMCO

• Asset classes are likely to be affected by the situation in Europe and, more broadly, by high debt levels in developed countries. The related political debate about austerity vs. growth is also critical.
• Fixed income investors should note whether countries control their own currencies and can monetize their debts. Those that can may be greater inflation risks. Those that cannot may be greater credit risks.
• These factors are contributing to market volatility and lower returns, which in turn are challenging investor expectations about asset classes.
• We encourage investors to broaden their opportunity sets, for example, looking more closely at emerging market government bonds. They also may consider assets such as real estate and commodities, which may partially replace traditional domestic equities.

Navigating the global landscape these days is tough. Macro risks range from uncertainty about the future of Europe to mixed messages about the U.S. economy – not to mention a host of concerns about indebtedness, policy and politics.

In the following interview, portfolio manager Curtis Mewbourne discusses how investors can approach asset allocation in such an environment and over the longer term.

Q: What are the most critical factors likely to affect asset classes over the next three to five years?
Mewbourne: Investors need to monitor the situation in Europe, whether they are directly invested there or not, because of the systemic implications of a potential shock to Europe’s banking system or sovereign debt. The eurozone has the second largest economy and the largest banking system in the world, and the slowdown that we are already seeing in emerging market growth is partially driven by slower demand for goods and services from Europe.

More broadly, asset classes are likely to be affected by high debt levels in Japan, the U.S. and other developed countries as well as the related political debate about the trade-off between austerity and growth. Unemployment levels remain elevated in many countries, partly as a result of austerity measures.

These factors are contributing to market volatility and lower returns, which in turn are challenging investor expectations about asset classes. For example, European equity markets in some cases are at the lowest levels in years, and, as a result, investors may be questioning the notion that European equities provide reasonable returns above inflation – a key point for pension-fund managers and other investors.

Similarly, the low policy interest rates that central banks are implementing around the globe contribute to government bonds in several countries trading at very low levels. These low yields create an asymmetric return profile: There is not much room for further price appreciation, while concerns about possible future inflation could lead to significant volatility and price declines. For fixed income investors, it is critical to understand whether bonds have credit risk, inflation risk or both. Countries with their own currencies have more flexibility to print money and monetize their debts, and hence typically have more inflation risk and less credit risk. Countries that do not have the ability to print their own currencies have the opposite. This largely explains the divergence between Europe and the U.S./U.K./Japan in terms of government bond yields and knock-on effects on risk premium valuations.

Put simply, nominal government bonds and traditional equity investments, at least in the case of Europe, have not performed in the way that investors have expected and likely may not perform according to textbook expectations going forward.

Q: Will we see more convergence – or divergence – in the behavior of asset classes?
Mewbourne: It depends on which asset classes we are talking about, but there are a few high level themes that are relevant to understanding how asset classes may behave. Very high global debt levels and unconventional monetary policies mean that balance sheets are more levered and the global economy is more vulnerable to policy changes. Under such conditions it is likely that certain macro factors, such as policy changes, will affect many asset classes in roughly the same way at the same time. Over the past few years, we have seen periods of heightened correlations between regional markets as well as between previously uncorrelated asset classes.

This is not set in stone. In some cases capital will move from one area to another, or fundamental economic differences will lead to divergence of asset classes. We have seen that recently in currency markets where there has been a large shift away from emerging market currencies and into the U.S. dollar.

Q: PIMCO has talked about the emergence of credit risk in the sovereign market. How will this affect portfolio construction?
Mewbourne: As I was saying before, fixed income is an asset class that has become quite different from textbook explanations. For example, five to seven years ago it was a reasonable decision for a European citizen saving for her child’s education to invest in government bonds, counting on a low probability of principal loss, little volatility and a modest return. Fast forward to today, and government bonds in many European countries have behaved quite differently than expected. The clearest example is the loss of principal on the restructuring of Greek bonds; but also prices of other European sovereign bonds suggest higher probabilities of potential losses. In all, the expected volatility, risk and returns on such bonds have changed, and therefore they likely play a different role in investors’ portfolios.

This shift is a challenge for certain institutional investors, such as insurance companies and some banks, whose business models or regulatory requirements require high-quality bonds with low probability of principal loss and low volatility.

Q: Staying with the topic of risk, what are some other risk factors investors should be managing, and how should they go about doing so?
Mewbourne: Investors need to think about the potential loss of principal on bonds of overly leveraged countries and companies. They also need to think about the loss of purchasing power from inflation as a result of central banks pursuing very low interest rates. When interest rates are lower than inflation, the resulting negative real yields eat away at investors’ purchasing power.

Given the issues that we have discussed, the time they need to spend thinking about and focusing on political risks has increased significantly, and they need to increase significantly their efforts in understanding and factoring such risks into their investment decisions.

Q: Let’s talk about opportunities: Are there new or emerging opportunities that investors should be thinking about? And can you offer some insights into alternative ways for investors to capture these opportunities?
Mewbourne: Markets are still healing from the major financial dislocation of 2008 and 2009 and, in a sense, the recovery creates opportunities in many areas for investors to identify and take advantage of attractive risk-adjusted returns. This requires a very active focus, as those opportunities can be in sectors that have become more credit sensitive and require more resources to review.

For example, in the non-agency mortgage market in the U.S., investors need to understand the underlying loans, a process that can take considerable time and knowledge but also lead to some very good opportunities.

Another example is the U.S. municipal bond market. That asset class has become much more credit sensitive and requires much more credit focus, but investors can really benefit from rolling up their sleeves and doing their credit research.

Also, the heightened market volatility that we expect in the years ahead can lead to greater risks but also opportunities during periods in which investors look to exit the same strategies at the same time. Given the geopolitical landscape, we expect overshoots in currency and commodity markets to result in buying opportunities.

Q: Ultimately, what are the key things investors should be thinking about or doing in their portfolios, considering PIMCO’s secular outlook?
Mewbourne: As risk and return characteristics transform, our view is that investors need to transform the way they think about using asset classes. We encourage them to broaden to the greatest degree possible their opportunity sets, for example, looking at emerging market government bonds as a replacement for some more traditional developed market government bonds.

Developed market government bonds have become riskier in some respects, and emerging market bonds are becoming less risky, and in cases where they pay a higher rate than inflation, they may be less risky both in terms of credit risk and the risk of purchasing power erosion.

We also encourage investors to broaden the type of financial instruments they consider. While they need to appreciate the risks of different instruments, they may benefit from investments in areas such as real estate and commodities as part of overall portfolio construction, and those areas can replace some of the roles that traditional domestic equities have played in the past both in terms of expected returns and volatility.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Tags: Asset Allocation, Asset Classes, Austerity, Banking System, Critical Factors, Debt Levels, Domestic Equities, Emerging Market, Eurozone, Global Landscape, Government Bonds, Indebtedness, Inflation Risks, Investor Expectations, Market Volatility, Mixed Messages, Other Developed Countries, PIMCO, Political Debate, Portfolio Manager, Sovereign Debt
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Out-of-Sync Markets Create Long-Term Opportunities

Monday, July 9th, 2012

Principal and Portfolio Manager Francis “Frank” Gannon provides thoughts regarding the economy, the markets and small-cap investing. Frank, a former panelist on Louis Rukeyser’s Wall Street, has 19 years of investment management experience and joined our team in 2006.

“I know what is around the corner—I just don’t know where the corner is…”*

- Kevin Keegan, Former International Footballer and former manager of the England National Football Team

Sentiment once again shifted dramatically in the second quarter of 2012, just as it did in 2011 and 2010. Now-familiar concerns over contagion from the ongoing sovereign debt crisis/fiscal crisis/recession across Europe, coupled with fears of decelerating growth in China and a fragile economic recovery in the United States, pressured the equity markets.

Even the Federal Open Market Committee (FOMC), at its most recent meeting in June, added to the air of uncertainty, as they lowered their expectations for economic growth and raised the forecast for the unemployment rate. At the same time, lack of clarity regarding fiscal policy and the coming “fiscal cliff” in January 2013 is building, further weighing on domestic economic activity and the markets.

After gaining more than 12% in the first quarter of 2012, the Russell 2000 Index lost 3.47% in the second quarter and was up 8.53% year-to-date through June 30, 2012. Interestingly, the small-cap Russell 2000 Index will soon mark the five-year anniversary of its pre-financial crisis peak, July 13, 2007. From this peak through the end of 2012′s second quarter, the Russell 2000 gained 0.04%.

To be sure, it has been an eventful five years for equities, the global economy, and geopolitics. We live in a world that craves certainty, yet the range of possible outcomes in today’s world feels infinite. To that concern, we are often asked how in today’s uncertain environment we marry the various top-down macro views and our bottom-up stock picking approach.

In today’s interconnected world, where random, unpredictable events across the globe are being priced into the markets at lightning speed, one’s ability to react is paramount to achieving consistent, long-term results. Our discipline of responding rationally without making predictions is built for just this type of environment.

Predicting what will be the next macro drivers of the markets has long been a favorite pastime for many strategists, fund managers, and market commentators alike. It is not ours. Our expertise is in smaller-company investing. We typically have little if anything to say about the economy in general and even less to say about large-scale, macro trends.

That being said, we are in the business of responding rationally to opportunities as they are created and being prepared to do so when they occur. In today’s interconnected world, where random, unpredictable events across the globe are being priced into the markets at lightning speed, one’s ability to react is paramount to achieving consistent, long-term results. Our discipline of responding rationally without making predictions is built for just this type of environment.

We once again find ourselves in another out of sync moment, where those same daily macro headlines are creating long-term micro opportunities. Not surprisingly, since the Russell 2000′s most recent peak in March the most defensive areas of the market have performed best while those more economically sensitive areas have dramatically underperformed. It is the same performance pattern we have witnessed during the market’s corrective phases over the last two years.

From our perspective, however, those defensive areas of the market (consumer staples, utilities, and REITs) remain expensive. At the same time, many of the economically sensitive areas of the market that have been hit the hardest are fraught with opportunity. Ironically, lost among the economic headlines and fear of owning these cyclical businesses are the quality standards we tend to focus on. For the moment, economic sensitivity is trumping quality, a byproduct of our macro-driven world.

Stay tuned…
FDG

*A favorite quotation of mine from a presentation courtesy of Dylan Grice, global strategist for Societé Generale, entitled “Macro & the Margin of Safety” that was delivered to the Value Intelligence Conference 2012, summing up the futility of macro investing.

Important Disclosure Information
Francis Gannon is a Portfolio Manager of Royce & Associates LLC. Mr. Gannon’s thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above, will continue in the future. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index.

Tags: Contagion, Debt Crisis, England National Football Team, Federal Open Market Committee, Fiscal Crisis, Fiscal Policy, Fomc, Footballer, Frank Gannon, Global Economy, Kevin Keegan, Louis Rukeyser, Macro Views, national football team, Open Market Committee, Portfolio Manager, Russell 2000 Index, Small Cap, Sovereign Debt, Term Opportunities, Unemployment Rate
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Three Years and Counting (Kashkari)

Thursday, June 14th, 2012

• In addition to muted economic growth, record low interest rates, and sustained high unemployment, extraordinary equity market volatility has been a repeated feature of the past three years.
• As heightened volatility persists, many equity investors remain on the sidelines. We think a better investment approach is to invest globally, across asset classes, reflecting the likelihood of the various outcomes.
• We believe managing against downside shocks is enormously beneficial to compounding attractive returns over the long term. Equity investors should continue to focus on
  higher-quality companies with strong balance sheets that are selling into higher-growth markets, including those that pay healthy dividends.

We recently concluded our Secular Forum, an annual event in which PIMCO investment professionals from around the world discuss and debate our three- to five-year outlook for the global economy and financial markets. The Secular Forum process demands that we focus on the long term and imposes a discipline on us that we believe makes us better stewards of our clients’ capital.

Mohamed A. El-Erian published a summary of our conclusions from the Forum, titled Policy Confusions and Inflection Points. And my portfolio manager colleagues are participating in a series of interviews discussing these conclusions.

My goal here is to discuss what our revised Secular Outlook means for equity investors. But first I think it is important to take a moment to review conclusions from prior Secular Forums and objectively consider what has actually happened in the intervening periods. What have we gotten right? What has surprised us?

In the spring of 2009, with the U.S. economy and financial markets still reeling from the financial crisis, PIMCO conducted its annual Secular Forum right on schedule. It was during this time that PIMCO first applied the term New Normal to its updated outlook for the global economy. It is important to note that I wasn’t at PIMCO at the time – I was still at the Treasury helping to fight the financial crisis. I only joined PIMCO six months after I left government.

As government officials consumed with trying to stabilize the global financial system, my colleagues and I were much more concerned about surviving the next few days or weeks than thinking about the next three to five years. It is noteworthy that an investment management firm had the poise to stop to think about the longer-term outlook during that stressful time.

The New Normal called for long-term deleveraging that would lead to lower growth than society had been accustomed to. It called for more modest investment returns across asset classes, as the leveraging of the economy reversed course. It called for increased regulation and reduced globalization. Most importantly, it said there would be no V-shaped recovery that is typically seen after a recession. It would be a long, hard adjustment period with sustained high unemployment. It also called for a transition of stress from private balance sheets to sovereign balance sheets.

These trends, unfortunately for societies, have played out as my PIMCO colleagues forecasted. I also observe that implicit in their forecast was the assumption that policymakers would be successful in stabilizing the financial system and preventing a collapse. In hindsight, they seem to have been more confident than we in government were at the time. I am glad they were right.

While this may seem self-congratulatory for me to pat my PIMCO colleagues on the back, as I noted above, I wasn’t at PIMCO at the time. I am just observing, with the benefit of hindsight, what has actually happened.

While PIMCO’s New Normal call has proven remarkably accurate, its implications for equities were less clear. PIMCO did not forecast that central banks would employ unprecedented aggressive monetary policy via quantitative easing with the specific goal of pushing up the prices of risk assets in an attempt to stimulate economic activity. The QEs have been effective in pushing up equities (see Chart 1 below) and staving off deflation, though the effect on real GDP is less clear. In addition, the New Normal did not forecast record corporate profits that many companies have enjoyed, especially large multinationals. In the past three years, equities have rallied more than the underlying economic fundamentals would have predicted on the back of extraordinary monetary policy activism and strong corporate earnings.

In addition to muted economic growth, record low interest rates, and sustained high unemployment, extraordinary equity market volatility has been a repeated feature of the past three years.

Chart 2 shows the VIX, or volatility index of the S&P 500 Index, over the past 10 years. You can see three fairly clear periods: “old normal,” financial crisis and New Normal. As the crisis has spread from corporate to sovereign balance sheets and from the U.S. to Europe, sentiment has repeatedly swung from fear to greed and back to fear, triggering wild swings in equity markets.

Many investors, both individuals and institutions, were truly shocked by the losses they experienced during the financial crisis: The S&P 500 fell 38% in 2008. After years of gains, many people couldn’t believe their nest eggs were being destroyed. This experience has left many investors both scared and scarred – and as heightened volatility persists, many equity investors remain on the sidelines.

Our updated Secular Outlook calls for a continuation of the deleveraging we’ve experienced for the past few years. Slow real economic growth in America of 1% to 2%, a likely recession in the eurozone stemming from the ongoing debt crisis, and – and this is really important – slowing growth in the emerging markets of 5%, down from 6% previously. Remember, emerging markets have powered the global economy for the past few years; the U.S. will have to carry more of that load now. But with more moderate overall global economic growth in the next three to five years, markets will be more vulnerable to shocks.

The volatility that equity markets have experienced in the last few years is also likely to continue for the foreseeable future. The crisis in Europe will take years to resolve in part because policymakers there are trying to simultaneously achieve multiple, often-divergent objectives: 1) preserve basic eurozone stability, 2) keep pressure on fiscal authorities to make hard choices and 3) keep inflation in check. These multiple objectives prevent them from taking final, decisive action to quell the crisis. Our base case outlook is continued spurts of crisis and volatility coming out of Europe. These policy and macro factors will likely continue to overwhelm company-specific factors in the short term.

Many investors aren’t sure what to do – where to turn for “safe” investment returns in light of this volatility. As I regularly meet with clients and financial advisors, I repeatedly hear a few questions about how to navigate these choppy equity markets that are worth discussing here:

Given the volatility of the New Normal, why should I invest in equities at all? Why shouldn’t I just sit in cash and wait it out?
Unfortunately the final end-state for the global economy following this debt-induced crisis is unclear. If the global economy faces deflation, sitting in cash or fixed income instruments will probably be the best option. Purchasing power will increase as prices fall. While a deflationary scenario is not impossible, it is the least likely outcome given central banks’ actions to date. More likely is a moderate inflation scenario. Sitting in cash in such a scenario will see purchasing power degrade due to inflation. Equities should perform well in a moderate inflation scenario. This is our highest likelihood outcome.

A high inflation scenario can’t be ruled out either. It is possible that central banks could lose control of inflation expectations. In such a scenario cash and bonds will likely perform the worst, with equities next. Real assets and commodities would likely perform best, because prices for those assets should rise with inflation.

Because of the uncertainty regarding the end-state of the global economy and the fact that the only scenario in our view where cash performs well is the least likely, deflationary scenario, sitting on the sidelines is unfortunately not a good option for those who have future liabilities they need to meet. We think a better investment approach is to invest globally, across asset classes, reflecting the likelihood of the various outcomes.

Given our outlook that moderate inflation is the outcome with the highest long-term probability, we believe equities should be a meaningful part of a diversified investment portfolio. Equity investors should continue to focus on higher-quality companies with strong balance sheets that are selling into higher-growth markets, including those that pay healthy dividends.

My clients just can’t take the equity market pullbacks. What should I do as a financial advisor?
Many clients are in this situation. From May 2002 to May 2007, during the old normal, the S&P 500 experienced a 5% correction from a recent high five times, or on average of once per year, and a 10% correction four times. In the three New Normal years from May 2009 to May 2012, the S&P 500 experienced seven 5% corrections, more than twice as often, and a 10% correction three times. This increased downside volatility not only has direct financial implications for clients, but also has indirect effects that are important too: The emotional swings are scaring clients into sitting on the sidelines. As discussed above, this could prove very costly if central banks are successful in engineering moderate inflation, let alone high inflation.

We believe clients and advisors should focus on strategies that can be used to manage downside volatility. There are a number of ways to pursue this: 1) Buying higher-quality companies and those with strong balance sheets, because they tend to be more resilient against shocks, according to our research. 2) Buying companies at deep discounts to their intrinsic value. 3) Buying companies offering more immediate return on investment through dividends. 4) Actively hedging the portfolio, with tail risk hedging (which refers to taking a defensive position against extreme market shocks), or other means. 5) Investing in multi-asset solutions that provide diversification and include equities, fixed income securities and commodities in one vehicle.

Is passive or active management better in this environment?
We believe there is a place in client portfolios for both passive and active management. Each has advantages. Passive management tends to be cheaper than active management. But with each pull back in the equity markets, a passive strategy should fall in lock-step with the market. Passive index replication, by definition, has no downside protection against market moves. If clients are alarmed about market corrections, passive management won’t help them. A related point that I have written about previously (Teaching to the Test – September 2011) is that many managers associate index investing with taking less risk. Index investing is taking no benchmark risk, but clients are still taking risk – as the S&P 500’s 38% loss in 2008 so painfully reminds us.

We believe active management should aim to provide clients with a better experience. That means enabling clients to participate in much of the growth, appreciation and income potential provided by a vibrant equity market, while also actively managing against major pullbacks associated with macroeconomic shocks that we’ve been experiencing over the last few years. Achieving this – capturing most of the upside while limiting the downside – isn’t easy. It requires both deep company-specific analysis and a strong top-down, macroeconomic framework. And we believe it requires investing globally to take advantage of the best possible risk-adjusted return opportunities wherever they are. Limiting the downside likely requires giving up some upside in a rally – and in this environment especially – we think that’s probably a good tradeoff. It would be great to be able to limit the downside without sacrificing any upside. Unfortunately that’s not realistic – but we believe managing against downside shocks is enormously beneficial to compounding attractive returns over the long term.

Although markets are again focused on risks from Europe right now, sentiment will likely swing back to “risk on” again, and people will wonder what all the fuss was about. And then at some point it will swing back to “risk off.” Equity investing in this environment isn’t easy or for the faint of heart. With long-term risks of global inflation, sitting on the sideline isn’t an option for many people. We think the right approach is to focus on the right companies and to be willing to give up a little upside, while working hard to protect the downside. Call it the New Normal of equity investing: Three years and counting.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investments in value securities involve the risk the market’s value assessment may differ from the manager and the performance of the securities may decline. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their financial advisor prior to making an investment decision.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.

Copyright © PIMCO

Tags: Asset Classes, Attractive Returns, Balance Sheets, Confusions, Downside, Equity Investors, Erian, Financial Markets, Global Economy, Growth Markets, Inflection Points, Investment Approach, Investment Professionals, Low Interest Rates, Market Volatility, Portfolio Manager, Quality Companies, Sidelines, Stewards, Term Equity
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I Should Have?!? (Saut)

Monday, May 21st, 2012

“I Should Have?!”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

May 21, 2012

“… A man has rigged up a turkey trap with a trail of corn leading into a big box with a hinged door. The man holds a long piece of twine connected to the door that he can use to pull the door shut once enough turkeys have wandered into the box. However, once he shuts the door, he can’t open it again without going back into the box, which would scare away any turkeys lurking on the outside. One day he had a dozen turkeys in his box. Then one walked out, leaving eleven. ‘I should have pulled the string when there were twelve inside,’ he thought, ‘but maybe if I wait, he will walk back in.’ While he was waiting for his twelfth turkey to return, two more turkeys walked out. ‘I should have been satisfied with the eleven,’ he thought. ‘If just one of them walks back, I will pull the string.’ While he was waiting, three more turkeys walked out. Eventually, he was left empty-handed. His problem was that he couldn’t give up the idea that some of the original turkeys would return … ”

… Why You Win or Lose, by Fred C. Kelly

“I should have sold when the S&P 500 broke below its rising trendline on April 9th at 1397” (see chart on page 3). “I really should have sold on May 11th when the S&P 500 (SPX/1295.22) traveled below its April 10th intraday reaction low of 1357.38.” So exclaimed one disgruntled portfolio manager last Friday since the SPX continued to surrender ground. Plainly, the “I should have” crowd surfaced again last week as the SPX knifed through my envisioned support zone of 1320 – 1340, causing one savvy seer to exclaim, “Markets always go further than most pundits believe, both on the upside and the downside.” Yet the recent downside dive from May 1st’s 1415 level into last Friday’s close of 1295.22 has caused many of my indicators to register readings not seen in a long time. For example, the McClellan Oscillator is now at oversold readings not seen since the recent April 10th trading bottom (see chart on page 3). Then there is the CBOE Equity Put/Call Ratio, which is flashing a “buy signal” that has proven profitable at every downside inflection point since 1994; or, as the astute folks at Bespoke write:

“Following today’s 0.44% decline (5/16/12) in the S&P 500, the 10-day Advance/Decline line for the S&P 500 has now dropped down to –1,930. This is an extreme oversold reading based on historical standards. For those unfamiliar with the indicator, the 10-Day A/D line is simply a rolling 10-day total of the daily net number (of similar readings) shows that equities have historically rebounded after hitting such extreme oversold levels. Over the next week, the S&P 500 averages a gain of 1.21% with positive returns two-thirds of the time. Over the next month, the S&P 500 averages a gain of 5.58% with positive returns 83% of the time. Going out three months, the S&P 500 averages a gain of 7.68%, and over the next six months the index averages a gain of 13.35%.”

Adding to the litany of downside inflection-point indicators is the AAII (American Association of Individual Investors) survey that recorded its lowest bullish reading (23.6% bulls) since August 2010. Moreover, my parade of short/intermediate-term indicators shows a composite reading that is at historic levels. To wit, there have only been only four other times when my indicators have combined to show such negative inclinations. More than seventy percent of the time, given such readings, the major market averages have been higher a week later, while 92% of the time they have been higher a month later. Accordingly, unless we are in “crash mode,” and I don’t believe that, it is time to ready your “buy list” and begin judiciously recommitting some of that cash to stocks; and, that is what I have been recommending. Indeed, over the past week I have been recommending recommitting some of the cash we suggested raising in February – April. One of the techniques we have used to accomplish this at similar inflection points was first proffered by our friends at Riverfront Investment Group back in 2009. As stated:

“First, identify the quantity of cash to be put to work – example: 20%. Second, break the trade into digestible chunks – example: break it into four parts, 5% each. Third, implement the first trade today – example: invest 5% into equities today. Fourth, set a date for implementing the second trade – example: two months from today invest the second 5%. Fifth, implement third and fourth segments if market pullbacks occur – example: invest the remaining 10% of the cash on market pullbacks. And six, after the date of the second trade occurs, return to step one with the remaining cash – example: two months from today, if the market never provides the opportunity to buy on a pullback, break the remaining 10% up into 3-4 parts and follow a strategy similar to the one utilized for investing the first 10%.”

I think Riverfront’s strategy is appropriate since the SPX is probing its next downside energy level. Further, the stock market’s internal energy level is totally exhausted on the downside, implying a tradable bottom is likely at hand unless we are involved in a mini-crash. The real question thus becomes, “If we get a rally from this oversold condition is it the start of a new “up leg,” or is it just a compression rally that will be brief followed by still lower prices?” Speaking to that point, it is worth considering the SPX is currently trading at a P/E ratio of 13.1x earnings. Since record keeping began there have only been five occasions when a bear market began with the SPX’s P/E ratio below 15x. Another timely question is, “Will the recent Dow Dive trigger QE3, Operation Twist II, or targeting GDP?” While equity markets can clearly do anything, at worst we should at least get a relief rally from here and at best it could be the start of a new “up leg.” Therefore, I think the gradual re-accumulation of investment positions is the correct strategy. For those participants not wanting to try and “catch a falling knife” by purchasing the exchange-traded product of your choice, a more conservative approach would be to accumulate dividend-paying stocks. Some that screen well technically, and have a Strong Buy rating from our fundamental analysts, for your potential shopping list include: 3.0%-yielding Automatic Data Processing (ADP/$51.98); 3.8%-yielding Rayonier (RYN/$42.08); 4.3%-yielding Digital Realty Trust (DLR/$68.48); 5.2%-yielding Enterprise Products Partners (EPD/$48.48); and 8.2%-yielding Linn Energy (LINE/$35.24).

Tags: Amp, Chief Investment Strategist, Corn, Crowd, Downside, Fred C Kelly, jeffrey saut, Last Friday, Mcclellan, Nbsp, Osc, Portfolio Manager, Pundits, Raymond James, Saut, Seer, Spx, Support Zone, Trendline, Turkeys, Twine
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Diversification 201: Implications of Diversification for Investor Behavior

Thursday, April 12th, 2012

by Rich Weiss
Senior Vice President and Senior Portfolio Manager,
American Century Investments

Weekly Market Update,

In this issue of Weekly Market Update, we present the latest installment in our occasional series on diversification. Here we look at diversification as a tool to help address many classic investor failings identified by the science of behavioral finance.

Earlier, in Diversification 101, we explained the rationale behind diversification and how it can be used as a framework for structuring a portfolio to help manage risk and maximize risk-adjusted performance. We also provided an Introduction to Alternative Investments meant to highlight the broad types of alternative strategies that can be used to diversify a traditional balanced portfolio of stocks and bonds. In future months we’ll address such topics as the state of diversification in a post-Financial Crisis world, and when and what types of diversification strategies make the most sense.

Investors Behaving Badly Better

One intriguing aspect of diversification is that it is born of modern portfolio theory, which assumes that the market is composed entirely of dispassionate, rational actors. In practice, however, investor behavior tends to be anything but rational and utility maximizing. This has given rise to an entirely new field of research termed “behavioral finance.”

The tension between efficient market and behavioral finance theorists makes for one of the enduring debates in financial and academic circles. But one thing they can both agree on is the tremendous benefit of diversification for investors—modern portfolio theorists because it creates more “efficient” portfolios; behavioralists because it puts structure around investor decisions and can help reduce the frequency and magnitude of mistakes. “Efficiency” in investing terms is defined as maximizing return for a given level of risk, and that investors can effect change in their portfolios’ risk-and-return profile by adding or subtracting uncorrelated assets to their portfolios.

In this regard, it’s instructive to look at market research firm DALBAR’s 2012 Quantitative Analysis of Investor Behavior. DALBAR devotes a portion of its new report to nine key behavioral errors, highlighting ways in which investors behave irrationally consistently and repeatedly over time. Behavioral finance topics in general, and DALBAR’s report specifically, make for fascinating reading. The biases they highlight influence investor behavior in a number of important ways. Here let’s focus on just one behavior—poorly timed buy and sell decisions—and look at how diversification can help mitigate the negative impact on investor performance over time.

Abandonment Rates

One well known investor sell mistake is to react badly to market events, eliminating equity investments and moving entirely to cash, effectively abandoning their investment strategy. Studies of investor behavior refer to this as the “abandonment rate,” or proportion of investors that simply throw in the towel when equity market volatility becomes too great to stomach. Our own analysis of academic and industry literature suggests that investors are prone to bailing out of portfolios that have incurred one or two years of losses.

To be clear, an appropriately diversified portfolio should carry just enough market risk to achieve an investor’s return objectives—and no more. Investment risk is something that should be measured, managed, and carefully considered up front in an investment plan—not something to react to after the fact, in knee jerk fashion.

Poor Timing, Poor Performance

Similarly, a number of studies indicate that the average equity investor dramatically underperforms the market as a result of poor market timing decisions. Indeed, DALBAR’s data show that in the 20 years ended in December 2011, the average equity investor dramatically underperformed the market (as represented by the S&P 500^® Index). This is directly attributable to poor market timing decisions—a pitfall more diversified investors tend to avoid.

Staying the Course

Here is where diversification comes in—based on available research, it turns out that investors in well-diversified asset allocation and target-date portfolios have lower abandonment rates¹ and do better² than those outside of such portfolios. In an analysis of investor behavior in retirement plans in the aftermath of the 2008 Financial Crisis, Morningstar found that those in well-diversified target-date funds “bucked a fund-industry trend in which investors tend to pull their money at market lows and chase investments close to their peaks.”³ Essentially all the research we have seen on this topic supports the conclusion that well-diversified portfolios encourage shareholders to stay the investing course despite the vagaries of the market.

Holding Period

To put a finer point on it, reacting to market volatility by selling in the face of volatility or bad news means that the average investors does not remain “invested for sufficiently long periods to derive the benefits of the investment markets,” according to DALBAR. Further, the report says that:

“The result is that the alpha created by portfolio management is lost to the average investor, who generally abandons investments at inopportune times, often in response to bad news. In 2011, as in years past, [systematically diversified] asset allocation (including target-date funds) fund investors have remained invested in their respective funds longer than equity or fixed-income investors. Investors’ tendency to hold asset allocation funds longer is a strong case for their inclusion in an investor’s portfolio.”

To be clear, we talk here about investor behavior in asset allocation strategies and retirement plans as a proxy for diversified and non-diversified portfolios. We cite these reports because they contain the most recent and objective data on the subject.

Whether you build your own portfolio of uncorrelated assets or choose a professionally managed and diversified asset allocation fund is up to you. The point is not how you get there. After all, your portfolio is likely to be a unique reflection of your own goals, risk tolerance, and other life cycle and financial considerations. The point is simply that effective diversification in the manner discussed in Diversification 101 can mean better risk-adjusted performance; a less volatile return pattern; better cumulative returns over time, other things equal; and lower abandonment rates and greater likelihood of sticking with an established investment plan. We believe that is a strategy worth striving for.

Rebalancing: Sell High, Buy Low

There is another way in which a diversified approach can improve the timing of investor buy and sell decisions, and that’s through the process of portfolio rebalancing. Step back for a second and think about diversification—at a high level, it’s a process of spreading assets within and across asset classes in a way that is likely to maximize your likelihood of sticking to your investment goals and objectives over time. You (or your financial professional) create a well-thought-out strategy weaving together all the aspects of your financial life to create a finely tuned, broadly diversified portfolio.

But as financial markets move—and in recent years they’ve moved around quite a bit—those carefully selected asset weightings and relationships get out of balance with your intended targets. Putting those weightings back in balance is called “rebalancing,” in which you sell winning assets and buy those that have underperformed. Let’s use a real-life example from 2008 to illustrate rebalancing in action. In 2008, stocks plummeted while government-backed bonds enjoyed one of their best years on record. We know from studies of investor behavior during the crisis that many equity-only investors sold stocks and abandoned their savings plan at this point.

Contrast that behavior with a diversified investor (with demonstrated lower abandonment rates and longer holding periods) who stuck with their overall strategy and rebalanced their portfolio at the end of the year. Because stocks performed so poorly relative to other investments, they would now be underrepresented in our diversified portfolio, while bonds would be comparatively overrepresented because they’d done so well. Rebalancing to predetermined weightings would mean you were selling bonds after a historic rally and buying equities after a historic sell-off. The contrast with investor behavior cited in the DALBAR and Morningstar studies could not be more stark. In no uncertain terms, then, systematic rebalancing enforces a disciplined buy-low, sell-high strategy that is central to a sound investment plan.

At American Century Investments, we believe strongly that investors would do well to adhere to a disciplined, diversified, long-term investment approach. Future pieces will address various aspects of diversification, among other topics.

American Century Investments^® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: Individual Investors | U.S Investment Professionals

Download a PDF of this post.

¹ Equity Abandonment in 2008–2009: Lower Among Balanced Fund Investors. John Ameriks, Ph.D.; Jill Marshall; Liqian Ren, Ph.D. December 2009

² Burgess + Associates, “Outcomes of Participant Investment Strategies 1997-2006,” Study Commissioned by John Hancock Retirement Plan Services, October 2007.

³ Morningstar Fund Analysts, “Target-Date Investors Stick Around, Earn Better Returns,” Fund Spy, March 16, 2010.

Diversification does not assure a profit nor does it protect against loss of principal.

This information is not intended to serve as investment advice; it is for educational purposes only.

Investment return and principal value of alternative investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Due to the limited focus of alternative investments, they may experience greater volatility than funds with a broader investment strategy. They are not intended to serve as complete investment programs by themselves.

The performance results provided here are hypothetical, and are only used for illustrative purposes.

Hypothetical performance results should not be considered indicative of any actual performance results, or any results that could be attained by clients.

The opinions expressed are those of Rich Weiss and are no guarantee of the future performance of any American Century Investments portfolio.

Tags: Academic Circles, Alternative Investments, American Century, American Century Investments, Balanced Portfolio, Behavioral Finance, Diversification Strategies, Efficient Market, Intriguing Aspect, Investor Behavior, Investor Decisions, Modern Portfolio Theory, Occasional Series, Portfolio Manager, Rational Actors, Rich Weiss, Senior Vice President, Stocks And Bonds, Stocks Bonds, Types Of Diversification
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The Demise of Risk-on / Risk-off and the Emergence of Heteroscedasticity

Wednesday, March 28th, 2012

by Jason Doiron
FRM, PRM, SVP – Head of Fixed Income & Derivatives
Sentinel Asset Management, Inc.

I estimate that I inadvertently watch 12 hours of financial news programming per day. Too much television? perhaps, but for a portfolio manager it has become an occupational necessity. One of the greatest benefits to watching this much television is that I can recite verbatim every commercial that plays on CNBC with no clue which company is sponsoring the ad – pig on a skateboard anyone? The other benefit is that I am provided with a front row seat to a rogues gallery of pundits who describe the complexities of the financial markets through sound bites.

After a close contest with “kick the can down the road” and “tail risk,” the undisputed champion of sound bites since 2008 has been “risk-on / risk-off.” Both terms accurately describe the market sentiment for certain periods over the past 3.5 years. But as with all good sound bites, the useful life span of these terms is quickly coming to an end. Before we bid farewell to these terms, let me explain my reasoning for predicting the demise of risk-on / risk-off.

1) Irrelevance:
No other term more accurately described the market sentiment in 4Q08 and 1Q09 than risk-off. During the summer of 2011, the term risk-off accurately described the sentiment in certain sectors of the fixed income market such as CMBS. But the term risk-off does not accurately describe a 2 point sell-off in the SPX [1] on a Thursday afternoon before a 3 day weekend in July. That is simply called a pull back.

2) Professional:
I can assure you that the terms risk-on and risk-off did not originate from anyone in the risk management profession. Risk management professionals do not reduce an opportunity set down to a binary outcome such as on/off. If a true risk management professional were trying to describe the risk on/off phenomenon, they would use a term like homoscedasticity.

3) Fundamentals:
The demise of the term risk-on / risk-off should be a welcomed event by investors. Over the past three years, the only question that investors have needed to get right is risk-on or risk-off. Investing became a binary outcome where the instruments that you utilized to express either of these views mattered little as long as you got the on / off call correct. This seems easy enough but in a homoscedastic world, the benefits of diversification will prove to be futile in your fight against the risk on / off mentality.

We are starting to see an investment landscape where fundamentals matter again. A landscape where securities derive their value from the fundamental underpinnings rather than from a headline on failed votes regarding debt ceiling limits or sovereign default write-downs. The pundits will need a new sound bite to succinctly describe this landscape so I offer up. Heteroscedasticity!

Sources: Sentinel Asset Management

[1] The Standard & Poor’s 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.

Copyright © Sentinel Asset Management, Inc.

Tags: Asset Management Inc, Binary Outcome, Cmbs, Cnbc, Complexities, Doiron, Fixed Income Market, Frm, Life Span, Market Sentiment, Portfolio Manager, Risk Management Profession, Risk Management Professional, Risk Management Professionals, Rogues Gallery, Row Seat, Sound Bites, Spx, Thursday Afternoon, Undisputed Champion
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Explaining the Stir over Recent “Fed-Speak” (American Century)

Friday, March 23rd, 2012

Explaining the Stir over Recent “Fed-Speak”

by Robert Gahagan, Senior Vice President, Senior Portfolio Manager, American Century Investments
and John Eichel Investment Writer

March 20, 2012

The official statement from the Federal Reserve’s March 13 interest rate policy committee meeting was relatively ho-hum (no significant changes from January’s statement), but other recent Fed communications have raised more of a stir. In particular, we explain what “fiscal cliff” and “sterilized QE” mean, and help put them into context. It’s all part of a mixed, uncertain economic outlook in which slower mid-year growth, like last year, can’t be ruled out, but higher inflation by next year is also a possibility.

The U.S. Federal Reserve (“the Fed”—the U.S. central bank) announced no immediate significant changes or tweaks in U.S. monetary policy after its latest Fed Open Market Committee (FOMC) meeting on March 13. The Committee voted to keep the federal funds rate target for short-term interest rates at a historically low 0–0.25% (where it’s been since December 2008), continuing, as it did in January, to say that it “anticipates that economic conditions…are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

The Committee also voted to continue “Operation Twist”-related selling of short-term U.S. Treasury securities and purchases of long-term Treasury securities. This strategy is intended to rebalance and refocus the Fed’s balance sheet toward longer maturities, designed to help keep long-term interest rates (such as home mortgage rates) low (see “Our Take on the Fed’s 50-Year Anniversary Revival of ‘Operation Twist,’” American Century Investments Blog, posted September 26, 2011).

Swirling Speculation about Inflation Risks

But the lack of change in the Fed’s last policy statement doesn’t mean that all is quiet and calm at the central bank. Despite the mostly status-quo nature of the statement, speculation has been swirling in the background among economists and other market participants and observers (and, reportedly within the Fed itself) regarding the Fed’s next policy moves or announcements.

Much of the speculation has centered on the accuracy of the Fed’s economic assessments and projections, especially its ability to accurately assess inflation risks. Up to this point, the Fed’s front-line position has left no doubt that the majority of its key current policy-makers remain much more concerned about the sustainability of the post-Great Recession economic recovery than about inflation, as demonstrated by the Fed’s continued extremely accommodative monetary strategies.

Uncertainties about the Actual Strength of the U.S. Economy

But some Fed critics (and governors within the Fed) think that the economic recovery is significantly stronger and more sustainable than the Fed is stating. They argue that the Fed is risking higher inflation and the formation of new speculative asset bubbles (like subprime mortgages and housing, before the Great Recession, or the Tech Bubble in the late 1990s) by continuing such a sustained period of unprecedented monetary accommodation.

One of the trillion-dollar questions of 2012-13 is whether the Fed will further stimulate the recovering U.S. economy (with more measures beyond the low federal funds rate target), or if it will have to scale back the accommodation to address the potentially inflation-fueling/bubble-building momentum of nearly five-straight years of unprecedented accommodative policy moves (dating back to 2007). Or, will it somehow have to both stimulate growth and contain inflation?

Busy Weeks for Fed Communications

Some of the speculation has been fueled by the Fed itself, from its recent statements and speeches, and also from selective releases of information via the central bank’s unofficial (but widely acknowledged) mouthpiece at the Wall Street Journal (WSJ), veteran Fed beat writer Jon Hilsenrath.

The two weeks just prior to the latest FOMC meeting—the weeks beginning February 27 and March 5—were particularly intriguing from a recent Fed communications standpoint. On February 29 and March 1, Fed Chairman Ben Bernanke gave his semiannual monetary policy report to the Congress (what used to be called Humphrey-Hawkins testimony), appearing before the House Financial Services Committee on February 29, and before the Senate Banking, Housing, and Urban Affairs Committee on March 1.

The Approaching “Fiscal Cliff”

Among the biggest attention-grabbers from those legislatively mandated Bernanke appearances was a fiscal-policy warning to Congress, outlining what could happen early next year if Congress continues to waffle and stall on budgetary matters.

Bernanke doesn’t typically highlight fiscal policy (government spending and programs to aid the economy), in his remarks, but in this case he pointedly warned that the U.S. economy faces a potential “massive fiscal cliff” on January 1, 2013 if President George W. Bush-era tax cuts, President Obama’s payroll tax cut, and extended unemployment benefits are all allowed to expire at that time, and $1.2 trillion in automatic mandatory across-the-board spending cuts agreed to last August are allowed to kick in.

As reported by the WSJ and the Congressional newspaper, The Hill, Bernanke warned: “Under current law, on January 1, 2013, there’s going to be a massive fiscal cliff of large spending cuts and tax increases. I hope that Congress will look at that and figure out ways to achieve the same long-run fiscal improvement without having it all happen at one date.”

An Argument to Remain Accommodative

Bernanke warned that allowing tax cuts to expire and trimming fiscal spending could slow economic growth. “You … have to protect the recovery in the near term,” he said. The idea that the recovery might be threatened by the fiscal cliff helped put downward pressure on U.S. stock indices on February 29, according to financial media reports that day.

Because of its potential economic impact, the possible fiscal cliff has been cited by some analysts in defense of the Fed’s continued accommodative policies, adding it to the list of significant headwinds facing the economy this year, which include the weak housing market, high unemployment, tight consumer credit conditions, high gas prices, and unsettled conditions in Europe and the Middle East.

Considering QE3

With short-term U.S. interest rates effectively at 0% for over three years, the Fed hasn’t had much maneuvering room in terms of making monetary policy more accommodative. One alternative that the Fed has pursued pretty aggressively over that period has been quantitative easing (QE—buying U.S. government securities to increase liquidity in the financial system and to keep long-term interest rates low).

We have already seen two recent waves of Fed QE in the U.S. (QE1, from 2008-2010, and QE2, from 2010-11) and a third is being considered, depending on the direction of economic data in 2012. (There’s a favorite saying of economists and analysts that “the decision to execute QE is data-dependent.”)

The primary data that QE depends on are economic growth signals and short-term interest rates—if the economy appears to be in recession or sliding in that direction, and short-term interest rates are too low to cut further, QE may be (and has been) called for.

The Case for “Sterilized QE”

But one of the risks of QE is inflation—adding liquidity and keeping interest rates low can eventually create demand pressures that can push up prices. It can also devalue the dollar relative to other currencies, which is also inflationary. As we mentioned earlier, the Fed now finds itself in a position where it’s still considering another round of QE (QE3) because of economic uncertainties, but it doesn’t want to trigger more potential inflation pressures.

The result: so-called “sterilized QE”—a form of QE described by Hilsenrath in the WSJ on March 7 (in what many speculated was a Fed-planted article) as follows: “The Fed would print new money to buy long-term mortgage or Treasury bonds but effectively tie up that money by borrowing it back for short periods at low rates…employing new market tools they have designed to better manage cash sloshing around in the financial system. Transactions like those… are called ‘reverse repos.’ A related program called ‘term deposits’ also ties up short-term money held by banks.”

Later in the article, Hilsenrath also provided this clarification: “The Fed hasn’t literally printed more money, but it has electronically credited the accounts of banks and investors with new money when it purchased their bonds under quantitative easing.”

Basically, “sterilized QE” is QE with more liquidity controls. We can elaborate on its details in future updates if it looks like it will actually be implemented—we should get more clues from the April and June FOMC meetings. For now, the Fed appears to be just letting us know what options it is considering.

Another interesting thing about this Hilsenrath article was its timing—it appeared the day after the U.S. stock market’s worst performance day of the year (when the S&P 500 dropped over 1.5%, and was down 2.2% over a two-day period), raising speculation that it was timed to help boost the market and confidence (which it apparently did—the S&P 500 rallied 3.9% over the next five sessions). This, along with the “fiscal cliff” example, show how closely tuned the markets are to what the Fed is saying and how they’re tracking what its intentions are.

The Continued Case for Inflation Protection

What’s the lesson for investors from all of this? We suggest being prepared for several different economic and market scenarios in 2012. In other words, stay diversified. If the Fed—with all of its research tools and economic brainpower at its disposal—is uncertain about the economic outlook, we all should tread lightly.

As the President and Chief Executive Officer of American Century Investments, Jonathan Thomas, has been writing to fund shareholders in our shareholder reports this year: “More market volatility appears likely in 2012…as uncertainties regarding European debt, economic strength, government budget deficits, and the U.S. presidential election sway investors. We believe strongly in adhering to a disciplined, diversified, long-term investment approach during volatile periods.”

We also believe in striving for inflation protection. Both the Fed and its critics appear to be giving serious consideration to the longer-term inflation implications of the past nearly five-straight years of accommodative monetary policies, and we suggest investors should too. To serve investors’ needs, American Century Investments offers a suite of funds that aim to provide various forms of inflation protection, utilizing holdings that include commodity and precious metal-linked securities, foreign securities and currencies, and inflation-linked bonds.

American Century Investments^® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: Individual Investors | U.S Investment Professionals

Download a PDF of this post.

The opinions expressed are those of Robert V. Gahagan and the fixed income portfolio management team at American Century Investments, and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.

Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.

Diversification does not assure a profit, nor does it protect against loss of principal.

Copyright © American Century Investments

Tags: American Century, American Century Investments, Economic Outlook, Federal Funds Rate, Gahagan, Home Mortgage Rates, Inflation Risks, Interest Rate Policy, Investment Writer, Maturities, Open Market Committee, Policy Committee, Portfolio Manager, Qe, Rate Target, S Central, Senior Vice President, Term Interest, Treasury Securities, U S Treasury
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“Fun, Fun, Fun” (Jeffrey Saut)

Tuesday, February 28th, 2012

“Fun, Fun, Fun”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

February 27, 2012

“… and she’ll have fun fun fun ‘til her daddy takes the t-bird away.”

… The Beach Boys, 1964

Except in this case it should be “fund, fund, fund” because I am in the Washington/Baltimore area speaking at conferences, renewing contacts on Capitol Hill, and seeing mutual fund managers. Some of the folks I will be seeing hang their hats at Friedman, Billings & Ramsey; aka, FBR & Co. I remember when in 1989 Manny Friedman scraped together $1 million and departed the Washington-based brokerage firm of Johnson, Lemon & Co. to formed FBR with his two partners Eric Billings and Russ Ramsey. The firm became a research boutique focusing on financial companies spurred by Manny’s prescient “calls” on the banks and real estate. That focus continues to this day, punctuated by a sagacious portfolio manager named David Ellison, captain of the FBR Small Cap Financial Fund (FBRSX/$18.31). I used to chat with David back in the 1980s when he was at Fidelity managing Fidelity’s Select Financial Fund. Interestingly, David currently owns a number of the smaller banks I have commented on in these missives. Even more interesting is that David is my kind of investor since when he can’t find attractive investment opportunities he is content to hold cash. Case in point, unable to find attractive investments going into the 2008 financial fiasco David held 60% of his fund in cash. Indeed, my kind of investor. Accordingly, participants wanting to fill the financial sleeve of their asset allocation model should consider David’s fund.

I spoke with yet another fund manager last week when I hosted a conference call for our financial advisors with Tom O’Halloran, who manages Lord Abbett’s Developing Growth Fund (LAGWX/$21.85). In its space LAGWX is the number one performing fund on a five-year basis according to Morningstar [replay (855) 859-2056; password 49023178]. While that fund is currently closed to new investors, the good folks at Lord Abbett have started another fund run by Tom using the same investment style. The fund is called The Growth Leaders Fund (LGLAX/$15.67) and is representative of the “smaller more nimble” funds I have championed for more than 12 years. The conference call began with some comments from me about the current state of the economy and the stock market. I concluded by noting that while the economy is not going to slip back into recession, GDP is also not likely to grow by more than 3.5% for awhile. In such an environment companies that can increase their revenues and earnings at a decent rate should produce good investment returns; and with that I turned the call over to Tom.

He began by talking about the four traits necessary for great companies. First, they must have a great business model. Second, the management team has to be competent and credible. Third, they must be operating in a healthy industry. And fourth, the company needs to demonstrate a competitive advantage. Tom believes that growing revenues, and earnings, at an outsized rate leads to stock outperformance and I agree. Interestingly, Tom uses technical analysis as an overlay to support his fundamental views. This is not an unimportant point because in this business price is reality! Ladies and gentlemen, I have seen a plethora of portfolio managers stay with losing positions far too long because they ignored the fact the share price was breaking down rather dramatically in the charts. By the time they saw the fundamentals deteriorate, the shares were off some 50% when if they would have had some kind of technical analysis discipline the loss would have been contained at 15% – 20%, but I digress.

Tom then discussed some themes like the Internet, the cloud, software, servers, social networking, the Internet gone mobile, healthcare, Americanism, the reindustrialization of America, etc. If that sounds a lot like me it should given this paragraph from last week’s letter:

“In addition to the theme that technology is making building more for less a reality, other themes I am encouraged by include: companies making products for American consumption are moving jobs back to the U.S.; the reindustrialization of America; Americanism; a move toward energy self sufficiency that will shrink our trade deficit; and then there are the themes outlined in the book Abundance: Why the Future Will Be Much Better Than You Think written by Peter H. Diamandis and Steven Kotler.”

Tom then proceeded to discuss select companies in the Growth Leaders Fund and why he owns them. Names mentioned included: Apple (AAPL/$522.41); Continental Resources (CLR/$94.75/Strong Buy); Google (GOOG/$609.90/Outperform); EMC (EMC/$27.52/ Strong Buy); Fortinet (FTNT/$26.99/Outperform); and Zynga (ZNGA/$12.93). Almost as if it were a “planted” question, one of our financial advisors stated, “You buy the kind of stocks that my clients should have some exposure to, but I am afraid to buy them because of their volatility.” My response was, “Precisely, and that is why you want to own this fund and let Tom manage the risk.”

Speaking to Tom’s position in Continental Resources, a lot of our energy stocks have gone parabolic over the past few weeks, including CLR. If you had followed our recommendation and made CLR shares a 3% position in a $100,000 portfolio when our fundamental analyst initiated research coverage, holding all the other stocks in said portfolio at a constant price shows that your position in CLR has now grown into a 16% portfolio “bet.” Accordingly, it makes asset allocation sense to rebalance that position back towards a smaller weighting and let some long-term capital gains accrue to the portfolio. The same can be said of other portfolio positions that have grown into too big of a weighting in portfolios. Also of note, our long-standing love affair with Wal-Mart (WMT/$58.79/Market Perform) ended last week with Budd Bugatch’s downgrade of WMT from Strong Buy to Market Perform, which has now become another rebalancing candidate.

As for the stock market, last week the S&P 500 (SPX/1365.74) eclipsed its previous reaction high, recorded on April 29, 2011 of 1363.61, and now stands at its highest level since June 6, 2008. The closing high, however, came on very low volume and with numerous divergences. The two most egregious are the lack of upside confirmation from the D-J Transportation Average (TRAN/5139.14) and the Russell 2000 (RUT/826.92). While there are clearly other divergences like the non-confirmation from the Operating Company Only Advance/Decline Line, the fact that there have been no 90% Upside Days this year, the narrowing leadership, too many three-digit stocks, etc., the Trannies and the Russell are indeed the two most worrisome. That’s because the RUT is more than 5% below its one-year high, while the Transports are ~9% below their one-year high. Historically, when the S&P 500 was at a fresh 52-week high, but the Russell 2000 and the DJ Transports were more than 5% below their respective 52-week highs, stocks have been vulnerable. Therefore, if I am going to err it is going to be by being too cautious (not bearish), consistent with Ben Graham’s mantra – The essence of investment management is the management of risks not the management of returns. Good portfolio management begins (and ends) with this tenant.

The call for this week: There have now been 37 trading sessions in 2012 and so far the S&P 500 has yet to experience a 1% Downside Day. This 37-session, or more, skein has occurred 11 other times in the past 84 years and has on every occasion except one seen the equity markets higher by the end of the year. Still, the rise since the “buying stampede” ended, which stopped on January 26, 2012 at Dow 12841.95, has felt unnatural to me. Surprisingly, the Industrials reside only 141 points above their intraday high of January 26th, causing one market maven to exclaim, “no wonder I feel like we’re in the Trading Twilight Zone.” Maybe there will be a resolution to that “unnatural feeling” this week when we experience Leap Day (February 29th). As our friends at Bespoke write, “There have been 21 leap days in which the market was open since 1900. … The average performance of the Dow on leap days has been -0.05% with a median return of -0.22%. … There have been three leap days that fell on a Wednesday (as it does this year) since 1900, and the index has risen once and fallen twice. The last leap day was February 29, 2008, and that day the Dow had a big fall of 2.51%.” I’ll speak to you next week.

Copyright © Raymond James

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