Fourth Quarter Client Letter

The 4^th quarter of the investment year frequently reminds me of the 4^th quarter of an NBA game.   The earlier quarters are played when the “time on the clock” has little meaning since there’s so much game time left.  But the 4^th quarter is played with a sense of urgency as the clock winds down.  While bench players frequently get their playing time in the earlier quarters while the best players play in the last minutes.  Red Auerbach used to say that it was more important to be the player on the court who finished the game rather than who started the game.

In the 4^th quarter of the investment year the equity markets tend to come alive with an upward bias that usually extends into the New Year.   Mutual funds and Investment managers keep score of how well they are doing and the unfortunate may be suffering from a bout of “performance anxiety” which has way of keeping a bid underneath the markets.  Those managers who’ve been underweight or underperforming coming into the quarter start to deploy capital swiftly, so as to not be left behind.  While we’ve had a modestly successful year so far, the finale of the year could make the difference from a modest year to a very good year.

Just as a coach wants the best players on the court at the end of the game, lagging stocks holding must give way to better performers.    In my 20 years of investing one of the most important tenets is to sell underperforming assets quickly as they will drag down returns.

Stocks:  As I wrote this past January I expected the U.S. Equity markets to be relatively flat within a trading range for the majority of 2010, until the 4^th quarter.   This is typical action for the second year of an economic expansion and 12 to 24 months from a major market bottom.   Consider it a period of digestion from the big move up in 2009, its normal and not generally a precursor to a major move down.    I mentioned that the most likely time frame for a move up from the trading range would be in the 4^th quarter.   It’s starting to appear that the move past the top of the range of 1130 on the S&P 500 to 1140 may be a signal that we’re ready to move up to at least 1200-1210.  Market indicators have improved measurably in the past two weeks but the risk of the market failing and moving below 1130 is still very real, so near term caution should be observed especially when considering that October is infamous for market declines.  That being said, sell-offs occurring within a strengthening market tend to be short and shallow.

If we continue to rally higher it will coincide with the anticipated Mid-term Presidential elections which tend to be a catalyst for a significant equity rally.   In fact, the next 9 months have historically been the three best quarters for equities during the entire 4 year period.  Mid-term rallies tend to range from high single digits to 30% or more with duration of six to nine months.

In sum, since 1900 the DJIA has tended to rise after the mid-term elections with the next 9 months being the most profitable of the Presidential term.  It’s possible that investors are looking at the polls which show a loss for the Democrats which will likely split Congress.    Since 1900, when we have a split Congress and a Democrat as President the DJIA has averaged 7% per annum.

Stock selection during the next 9 months will be critical in order to maximize the opportunity.   Third year rallies should be viewed from the perspective of Secular Bull or Secular Bear markets as the DJIA gain since 1900 during a Secular Bull has been 16.% while during Secular Bear’s are a subdued 6.4%.

Emerging Market stocks especially in Latin America should do quite well in absolute and relative terms compared to US equities.   EM and Latin America are in Secular Bull mode while the U.S. is in Secular Bear mode.  Our positions in IRSA Inversiones Y Representaci (IRS), Companhia de Saneamento Basico do Estado de Sao Paulo (SBS) and Telecom Argentina (TEO),  Enersis (ENI) are starting to perform with good relative strength.

Green Screens:  On our Green screen where our proprietary model filters the sea of Green for the best are two new names.   These two Green Investment names could run fast if we rally into the year end:

Solarfun (SOLF) – Chinese developer of solar energy equipment including the sale of photovoltaic products

Sunopta (STKL) – An organic food maker focusing on soy and oats for the organic and natural food markets.  Packaged products include soy milk and a whole array of grain based food products.

US markets:  Since the market bottom in March 2009 there have been nine rallies of 5% or more.  In all nine cases the Materials and Industrial sectors have lead in performance.  Representative of these two sectors which also showed near the top of our model selections are WHX Corp, (WXCO), Material Sciences (MASC) and very strong performers: TPC Group (TPCG), Motorcar Parts of America (MPAA) and Dorman Products (DORM).

Bonds: In a statement made by the Federal Open Market Committee they outright stated their concerns about deflation and that at present the inflation rate was “somewhat below” their intended goal.  In addition, the Fed statement mentioned that inflation expectations are “subdued for some time before rising to levels that the Committee considers consistent with its mandate.”  The mandate of the FOMC is for stable asset prices and full employment.   In addition the Fed made a remarkable statement:  The FOMC stands ready to “provide additional accommodations if needed to support the economic recovery, and return inflation, over time to levels consistent with its mandate.”

The change in language likely means that the Fed could initiate another round of Quantitative Easing (QE2) sooner rather than later.   QE is a process where the Fed goes to the open market or the major banks and buys Treasury bonds in an effort to drive the prices higher thus lowering the yield.   By purchasing the bonds in exchange for cash, the banks primarily, can become flush with cash which hopefully will cause them to initiate more loans thus helping the economy.    The media often states that the Feds actions resemble “cash thrown out of a helicopter” when in fact, QE does not “create” new monies at all, it exchanges bonds for cash in a zero sum transaction.

There are two major risks to the QE strategy (amongst others):

1. The banks will hoard the cash and not initiate loans.   While distasteful to most of us, it’s essential for the Federal Reserve to stand behind the banking industries sensible loans.  Otherwise, banks have little incentive to loan with the flatter yield curve and principal risk.  The opposing argument is that if the Fed lowers long term rates to the point of near term rates, the incentive to make loans with higher interest rates becomes all the more attractive.  If you can issue a mortgage at 5% then it’s obviously better than earning 2% or less with a Treasury.

2.  Assuming QE2 is successful, we’ll be faced with the issue of a banking system flush with cash and a Treasury market artificially supported by the Fed.   Should our economy prove itself to be self sustaining, (employment increases to acceptable levels) the cash that was injected into the economy will have to be addressed.  It’s very possible that inflation above what we’ve seen since the very early 1980’s could return which was a byproduct of government spending the 1970’s.  Inflation is an easier enemy to deal with than deflation, so the lesser of evils might be our friend.

For those of you that don’t remember or weren’t around in the early 80’s, short term bonds yielded 20%!  I can remember municipal bond investors who wouldn’t accept less than 12% tax free yields.   It would be an understatement to state that the 70’s and early 80’s were devastating to bond investors.

Eventually, the Fed will withdraw support to Treasury prices and the Treasury bond market will revert from its current significant overvaluation to historical mean valuations, in other words a significant decline in value but the magic question is “when?”  In terms of the Macro investment perspective, the best trade for the next half dozen years may be shorting the US Treasury market via symbol “TBT”.

Positive themes from QE 2:

1.  Increase in incentive for banks to loan and increased consumer spending.   A by-product of this will be an increase in mortgage refinancing which will free up cash and spending for the consumer.

2. Increase the odds of stabilizing the real estate market.  Lower rates imply higher affordability and easier debt service ratios.

3. Investment choices are continually evaluated for relative value and attraction.  With Treasury rates at 2% or less for longer term Treasuries, the “real return” adjusting for inflation will likely approach 0% and drop into negative “real returns” should the economy pick up steam or a return of inflation.   Asset prices for stocks should continue to grow as investors defect from bonds with little return to assets with better potential.

4. Lower dollar:  Lower rates probably mean the dollar continues to be weak.  But a weak dollar helps exports and would continue to support Gold.  It also supports commodity based economies such as Latin America.

It’s my best guess that the Federal Reserve will do everything possible , even at the risk of higher inflation in a couple of years to keep the economy away from Deflation.   This means generally higher valuations for assets, which by the way was one of the most important failures of the Japanese response to their deflation.

Recently John Paulson who made a fortune for his hedge fund by shorting the US Mortgage backed securities market had this to say about bonds/fixed income:

“The purchase of long-dated bonds, either Treasuries or corporate, should turn out to be a horrible trade. Rates are at record lows, and the economy is turning and should continue to churn higher. Paulson expects roughly 2% GDP growth for both 2011 and 2012. Quantitative easing should contribute to significant inflation over the next few years, with inflation possibly hitting low-double digits by 2012. This is bad for the 10- and 30-year and bad for the U.S. dollar. The U.S. dollar should fall and the yields on long-dated U.S. Treasuries should rise.”

RMHI Model, Research and Hedging update:  I’ve made significant progress in the past year on refining our models and including a hedging option.    Results from the equity selection model have been quite good in recent months but most of my energies have been devoted to finding a reliable mechanism in which the Hedging option should be deployed.     In the past my focus has primarily been to concentrate on Investor Sentiment, however further research has steered me to concentrate on corporate earnings shifts.

There were several factors I wanted in a model if Hedging was to be employed:

1. Low Hedging Frequency:  I was not looking for a hedging strategy that created a lot of “noise”.  In other words, a low number of hedging situations over an extended time period matched with a high probability of success.   We’re not looking to catch every downdraft as that’s impossible and turnover costs would be enormous.  I’m looking for the big move down where a measureable deterioration in corporate earnings is accelerating.

2. Foundation of the strategy had to be relatively simple with common sense:  Complexity tends to be its own enemy as the number of issues that can go wrong increases when the number of factors to consider increases.

3. The use of Hedging had to exceed the rate of return of cash.  The Hedging strategy had to create significant and measureable value beyond the rate of return of a money market fund; otherwise it would be wise to simply invest in money market funds while the strategy determined that stocks were to be avoided.  The choice of Hedging options has increased in recent years.  Hedging with the use of Treasury bonds and bills, Money Market funds, Inverse Exchange Traded Funds for the Russell 2000 and S&P 500 were considered, including those with and without leverage.  Options and Futures were not considered at this time.  The best results came from the Proshares Ultra Short S&P 500 ETF symbol “SDS”.

My test results revealed that low frequency/high probability hedging model could be created by focusing on current earnings estimates for the S&P 500 index.  In nine years of back-testing the RMHI Model with Hedging triggered only three instances where Hedging was in order and all three instances were “profitable”.    The

The model did prevent major erosion in value for the sample account in the Bear Markets of 2002 and 2008 and boosted the annual rate of return significantly.  The actual data will not be published publicly but only available upon client request.

I’m still searching for a way to do “out of sample testing” such as testing the model in the 1970’s for example.  The back test period dates from 2001 to the present.

The Hedging feature of the RMHI is primarily a Bear Market identifier and not designed to catch short market corrections such as what we experienced early this year.   The model identifies potential Bear Markets which are attributed to the potential of a Recession due to significant declines in S&P 500 earnings.

At present earnings estimates for the S&P 500 have been rising.   After bottoming at $79.53 in late July/early August, it rose to $79.93 at the start of September and is now sitting at $80.32. The trend is up, and the market is following the earnings, as it always does.   Soon 2011 estimates will be driving the markets as 2010 moves to the rear.   Analyst estimates are $92.41 and rising for the S&P 500 in 2011.  Hence the Hedging option for the RMHI Model is not close to signaling a potential for a Bear Market.

To sum it all up:  For the mean time the list and strength of the positives for equities continue to outweigh the negatives, the negative being the anemic rate of earnings growth…but it remains in “Growth” mode.   Furthermore it is my opinion that the Federal Reserve will do whatever it takes to resuscitate the economy and housing even if means inflation down the road.

Equities have just entered what is historically the strongest 9 month period as defined by the Presidential term.  It many ways, it’s all about politics and the need to get reelected.   Just as President Clinton moved to the center of the political spectrum after his second year, President Obama may inch toward the center himself to prepare for his own re-election.  A shift towards the center combined with a more deliberate attempt at job creation with a less antagonistic stance towards business would lower the risk of adding employees.

Copper prices which are a great economic barometer have moved to a new 2010 closing price high.

Select bonds are still producing here, especially High Yield and Emerging market debt.   However, the overwhelming bullish consensus on bonds, especially Treasuries is disturbing.  The US Treasury market is likely topping out.  In addition, there now many non confirmations in Sovereign bonds, as British, German and French bonds have not made a new high in price while US Treasuries have done so.   This may mean the move up in bond prices is losing steam and a change in direction is forthcoming.

All the best,

Brad Pappas

Utilizing Investor Sentiment for the Green Investor

Too few individual investors how to use Investor Sentiment to their advantage.    Last week when the New York Times ran a front page story regarding individual investors fleeing equity mutual funds in favor of bond mutual funds, it should have made any long term Socially Responsible Investor giddy with glee.

Why?

Extreme negative sentiment as depicted in the NY Times should be used as an inverse barometer of when to invest.  However, more often group think sets in and investor is intimidated by being the lone wolf buying shares while the herd is stampeding in the other direction.

Right now, sentiment as expressed by the American Association of Individual Investors is getting extremely negative….and thats a good thing.   Who’s left to sell when only 21% of members polled are positive on the markets?  21% happens to be one of the lowest polls recorded in the past 15 years.   You may be right in your views of why you want to sell…….but, and this is the tricky part that the majority of investors never learn to master:  You may be right in your thesis but if you’re in the majority with your views, chances are your opinions have already been absorbed by the markets.

Using data supplied by www.sentimentrader.com:

Since 1987, there have been 47 instances where AAII sentiment fell to 21% or below.  The results are:

3 months later: the average return was 5.8% for the S&P 500 with 98% of the 47 instances positive.

6 months later: the average return was 10.9% for the S&P 500 with 91% of the 47 instances positive.

In conclusion, many investors think they can manage their assets completely on their own but unfortunately do not know how to interpret sentiment data.  Going against the herd is never easy but you must be able to master your emotions in order to be a successful investor, otherwise you might consider hiring an adviser who’s weathered a great many storms in their career.