As one of our clients opined recently, “I knew I would need to buckle up a bit this year but didn’t expect I would need a 6 point harness!”  Yes the widely expected higher market volatility is with us now.  Losers are becoming more pronounced and worrisome while gainers have been limited and thin.  Such is the nature of a market correction.  You already know that I expect anything but an average 8% year as is the consensus among market gurus, so let’s look at the current state of investment opportunity and risk as it stands so far in 2015.

 

Growth and Income

 

For those like us who regularly measure risk and reward metrics among various asset classes, investment styles and strategies, you have a clear path to walk so far.  This year, we are seeing the market showing strong and broad preference for all types of income oriented securities (interest or dividends) and some very focused, selective desire for growth.  Virtually everything else is under selling pressure.   2013 and the early part of 2014 were just the opposite in terms of investor preferences so take note.  For those who recognized the shift in July of 2014 associated with the long-term bottom in the US dollar, you have had to do very little to your portfolio thus far in 2015.

 

Here’s the list of INCOME bearing securities that continue to push out to new highs with very little selling pressure.

 

Long term Treasury bonds

Real Estate funds and REITS

Preferred Securities

Investment Grade Corporate bonds

Utilities

Municipal bond funds (high yield and intermediate term)

Select Dividend paying stocks – mostly in the consumer staples sectors

*We own great gobs of all of these except long-term Treasury bonds for our clients.

Here’s a list of the GROWTH sectors and securities also making new highs

Biotech

Notice the very short “list”

Now I’m painting a very bleak looking picture of the market based solely on new highs but that doesn’t tell the whole story.  There are a number of things that are beginning to look like they want to form attractive bottoming patterns and others that are showing clear relative strength to the broad US stock market but are not yet in obvious up-trends.  Among those showing relative strength, I think there are some short-term opportunities developing as considerations for upgrades or for new money looking to get invested.

 

SELECT Internationals

2014 was a tough year for internationals with the exception of China and India.  Most were down on the year in the double digits.  Oil dependent countries lost 30% or more.   With the end of year, we looked at the all the country oriented fundamental research and found several countries to be a better value in terms of their stock market and with higher economic growth rates than the US.   Specifically, these are developing Asia Pacific ex Japan, South Africa, Turkey and India.  All others are either on par with the US or not as attractive as the US.  Developing country ETFs and aggregate funds like emerging markets have also shown some very nice relative strength to the US stock market since the lows in December even while the US dollar continues to rage higher and commodities of all sorts make 10 and 15 year new lows.  I’ve said this several times in the last 6 months but I find it very interesting that emerging markets and commodities have become non-correlated (are decoupling).  This has been a long -standing positive relationship for many years, almost decades and it tells me that emerging markets are now stronger than most think or that commodities are perhaps artificially oversold now.  Considering the relative growth prospects, fundamental strength and improving technical price patterns, we think there is a case to be made for cutting back a little exposure to the US market and re-engaging with select internationals (those mentioned above).  Move slowly and mildly if you want to make this change.  We have taken small entry level positions as of last week with proceeds from the sale of select US based index and sector funds.  Beyond this select list of internationals, I would continue to steer clear of most overseas investments for 2015 (see discussion of US dollar below)

 

Energy

 

What?  I know – energy companies have been in the doghouse in sync with the new uptrend in the US dollar since last July.  They have fallen by nearly 50% in less than 5 months taking no prisoners.  I saw Unleaded gas in Denver on Monday for $1.81.  But looking at the short term it seems that energy funds and stocks are now working hard to find a low.  Each down day in the stock market, we see energy stocks recover nicely into the close and sometime finish UP on the day.  Even the Flintstones of energy companies (Exxon Mobile) is outperforming the S&P 500 since the last major market low on December 15^th!  Some big money is beginning to accumulate energy stocks.  We are not (yet).  Our discipline mandates positive price trends to justify a current investment and I see no positive price trends in the energy complex yet.  From what I understand, imbalances between the NEW glut in supply and LONG standing decline in global demand for oil since the year 2001 are likely to continue well into 2016.  But have energy prices fallen enough to price in those metrics?  Maybe, but I’m doubtful we’ll see a real sustainable surge higher until the imbalance improves.  Those arguing that falling oil represents the real truth of stagnant global growth are not looking at the facts.  Oil demand has been falling for years in response to higher fuel efficiency standards, greater shifting of global economy toward service based industry as well as substitution effects coming from adoption of renewables.  As I said last year, the power structure in the energy complex is shifting away from traditional fossil fuels and carbon based power at a deliberate and consistent rate annually (2-3%).  Energy may be a developing investment opportunity but it might be better to stick with some of the more progressive energy companies with diversity in their product and servicing lines if you want to buy in.  All in, I think there are better investment options than energy in 2015 but some stability in the energy complex might be a good thing for the market as a whole with the exception of the consumer groups.

 

Long US Dollar

 

This is a very strong trend in the market and one that is wildly oversubscribed by hedge funds and technical types.  The US dollar has been raging higher since July creating the clear channel of winners and losers.  We did a lot of research last year looking at past periods of US dollar strength.  The returns by asset class and sectors then are identical to the trends we see today.  A strong US dollar favors domestic issues, growth, cyclical sectors like consumer, bonds, real estate, utilities, health care and technology specifically semiconductors.  These are the very things that continue to look great today.  Now the trend in the US dollar is stretched to the upside in the short term but long term the up move has just barely begun and is likely to continue.  If one wants to TRADE internationals or energy or commodities each time the US dollar falls back a bit, it could be worth the ride, but I would not expect much in the way of longer term trends in these areas as I mentioned above.  What would it take for the US dollar to reverse its uptrend?  It would take Europe becoming a stronger economic force than the US.  It would take a massive recession in the US driving a complete reversal in US Federal reserve policy and a return to Quantitative Easing.  I don’t see either of these events happening anytime in the next 2-3 years.  Bet on a strong US dollar for a long-term trade and bet on the sectors that go along for the ride.  Let’s not make this harder than it is.

That’s it for this week and next as I’ll be finishing the year-end Change of Seasons report where we outline in detail our investing principles, our process and our discipline for all to see.    If you are a client, please take some time to read this upcoming report.  It will answer many of your questions about how we manage your money and build confidence that our systems are truly built for “All Seasons”.

 

Happy New Year to everyone!

Sam Jones

Slipping just under the wire with my final post on 2015 forecasts, I’d like to cover what I see as likely investor sentiment and behavior patterns as the 3^rd part of this forward looking series.  Can you believe that 2015 was the future date set in the classic movie “Back to the Future”?  And here we are!  When it comes to the mass of investor behavior, events in the past are often the same in the future.

Two Guys in a Hot Tub

In Steamboat during the holidays, we get our fare share of wealthy resort travellers.  So there are two guys sitting in a hot tub (sounds like a joke right?).  Actually there are three including me.  Small talk turns to “what do you do”.  They are retired, one was a CFO of a “major” US company, and the other was in Oil and Gas for 30 years.   Cash is oozing out of their pores.  I am a lowly money manager.  The conversation goes like this:

Oil Guy:  So I guess you’re probably telling all of your clients to just put it all in the Vanguard Index 500 now right?

Me:  mumble something incoherent with an awkward chuckle.

CFO Guy:  I hope not!  I was smart enough to sell all of my Vanguard funds in 2008 (he means the end of 2008 near the lows but doesn’t say that) but I haven’t gotten back in since then.  I’m afraid to buy at these levels and I’ve missed this entire bull market.  I thought indexing was the way to go but now I’m not so sure.

Me:  That’s the first honest statement I’ve ever heard in a hot tub.

Oil Guy:  mumbles something incoherent with an awkward chuckle

Funny and true story.  Investor psychology is now in a bipolar state captured by these two gentlemen.  Some like our Oil friend are committed to buying more and more of the same S&P 500 index funds on the assumption that returns are cheap and easy.  Their intentions are to passively hold their index positions but we know what happens when these become less productive and doubt enters the picture following deep declines.  The trap is set for this fella but he is voluntarily walking into it nevertheless.  Our other CFO friend is skeptical but ultimately will give in to his emotional need to participate this year.  He will take steps to buy something with his cash as many are doing now.  That something may not be a stock index fund but more likely something that seems safe – More on this in a minute.  Again, the trap is set for the latecomer buying the wrong asset at the wrong time.  Strangely, the stats on investor confidence show that more investors are in the CFO guy’s camp making the assumption that the markets are now overvalued and subject to downside risk.  This is not a new phenomenon as this negative and falling sentiment toward stock valuations has been with us since 2012, even as prices continue to rise year after year.

If the past is our guide to the future, I’m going with the assumption that some time in 2015, investors will find stocks attractive again, either by way of a deep correction or by way of capitulating to sharply higher prices.  There is a reasonable chance of both events in 2015!  Buckle up.

Buying Back In – But To Something “Safe”

As I mentioned above, our CFO friend is going to put his money to work this year.  I can hear it in his voice.  Cash moving from money market funds into the US financial markets will happen in 2015 as long as prices continue to trend higher.  The real question is where will it go?  Given the skepticism identified in the fine Bespoke chart above, it seems that investors will reach for participation as a means of adding net exposure but their selection will be in something with perceived safety and strong recent history or performance.  US Treasury bonds and Utilities come to mind based on some wild outperformance in 2014.  Utilities on average are currently earning 2-3%/ year (EPS).  In 2014, they gained nearly 30%.  They are the most overvalued they have been in the last 25 years.   We currently own utilities but they are on the chopping block now.  Long term US Treasuries tell the same story with an annual yield of 3.3% and gain of 27% in 2014 erasing all of 2013 LOSSES by a few points.  The Barclays Aggregate Bond index didn’t fare as well but did produce enough return (+6%) to attract that investor looking for something “safe”.

Bespoke did a nice job of running sector valuations relative to their long term median levels and came up with the following.  Mind you, a sector or the market for that matter, can remain overvalued or undervalued for a very long time, much longer than we might expect.  Overvalued is not a sell order but simply a condition to be aware of.  Same goes for oversold – but the opposite.

Investors looking for something safe to buy amid their valuation skepticism should be looking to the top 5 sectors groups showing lower “current” values compared to “median” values.  I think telecom should be top of the buy list as these stocks and funds also tend to pay out some of the best dividends.  We plan to rotate some of our current utility positions to telecom and materials in the coming weeks as we already have a large stake in technology and industrials.  Energy is now on the watch list for us but it’s still too early to buy that sector.  Buyers beware, safe investments for your reinvestment strategy based on past returns may be just the thing to avoid in 2015.

Banking on Forecasts (including this one)

According to the average institutional money shop, the US stock market should gain 8.1% in 2015.  This the median forecast.  Very oddly, these same forecasters got it almost exactly right in 2014 with returns coming in at 11%, the median was for 12% this time last year.  It would be a small miracle if these forecasters got it right two years in a row – they are never right and usually not even close at this time of year.  They do a great job of changing their forecasts in June (wink).  Investors would be wise to assume nothing in 2015.  I would offer that a range of returns for the S&P 500 will be plus or minus 14%, roughly 2300 on the upside and maybe 1740 on the downside for the S&P 500.  Big swings will drive big flows of funds in and out of stocks mostly at unfortunate times.  My advice is to try to position your portfolio early in the year for an increase in volatility.  I would recommend reaching into the non-correlated investment world, which we are doing, now by increasing our allocations to “liquid alternative” funds like managed futures funds, REITS and Long short funds.  Our goal is to get comfortable with a more diversified mix of holdings, gradually cutting equity exposure at the same time as stops are hit.  I too see and read all of the good news related to consumers, the US economy, to low gas prices and interest rates with no risk of inflation.  I understand the aggregate expectation of 8% returns.  But when all the news is perfect, we should all be watchful for the unexpected.

And this ends our three part series of forward looking wild guesswork.  And so it begins…

Thank you for being our valued clients – we truly appreciate your trust and confidence and never take your business for granted.  We humbly look forward to serving you in 2015.

Cheers

Sam Jones

Continuing on our series of forward looking wild speculations about 2015, this update will be about timing and possible price patterns.  Clearly, this is reckless and meaningless when it comes down to it, as conditions will always change making forecasting look silly.  As they say, forecasts are for show, trades are for dough… on with the show.

Signs of an Intermediate Term Top Developing

The crash in oil or the Russian Ruble or the Greek market will not by themselves be the catalysts for a market top in the US.  However, they do provide a higher level of instability and have some dislocating effects on other countries, asset classes, etc.  For instance, clearly we have seen a ton of downward pressure on the US corporate high yield market due to their 15% exposure to bonds issued by oil and gas companies.  But even without this exposure, high yield corporate bonds peaked all the way back in July before any of the oil price carnage.  Failures in peripheral markets do create some higher volatility for our primary markets but they are not by themselves large enough issues to change the long term primary trend of the US stock or bond markets.

There are other more serious signs, however.  In the last 6 months we have seen the yield curve in our own domestic bond market flatten substantially.  To be clear, the curve is not yet flat but moving in that direction.  An actual inverted yield curve tends to lead most major stock market tops by 2-3 months and is indicative of a pending recession.  I don’t see an inverted yield curve until later in 2015 but it is a warning flag of sorts.

Small caps and High yield bonds are canaries for our domestic stock market and we are seeing clear and present danger signs here.  I am hopeful, almost expecting, these two groups to break out to new highs either this month or in January effectively eliminating this concern but until then, our Net Exposure analysis really won’t let us get more aggressive with our positions.

The Federal Reserve is also not going to be in a real hurry to raise rates but neither are they promising to be as accommodating as anytime in the last 6 years.  The threat of a rising Federal Funds rate is now with us and the short end of the yield curve is reflecting that risk.  For long dated bonds it’s just the opposite.  Here again, we have some massive external influence (foreign buyers) driving our long bond market to absurd price levels.  They must be in a great deal of pain (and fear) to consider investing massively in US bonds paying 3% interest annually paid for with foreign currency that is losing 8-10% on exchange to USD.   If I were the Federal Reserve, I would dump some of the massive inventory of Treasury bonds now and let the rest of the world carry the risk in what would be the most incredible (and lucky) trade benefiting US tax payers of all time.

Finally, we must note that Index Mania is with us again and sadly it tends to appear within a few months or quarters of a significant market peak.  As individual sectors, one by one sell off, we are often left looking at the broad market indices as the last man standing and thus deserving of all of our investment capital.  Buyer beware! Jim Stack of Invest Tech did an excellent job noting the Index Frenzy headlines at major market peaks (1999, 2007 and now again in 2014?).  These headlines tend to be a little early but not by much.  Take a look.

“Saving For Retirement” – Index Fever Fortune Magazine – 11/1998

“Who Needs a Money Manager?” – Business Week  2/1999

“Index funds help you avoid risks of stock selection” – Boston Globe 2/2007

“Index Funds: So Hot Right Now” – Motley Fool 12/2006

“Owning the S&P 500 is Cheap, easy and smart” – USA Today 7/2007

And now…

“30 Reasons to fall in love with index funds” – Market Watch 6/ 2014

“Vanguard Balloons as Investors Flock to Index Funds” – Barron’s 8/ 2014

“Investors Flocking into index funds; Here’s Why” – CNBC 11/2014

Possible Pattern for 2015

Here’s my guess as a long as you don’t hold me to it.  I think there is a reasonable chance that the US stock market will finish near it’s highs of this year starting a rebound right here, right now.  If there are not too many international disruptions, the melt up rally could carry into the first few months of the year but with a higher degree of weekly volatility than we have seen in recent past.  Once oil inventories fall by March and oil begins to rebound smartly, all the consumer good will (and extra earnings) generated from cheap gas will go away leaving us with a set up for an intermediate term market correction from higher valuation levels.   From here we could easily see a 20+% decline in the US stock market before summer time 2015, erasing all of 2014 gains plus some of 2013’s gains.  Our intention is to be ready to cut equity exposure, play defense and shift to non-correlated alternatives in the first part of 2015 depending on what happens.

But I don’t see this deep correction event being the end of this secular bull market.  In fact, if the US economy can avoid recession, I would view such a deep correction as a very rich opportunity to buy cheap stocks within a longer term global economic recovery.   We might then find ourselves picking up VERY cheap technology, basic materials, industrials, commodities, energy companies and inflation hedges and re-engaging with some emerging market exposure (discussed last week).   If we don’t see some expansion in the P/E multiples for stocks in the next 3-5 months, we could see it happen on the other side of the deep correction. Valuation guys suggest that S&P 500 index at 2300 would put us at a similar extreme valuation high as other bull market peaks based on current earnings.  So I still think this secular bull market has longer to run beyond an early 2015 correction.    My gut feeling is that there is just too much cash sitting on the sidelines and the secular bull market won’t end in earnest until a majority of this cash is put to work.  The US is also (still) the best looking horse in the glue factory so we have the added support of international investors as well.  We will plan to aggressively buy any significant discount in stocks in 2015.

Coincident with the bottom of the deep stock and commodities correction in mid 2015, I see a top (permanent) in the US bond market.  This will be another great moment to cut or eliminate bond exposure, perhaps your last.  Heed the signs, avoid assumptions and be ready for some higher volatility in 2015.

Have a great week as you prep for the holidays

Cheers

Sam Jones

And so it begins, themes and forecasts for the New Year.  As usual, December will be a month to sponge all the prognostications and form an opinion to help guide investment choices throughout 2015.   As the first of this forward looking series, we’ll start with the high level themes of what we know today, heavy on fact – light on guesswork.

 

Commodities

 

As a clear and defined six month trend, we know that the primary trend for commodities of all sorts is down, very sharply.  Major support has been broken in the metals and energy groups and we have no idea how long this asset class will continue lower.  Commodities should hold almost no weight in your investment portfolio now but we’ll be watchful for some incredible upside opportunities after a complex bottom develops (months away).  The energy group is heading clearly down to the long term trend line at this point, which could provide some stability – see chart below of the Energy Select Sector ETF (XLE).  Another 8% lower will bring the price back to the long term UP trend line and the break out level from 2011.

 

Are commodities dead?  For now, yes.  But longer term, the world is doing nothing but gobbling up natural resources at a faster and faster rate.  Developing countries are driving new demand, resurgent economies need more materials to build out, and more humans are eating, drinking, driving, and living than last year.  Jeremy Grantham of GMO does an excellent job outlining the facts behind long term global resource scarcity and it is a real thing.  Commodities may very well be a place for us to make money in 2015 as they now represent some of the best values and dividends.  Remember, let it bottom first!

 

Bonds

 

Treasury bonds and all forms of sovereign (Government issued) debt are ugly and will be at best unproductive investments for a long time.  I said the same about Gold at our annual meeting in October of 2011 showing the folly of ATM type devices that kick out little cute bars of bullion in a Middle East casino.  Gold is down over 40% since then.

 

 

I said the same thing about real estate in 2006 when it became painfully obvious that we had approached a “House of Cards” moment.  Very few areas of the country have yet to exceed real estate price levels set in 2006 after falling dramatically in the last eight years.  Real estate is still dead money and this is clearly not the time to chase or get into the fix and flip business.

 

Now, the 30 year US Treasury bond is up nearly 22% YTD making such a statement sound flat out wrong.  But what if I told you that this same bond is still down -1.73% from its high in 2012 while stocks have been appreciating at 15-18% annually.  Hear me now; if there were a moment in time, in history, to sell your long term Treasury bonds as it has now recovered (but not exceeded) the losses incurred in 2013, this would be it.  Follow Bill Gross if you don’t believe me.

 

Stocks

 

Stocks are still your best, most liquid, bet for making returns in 2015.  However, as I said at this year’s annual meeting, there are no more free rides from here on out.  Returns will be earned, not given in 2015.  By that I mean that robust systems focusing on portfolio net exposure, selectivity and position sizing will generate higher risk adjusted returns than simply owning a few indices passively.  Volatility is already on the rise and monthly whips in your stock account balances will become more pronounced.  Stocks and stock markets are now expensive but there are still pockets of opportunity.  Domestically, we’re definitely having a harder time finding things that are establishing new up trends but offer some value.   Like the commodities groups, internationals are becoming increasingly attractive but are not yet showing leadership, especially when adjusted for a rising US dollar.   Every week, I see more “piling on” mentality among late investors to US stocks, chasing absurdly priced securities.  Clearly 2014 will be a year for the record books in terms of net new inflows of cash into equity funds – nearly $180B so far.    Now the money shows up?  Now after nearly six consecutive years of cumulative gains in stocks?  After 200%, investors decide to put some cash to work?  Behavioral economics is not pretty as the cycle of buy high and sell lows is obviously still in play.  If you’re going to add money to the markets now, please do it with someone who has a system, a real historical track record and the will to manage risk when needed.

 

Other Stuff

 

Now that Black Monday through Sunday is behind us, we know that retail sales were down substantially year over year (-11%).  Excuses have been running wild but the answer is still clear to me.  Retail, as we have known it is on the ropes as brick and mortar stores continue to give way to on-line shopping.  I heard an interview with a company called Bonobos.com .  I think this model or some derivative of it will become more prolific.  Check it out – guide shops where you just go to try something on, and then it’s delivered to you next day.   I don’t know what will happen to Malls and all the big box spaces but I wouldn’t depend on their survival.  On-line sales are still barely 10% of total sales and we can see the negative impact already.  Imagine when on-line sales get to 20-30%?  Speaking of….. the key ingredient to the success of on-line sales is obviously delivery.  UPS and Fed Ex will be winners for a long time (we own UPS in Worldwide Sectors in full disclosure).   Amazon (AMZN) and Google (GOOG) are down substantially this year as they take a breather from 2013.  They could be close to a great buy and source of additional returns in 2015.

 

Auto transportation, efficient buildings and primary energy are going through historical evolutions.  This theme is still well in place and will accelerate making renewables, energy efficiency and clean technology attractive sectors on discounts.  They have held up very well as traditional fossil fuel companies have entered bear markets.  2014 has been a Transition year for efficiency companies after the blow out in 2013 (+60%) but not a bad one.  Stay tuned as this story is not over.

I also see the megatrend in healthcare, biotech and pharma as connected firmly to an aging baby boomer population.  I have no doubt that the Affordable Care Act will get a work over with the next administration but it will not change the fact that we have one of the biggest generations of all time wanting to age gracefully and stay active well into their 80’s and 90’s.  They have the money to spend on self-preservation and they will do it.  Maintain core positions in these areas and buy discounts until further notice.

Finally, it seems that the innovation cycle for technology may be tapering at least for some applications and distribution in the US.  Technology companies with a strong presence in the developing world still have long legs but are also subject to international risk amid currency wars.  Mobile, social and local are still big themes and the carriers of data (wireless and networking) should still be solid core positions.  But anything in the desktop hardware space is hard to hold in my book as we all can do more with handheld stuff.  Wireless charging is neato, coming soon.

 

That’s all I can think of for now but stay tuned to the Red Sky Report this month as I take a stab at patterns and timing for 2015.

 

Have a great week

 

Sam Jones

While we were all sitting around rubbing our bellies last Friday, the financial world not so quietly turned meaningfully.  Energy and the commodities complex may have just experienced a washout event in the short term.  Several other sectors are running into price pattern trouble and the stock market in general has again moved back into the high-risk zone based on a number of important metrics.  This is not a time to get complacent despite the happy season.

Energy and Commodities

Friday was perhaps one of the ugliest single days I have seen for commodities, including gold and silver, as well as anything that even smelled of fossil fuel.  Losses in single stock names were in the double digits, diversified energy funds lost between 6-8%, and commodities funds were down 4-6%.  Wow!  Now of course any self respecting investor would have been long gone from these sectors as price trends clearly fell apart five months ago.  There are several important truths and lessons to be learned from what is happening in the energy world specifically.

 

In terms of truths, we can be sure that OPEC nations in the Middle East will win this game of chicken with our domestic energy producers.  They will happily wait us out knowing that we cannot operate profitably at much lower price levels.    Domestic oil and gas production costs are 3-4 times that of the Middle East by the nature of access and availability.  Furthermore, the quality of US oil and gas is lower making it more expensive to refine into usable fuel.  “Drill baby Drill” mentality has driven our domestic production levels to the absurd leaving the world with a glut of supply while our costs of production continue to rise year over year.  Other truths – the price of gas at the pump will not track the price of oil as much as you might hope.  Refining capacity is the issue and a key element determining supply and price of gasoline in distribution.  Here we have a bottleneck as the US has not expanded our refining capacity in years.  Oil prices have fallen from the highs by 34% through last Friday.  Gas prices have fallen only 15% in my neck of the woods ($3.68 to $3.12).  We have an ugly situation for the energy companies which is starting to look a lot like the gold bust days in the 1800’s.  Finally, we also know that energy stock prices have retreated dramatically and may be carving out a very volatile bottom at least until the next round of earnings.  Every energy analysis in the world is crying FIRE so expectations are already very low.  We’ll see if actual earnings are better or worse early in 2015.   Bottom fishing is a possibility now but only in your highly risk tolerant accounts.

 

On the lesson front, we are seeing what happens to a sector or an asset class in the aftermath of years of price manipulation.  Oil prices have had the luxury of OPEC to regulate them with supply side controls.  When prices are too low, OPEC would cut production, when too high, they would increase production.  Now OPEC has formally announced that the West has made their own bed by allowing unbridled production and extraction.  We have run amuck in our frenzy to make a buck assuming prices would always remain somewhat stable. Obviously that is no longer the case.  Now that OPEC has removed itself as a quasi-regulator of supply or buyer of last resort, we see what happens; the market quickly and violently finds a “market” price based on actual supply and demand.  Now think about what other asset classes have been heavily manipulated.  How about bonds and interest rates?  How about Sovereign currency markets?  We should all be potentially ready for some violent repricing in interest rates once our central bankers in Europe, Japan or the Federal Reserve make the same choices as OPEC.  There is too much supply of low value Sovereign debt and paper currency in the world financial system just as there is currently too much supply of oil and gas in the world.

Sector Weakness

Last week, I spoke at length about selection.  Selection analysis and criteria are one of our important risk management tools keeping our clients invested in things that go up and out of things that go down with focus on market leadership.  Back in July several sectors and asset classes peaked and began corrections, which have yet to reverse to the upside.  These are energy, commodities, metals, basic materials, precious metals, Europe, emerging markets, high yield bonds and all small caps.  Everything else has really pushed out to new highs after the steep market correction in mid October.  Some areas have pushed out stronger than others.  Clear leadership still exists in large cap value, healthcare, biotech, pharmaceuticals, utilities and consumer staples (note – all defensive sectors) while we have seen only marginal leadership in financials, technology and banking (note- all growth sectors).  In the last few sessions, we have seen an early breakdown in banking and possibly technology.  As a market moves closer to a more meaningful top ahead of a protracted bear market, we often see sector drop outs and I’m especially aware that this might be happening now.  Today we sold our long-standing bank sector funds to cash and have several other sells ready if necessary.

Market Indicators Flashing High Risk Again

Coincidentally, last week we saw several of our critical market metrics move again to a high risk zone.  Some of these metrics are subjective like sentiment figures; others are more empirical like valuations and money flow.  At the bottom in October, I made a list of all the good stuff I saw from a short-term technical perspective.  The list was long giving us some great reasons to add exposure to our strategies and get reinvested after cutting exposure since July.  Now, if I were to make another list, it would be stacked with bearish indicators.  In fact, Jason Goepfert of Sentimenttrader.com actually quantifies the number of technical indicators at both bullish and bearish extremes.  This morning, I count 26 at extremes that are bearish for stocks looking forward and only 6 in the bullish camp. This doesn’t mean that prices can’t go higher but simply that the odds of December meeting the up, up and away expectations are suddenly not very good.

 

These indicators, while mostly short term, do influence our net exposure model discussed last week.  From a longer term perspective, I am increasingly concerned about valuations, which have moved to the same levels as 2000 and 2007 or in some cases higher.  Most valuation models suggest the seven year (yes the next seven years!) average annual returns for stocks will be at best around 2% until we get a deep stock market correction.   All things considered, given the deteriorating technical conditions and the fact that we may be losing more sectors incrementally, we are selling as needed and keeping proceeds in cash for now as we purposely reduce our net exposure.  We are not smart enough to know that day when to sell all but our system will have us defensively positioned as daily conditions warrant.  If you don’t have a sell side system or discipline beyond gut and watching your account balance, please call us.

That’s it for this week – sorry for the gloom during this festive season.

But do make it a great week!

Sam Jones

Managing your money without a well-defined risk control system is a bit like Thanksgiving dinner without any of the trimmings.  While the markets are exploding out to new highs again in near vertical fashion and investors again seem scared of nothing, it’s a great time to monitor the status of our various risk controls.

Performance Objectives versus Beating the Market

Last week, I spoke of the ills associated with trying to beat the market, or the S&P 500 index as so many have accepted as a proxy.  Beating the market should never be your goal as an investor and I don’t say that defensively.  The market is a fully invested, 100% stock only index in most people’s minds.  Is that your allocation?  Do you aspire only to outperform a 100% invested stock only index?  Can you handle that type of risk when it goes down 2%/ week? Or losses 50% – twice since year 2000?  Evidence suggests no one can because they all sell at the lows of every correction or the lows of every bear market.  They all think they will know when to sell out at the highs, but they don’t and they never do.  Investors need to become more mature frankly and begin thinking and acting on goals of performance objectives.  Personally, I am trying to hit 8% average annual returns on my entire investment portfolio net of fees.  My judgment period is generally a 5-7 year time frame on a rolling basis.  What’s your performance objective for your age, your asset level, your income and your capital requirements either before or after retirement?  Do you know?  We have gone through this process with most of our wealth management clients and they know what they need to make, what their objectives are and we work hard to help them meet THOSE objectives.  Now beating the market becomes something less important and we don’t fret about it.

It sounds easier than it is to just dial a return however.  We often don’t have the environment in place to make money and sometimes our best value is simply not losing money.  To hit a performance objective over time, we need consistency of returns and we accomplish this through our dynamic asset management style.  Earning respectable returns with lower downside risk and volatility gives us the confidence to do things like buy low (because we aren’t screaming in panic) and sell high (because we don’t care if we beat the market every day or every week). But successful execution of such a system does not come from methods like passive indexing.  Quite the opposite.  It involves making adjustments regularly if necessary, to three critical dials.  These are the trimmings of our system that keep us focused on hitting our performance objectives for our clients.

Trimming #1 – Net Exposure

Historically, we haven’t talked much about our investment process.  Most don’t really want to know how the sausage is made right?  But in recent months, I’ve found our new clients want to see it, all of it.  Confidence in management skill and the ability to produce consistent returns in the future is really about having a well-defined, well-disciplined system.  We do have the past returns based on real accounts (nothing hypothetical) to show with pride but they will always be past returns.  Maybe we got lucky…. for the last 15 years.  So let’s talk about our process starting with our first decision point – Net Exposure.  The analysis here focuses on slow moving stuff measured on monthly and quarterly basis.  We look at the primary trend of various asset classes.  Is it going up (the stock market), going down (commodities) or going nowhere (the bond market).  We look at valuations using market cap to GDP ratios.  We look at things called the Tobin Q and historical 12-month P/E ratios for the S&P 500.  We look at long range technical data like market breadth, summation indices, consumer sentiment, volume and leadership for confirmation of trend.  We also look at the economic and fundamental environment including monetary policy, earnings and revenue growth.  We also spend nearly $100,000/ year on expensive research from smart, lifetime investment shops that do an excellent job of summarizing lots of this data and helping us make critical decisions.

All of this goes into the hopper and we make monthly decisions as to how much investment capital we want exposed to the market and which asset classes we want to emphasize.  Today, we have very little reason to be in bonds, commodities, internationals or cash.  We have lots and lots of reasons to be almost fully invested in domestic stock and equities.  With that said, valuations are becoming less attractive as we have clearly moved to the upper end of the historic spectrum.  That means that our next significant moves will be defensive and our expectations for future returns from these levels are going to be muted.  When we get our next deep stock market correction, then our opportunities will expand again.  Net exposure is perhaps the most important dial any investor can touch and we only do so when we need to.

Trimming #2 – Selection

Once we decide how much exposure to have and which asset classes we’ll own, then we get selective.  This is the faster moving stuff.  Cash is always an option in this selection process and we measure relative strength of various sectors (financials, technology, healthcare), styles (Value or growth) and size (small caps, or large caps) on a rolling 30-day window.  Doing so leads us into the leadership groups on all fronts and out of those things that are lagging.  Believe it or not there is far more consistency here than you might think.  Healthcare, biotech and pharma have been leading sectors for almost two years and these have been among our holdings for as long.  Small caps have been out of favor for almost a full year but now they are surging again and possibly regaining leadership.  We are taking early positions in small caps now after avoiding them for most of 2014.  Energy has been in the dog house along with gold and silver for quite a while.  They are trying to find a bottom but it’s still too early to jump in yet.  You get the idea.  Now let’s say that the market puts in a top today and the Dow opens down 200 points tomorrow and then loses another 2-3% over the next couple weeks.  Cash, or money markets, would bubble to the top of our daily ranking in our selection system telling us to… buy cash (aka sell something).  You can guess where cash is in the ranking now I bet.  It’s right above energy, gold and silver

Trimming #3 – Position Sizing

Just like Thanksgiving dinner, we are always a bit conscious of our portion sizes – I hope.  I’m a sucker of stuffing and garlic mash potatoes so I give those a bigger position size on my plate.   When all things agree like the right sector in the right time of the business cycle and the right valuations with an attractive price pattern, we might find ourselves looking at this security or sector with a great deal of conviction.  Healthcare and Pharma are great examples on all fronts except valuations, which are quite high now after recent years of out-performance.  These sectors have the largest position sizes in our stock strategies.  Berkshire Hathaway is up 24% this year and is the largest position in the All Season strategy.  Some day BRKB will top out and start under-performing.  We will first cut the position size down and then ultimately replace it entirely.  I like position sizing as a tool to fine tune a strategy dialing into those things that have great odds of making money and dialing down those things that aren’t quite as appealing.  Putting it all on Garlic mashers might not be a great idea right?

And always have a safety net…

Beyond all three trimmings, we also put sell criteria on every position we own.  It might be a moving average or a last low in price.  It might be a certain spread to treasuries in the case of our income strategies or a momentum indicator for a fast moving speculative stock.  When the sell criteria are hit, if we don’t trim a position away first, then the position is sold to cash and we find something else to own.  The safety net is not at the portfolio level but assessed against each position every day.

Now, when we say we work hard at what we do, you get the idea.  We work constantly with all of our trimmings to ensure that our client’s are hitting reasonable performance objectives over time.  If we happen to beat the market over time, good for all of us.

Now I’m hungry – Have a safe and happy Thanksgiving surrounded by friends, family and smiling faces.

Cheers

Sam Jones

Don’t worry, I’m not going to get biblical on you with this update.  But, I do have several market and personal finance revelations to share that every investor should know at this stage of the cycle.

Benchmark Revelations

The financial services industry always seems obsessed with benchmarks.  Where would companies like Morningstar be without them right?  Three stars, five stars, whatever, all derived from comparisons to a benchmark of some sort.  I love it when I see an index benchmarked to the same index.  A perfect 10 every time!  The creators of LIBOR (London Inter Bank Offered Rate) benchmark are now in hot water as it seems they have been adjusting LIBOR rates to satisfy the needs of their banking products.  Why not make it easier to sell your loan product, which is tied to LIBOR rates, by changing LIBOR itself?  Wall Street has so much hatred for current bank regs because they are so restrictive.  My take – bank regs can never be too stringent – not from what I’ve seen in the last two decades.  Increased credit regulations do not restrict lending but rather bankers who do not want to lend money for 30 years at 3% interest rates.  Trust me, when rates move up to 5,6, 7 and 8%, you will magically see lending restrictions lifted again.

In a recent conversation, it was mentioned that “the market” is up 10% YTD.  What is “the market”?  Is it the S&P 500, which is up 10.5% YTD and 30% into all time new highs?  Is it the Dow Jones Industrial Average of 30 stocks which is up  6.4% YTD and out to new highs by 24%? Or maybe we should consider any number of the broader, global indices for comparison.  I have 343 indices in my universe.  The NYSE Composite index has not yet made a new high from the one set in July with roughly 2.3% to go.   The MSCI Global Stock index is up 2.85% including a heavy weighting in the US, and is still trading below the highs set in…. 2007!  So here’s the revelation regarding benchmarking.  US only stock indices like the S&P 500 and the Dow are cap-weighted indexes meaning a small company like Apple or GE can wildly skew the total performance of each.  But why should you or I care?  What happens in the world of benchmarking standards when applied without real knowledge is that we all tend to work harder and harder to beat something that isn’t reflective of total “market” conditions.  We are effectively driven to chase returns among only those things that are moving faster than the fastest benchmark leading us to own wildly overbought stuff that are experiencing nearly vertical price patterns.  Apple is the largest company in the world by market capitalization.  It is the biggest stock in the S&P 500.  If we want to beat the S&P 500, why not just own Apple? Is beating the benchmark the only objective?  For MOST of our industry, the answer is yes which is why everyone must own Apple, whether they really like it or not.

 

From a personal finance perspective, chasing performance or evaluating an investment manager using something like the S&P 500 as a benchmark is almost a recipe for failure by itself.  You will always find yourself buying a stock or fund that has already run higher or looking off a perfectly respectable performance stream just because it doesn’t beat the S&P 500 every week or every quarter.  At All Season Financial, we are conscious of what “the markets” are doing but really focused on meeting our self imposed strategy return and risk objectives.  These objectives are based on our analysis of what is possible in the way of generating the highest risk adjusted returns we can given strategy design, asset class risks and opportunities.  For instance, within a given risk profile, our tactical equity models (3) are shooting for average annual returns between 8-12% net of all fees in the current market.  Our blended asset strategies (3) are shooting for 6-10% average annual returns and our income models (2) are shooting for 4-6% average annual returns net of all fees.  We measure these objectives against real returns on a rolling 5-6 year window and we don’t really care about benchmarking beyond that frankly and our objectives have both return and risk criteria.  

Credit Market Revelations

Revelations, as the last book in the Bible’s New Testament, is really about a suggested apocalypse.  I am not suggesting anything of the sort for the credit markets.  However, I am not alone in my long range assumption that our global credit markets, specifically sovereign debt or government bonds from all countries, are in their final stages of very, very long bull markets.  Currency wars between countries have been with us now for nearly eight years, together with massive stimulus and quantitative easing measures by central bankers all having the effect of driving bond prices artifically up and interest rates down to nearly zero.  For most sovereign debt issues, I believe we saw a bottom in rates (top in prices) in July of 2012 with the most glaring example coming from Japanese Government bonds (JGBs).  In July of 2014, the US dollar index confirmed a meaningful and associated bottom as well and has been heading almost parabolicaly higher since.   Bill Gross sees the writing on the wall and left Pimco.   Now the table is set for a revelation of sorts in the credit market when the price of government bonds of the US and Europe begin to move lower meaningfully signaling a primary trend change.  For the crafty dynamic asset allocators like us, we might yawn and simply rotate more into dividend paying stocks, preferred securities or perhaps bond surrogates like gas, electric and water utilities – happening now.  Those in fixed blends of stocks and bonds like the many trillions trapped in 60/40 blends or things called “Balanced” funds will see their returns flat line year over year over year.  Those with all of their money in government bonds will not yawn, they will be very sad as they watch their wealth do what’s happening in Japanese bonds, losing -12% annually.

When our credit market revelation occurs or is recognized, stocks will not like it initially, and this will be the catalyst for our next bear market in stocks without a doubt. I will be surprised if we don’t see it happen by next summer.   But any decline in stock prices while interest rates are moving gradually and persistently higher will be one of the last great moments to buy equities at a discount.  Between now and then, we have our End Game (topic of many updates) to contend with and will be focused on capital preservation as always.

Tax Time Revelations

Yes it’s that time again and 2014 is going to be terrible for mutual fund capital gain distributions.  I have seen notices from several fund shops announcing 15, 20 and 25% distributions to shareholders this month and next.  Let me explain why this is terrible for you as a shareholder.  Distributions are not like dividends or other income.  Mutual fund distributions are simply taxable gains passed from the fund to you the shareholder and the share price is adjusted down appropriately on the same day.  THERE IS ZERO ADVANTAGE TO YOU AS AN INVESTOR.  You own the shares so you are required to pay the tax for the fund’s aggregate gains realized each year.  But suppose you bought the fund in January of this year and it’s up only 5% since purchase.  The fund is effectively handing you capital gain earned over the course of the entire bull market dating back to 2009 regardless of whether you owned it back then or not.  2014 is proving to be that year in which mutual fund managers took a lot of profits on long-term positions and are planning to “distribute” those long-term gains to current shareholders.  The personal finance tip is this.  Check your fund and see if you can find out how much they plan to distribute.  They are very sneaky these days because they don’t want everyone to sell out ahead of large distributions, which is exactly what you should do if the distribution is beyond 5-7% in our view.  Sell it and buy something else – something that is not a mutual fund.

Several years ago, in light of these types of things with mutual funds as well as the egregious abuse in terms of costs, redemption fees, adverse trading policies etc., we made the conscious decision to move away from all mutual funds except those that don’t pay distributions like index funds or select bond funds.  Instead, we employ exchange traded funds and individual stock issues which are clean, tradable and pay out real income and dividend streams.  Yes, we pay a little periodically in transaction costs ($7.95) but we save an enormous amount in avoiding things like tax distributions.

This is also the time to review your tax strategy in terms of itemized deductions, contributions to retirement plans or education accounts like 529 plans.  It is a time to consider charitable giving either as cash or appreciated stock.  We have the knowledge and the people to help but every situation is different.  Please feel free to call us but don’t wait until the last week of December.  We can help you if you give us time to do so.

*Reminder – This Wednesday is our H.I.P. investor Solution Series Webcast – 9:00 am.  The notice is posted on this Red Sky Report with link to log in info.  H.I.P. stands for High Income Producing as in those making more than $250k in annual income.  You won’t want to miss this webcast as you are now the IRS’s favorite punching bag.

Have a great week!

Sam Jones

Statistically and emotionally, the market action last week put to rest many investor fears, specifically those questioning whether the bull market in stocks was still alive.  Prices did not succumb to selling pressure after the enormous recovery in late October, but instead marched higher with broad support and enthusiasm.  Strangely, I found my inner contrarian flaring up again.  While I remain bullish and our portfolios are allocated as such in the short term, I am beginning to see the ingredients for our next major global financial dislocation taking shape.

Schwab Impact

The Schwab Impact conference was held in Denver this year and what a show!  It was apparently a grand event with the likes of Train, GW Bush, and Ben Bernanke there to entertain – in order of most to least entertaining.  I didn’t go but spent quite of bit of brain matter reviewing the highlights and reading through the various presentation notes from Keynote speakers.  A few things raised my eyebrows.

1.  EVERYONE expects the bull market in US stocks to continue for roughly another 12 months (until after the 2nd rate hike by the Fed) but with higher levels of weekly and monthly volatility.   The market rarely (read never) does was EVERYONE expects.  Note to self – be ready for anything at any time.

2.  Ben Bernanke admitted that the Fed was operating in a “Fog of War” during the financial meltdown of 2008.  He said they had to improvise and work creatively to come up with solutions to massive forces.  He was pleased with the results of their grand experiment.  Note to self – Is the experiment over?  Sounds like a “mission accomplished” speech I heard once.

1. 3.  Global headwinds to real and sustained growth are still with us.  They are first resource scarcity, especially arable land and food.  Second, poor demographics (like our own aging baby boomer population) in developed countries effectively creating a drag on our share of global GDP. Third, wealth inequality and massive poverty in emerging countries is not a solid foundation.  Forth, political systems with high turnover election cycles (like the US) force our leadership to only think and act on short term issues with high popular appeal rather than finding solutions to long term problems.  Finally, technology and robotics are still replacing wage earning jobs (although creating some as well) on a massive scale.  Note to self – These are big problems not easily solved.  Bear markets are not gone, nor will they be easy to tolerate. 
2.  

The rest of the topics were really industry related and I’m guessing not of interest to our readers.

Good for Now But Problems Developing

The problems that I’m seeing develop are thankfully slow moving ones.  In the short term, I find little in the way of fundamental or technical evidence to warrant anything other than a fully invested position.  It will be important for certain sectors like energy, metals and materials to continue rebounding from recent lows.  Last week was all good with technology, industrials and financials receiving some of the love from the runaway advances in healthcare, utilities and consumer staples.  In fact, if this relative strength rotation continues, we may need to reallocate back toward the growth side of the market next week after sitting in the defense camp for several months now.  Even our bellwether names like GE (GE), Walmart (WMT) and Boeing (BA) are forming breakout patterns after trading flat to down all year.   On top of that, we are now right at the beginning of the best six months of the year in terms of productive gains and right on the front edge of the best three quarters of the entire four year presidential cycle.  In a nutshell, conditions are right for rather robust move higher if the market wants it.

Looking out further into 2015, I see potential ingredients for the next bear market developing.  Of course, there are the widely announced prognostications of global credit market failures on the back of overly supportive stimulus measures by central banks.  Europe is a disaster and Japan is in worse shape than I thought with central bankers on high alert.  High yield bonds will let us know when these credit market risks move to the front burner.  But on top of that, there is some weakness in the economic numbers coming through the pipeline now.  Car sales, specifically in trucks, are now down year over year for the first time since the lows in 2009.  Employment numbers are healthy in absolute numbers but this month was a bit of a disappointment comparatively.  Wage pressure is also on the rise for the first time in several years (hinting at inflation to come) as are hours worked.  Housing continues to lag what we would expect for this stage of the cycle and we haven’t even seen borrowing rates move up meaningfully yet.  Technically, pricing structures are healthy but we’re obviously seeing an increase in weekly and monthly volatility.  As the market rises so too does sentiment and available cash is deployed.  Once everyone is in, who will buy?  I expect more looking forward as I mentioned at our annual meeting last month.  On the earnings front, the numbers have been good this quarter but stocks somehow seem vulnerable to anything that could be interpreted as a negative.  Financial engineering is clearly happening now to keep those earnings coming on strong but Wall Street has a good nose and seems to be punishing those that stink.   All in all, I see some deterioration in fundamentals, in real earnings, and in technical conditions albeit from very high and very favorable levels.  These are not show stopping events but slow moving changes that occur over months and quarters as we approach a more significant cyclical peak.

When fear of the future creeps in, I fall back on our risk management system, knowing that it will sniff out weakness as it happens, tripping sell signals and moving us out of harms way hopefully early in the cycle.   The recent correction in October nearly pushed us over that line in a jerky and painful affair, but prices reversed just before we had to do much of anything.  It may have been a warning of sorts but clearly buyers are still waiting with cash in hand to pounce on any discounts. At some point, our current “buy the dip” mentality will give way and the markets will begin to reflect less favorable conditions.    We’ll be ready to act when the time comes.  In the meantime, we are glad to be breaking out of the summer slump and hope to add some real numbers before year end.

Sunny and 60 in Colorado this past weekend – Winter?

Cheers

Sam Jones

The current bull market, now in its 6^th year of existence, has been called the least respected of all bulls.  Investors simply refuse to give it due credit, nor invest much of their hoards of cash paying nearly zero.  Behind all the disrespect, there has been that underlying assumption of guilt that all the gains are just smoke and mirrors, created and maintained by the grand Fed experiment in Quantitative Easing, and ultimately doomed to fail spectacularly.  At this point, there has to be some reasonable doubt creeping into the minds of the minds of the prosecutors.  This market is not guilty.

Heading to Euphoric?

I presented this slide at our annual meeting last month, making a case that the current level of skepticism reigning over the financial markets was not a condition that we often see at major market peaks.  More often the end comes once everyone believes that we are in a new era of prosperity (“This time is different”).  It ends when cash is invested fully and expectations for future gains are the only expectations.  Sir John Templeton was quite right.  Consequently, I made my case that given the very “neutral” view (47%) of the stock market in recent surveys, we are not yet to the end of this this bull market and won’t be until we see some sense of euphoria or “very positive”  survey results.

Market Response to the End of QE

You’ve certainly read by now that the market was in no way surprised or affected by the Federal Reserve’s announcement regarding ending their bond buying program at their last meeting.   Quite the contrary.  Stocks pushed out to all time new highs.  The prosecutors claimed that it was all because of the Fed via an increasing Federal balance sheet running closely in sync with the rise in equity prices.  I’ll offer this very excellent set of charts from Bespoke in defense of the market. Yes prices have risen with the money supply (Fed Balance Sheet) but also in sync with Consumer confidence, the labor market and Consumer Spending just like every bull market in history.  Thank you to www.bespoke.com

Gold, The Ultimate Store of Wealth?

The prosecution’s theme suggesting it’s all because the Fed has also led many astray in the form of investments in precious metals like gold and silver.  The noise here was deafening in 2011 after several years of 20% annualized gains in the shiny stuff.  The logic was as follows;  Gold and silver can’t lose as the Federal Reserve is purposely printing money and devaluing the US dollar to artificially prop up the US economy and the financial markets.  Scandalous!  In early 2012, we made several broad and loud announcements to sell Gold and Silver as it appeared the US dollar was seeking a bottom.  Beyond a few failed trades lasting not more than a week or two, we have not touched gold or silver since.    As of late 2011, Gold has now lost more than -38% while the S&P 500 has gained nearly 80%.   This is the ugliest chart out there.  The gold miner’s index (GDX) is shown in Red, the S&P 500 index in Green.  Notice the very painful break of support for GDX in the last couple weeks in the lower right corner.

Finally, now I am seeing some capitulation selling so I would be surprised to see another short term low developing soon, but this is not likely an opportunity to buy gold and silver or mining stocks as the US dollar has just started moving higher.  Macro trends associated with currencies are long affairs.  As I’ve said before, more money has been lost by investments in gold and silver than any other “thing” (I won’t call it an asset class).

Closing Arguments

The bull market in stocks is still alive and fueled on solid fundamental evidence.  True, valuations are not cheap anymore and clearly at some point in the future, perhaps the not so distant future, stocks will put in a longer term peak.  They will do so in reference to hard evidence that the US economy is beginning to decelerate not because the Federal Reserve has become an enemy.  Those who have proclaimed this bull market as guilty and failed to embrace the trends as they are, have failed to participate in one of the greatest opportunities to create investment wealth in our country’s history.  Sadly, I fear that some portion of the prosecution might be ready to jump sides to the defense as they join the “Euphoric” just in time for the real market peak to emerge.  This can be an ugly business especially for those who cannot accept conditions that fly in the face of their convictions (political, religious, etc).  Ego has no place in the investing world.

The defense rests

Have a great week

Sam Jones

Well I can’t say that last week’s rebound rally was a surprise after all the positive technical set ups we saw on 10/15 (listed last week).  What did surprise me was both the strength and magnitude of the move pushing right into the close on Friday.  Bulls are still very much in charge of this market but the corrective work still isn’t quite finished on a more intermediate term basis.  The market is also speaking loudly about the future of the economy, which is at odds with current reports.  Something’s up – pay attention.

Correction Not Likely Complete

First let me tell you the good news.  Last week, the S&P 500 was able to retake the breakdown point at roughly 1905 on the index after tagging the 200-day moving average with perfect precision.  If the index can hold above that level on any pullback, the odds are good that we’ll retest (or exceed) the all time highs before year end.  There was also a brief attempt by the Dow Transportation index to make an all time new high but that was snuffed in the final hour on Friday.  Maybe today – looks likely.  Transports are no doubt benefitting from lower oil which is still trading under $80/ barrel to the chagrin of Putin and his tribe of Petro-dictators.  Meanwhile utilities are and have been breaking out to all time new highs and have gone parabolic.  The Dow theory guys have to be looking at Transports and Utils and begin to expect an eventual all time new high for the Dow itself.  Rarely do these three horseman diverge for long.  Healthcare, select pharma and biotech and consumer staples are also at all time new highs.

Now if one looks at the character of the above mentioned sector strength, we see the financial markets still deeply committed to a traditional recession trade where defensive sectors rule.  Growth sectors like small caps, energy, internet, tech, banking and financials to a degree have not been getting the type of buying enthusiasm we might hope for.  These groups are thankfully participating but not leading.  Now here’s why this is important from an overall market trend perspective.  Due to the sector weightings in the S&P 500, we simply cannot, have not, nor will see, a sustainable market rally without heavy participation and leadership coming from technology, financials, healthcare, consumer discretionary and industrials which combined account for 70% of the S&P 500 (see below).  Energy is also significant at 10% but has also been a drag on the markets.  Along those lines, I think it’s also important that small caps lead the market higher from a sentiment perspective and indicative of an environment where traders are accepting of some risk.  Small caps have been underperforming the broad US stock market since early April.   Right now, I see a market that has bounced impressively as a whole but unfortunately lead by the wrong groups.  I’m going with the premise that our correction, which really began in early July (with a failed attempt at a new high in Sept) has some more work to do.  That means, we should be preparing for the next down leg in the markets and we’ll want to be very watchful of relative strength during that decline.  If the “right” groups hold up well and see new enthusiasm among buyers, I think we could have an explosive finish to the year.  As I write, I’m watching some of this happen today with the S&P 500 marginally down and tech, financial and healthcare sectors are trading slightly up. Conversely, if the “right” groups lead lower and sell off aggressively, it would be safe to say the high is in for the year and probably into early 2015.

www.Bepoke.com 10/26

Economy and Market Arguing

As is often the case, the financial markets regularly move ahead of the economy by 6-9 months.  I chuckle when I hear people say things like “the stock market caused the real estate crash”.  No, that’s simply poor understanding.  The US stock market peaked in mid 2007, real estate and the economy completely fell apart in early 2008.  The stock market caused nothing but simply reflected investors’ underlying fears and concerns about the real trends in overbought real estate and the rate of deceleration in the economy.  Perception of the strength and weakness in the economy drives prices higher or lower, not the reverse.  Today, we have a similar set up where the market is speaking loudly about the future likelihood of a US recession as mentioned above.  Meanwhile practically every economic report continues to chug higher including employment (jobless claims at a new 14 year low!), consumer confidence, leading indicators at all time highs, general business conditions (still positive and favorable) and yes even earnings thus far (65% beating expectations).  We haven’t yet even started to decelerate economically according to last month’s reports.

Still, technical guys would be very wise to watch some of the predictive macro indicators for additional signs of economic strain.  Specifically, the spread between the 10 year and 20 year Treasury bond rates is now only 48 basis points – very tight.  Yield curve folks know that when the 10 year bond rate moves above the 20 year rate, we have an inverted yield curve and that condition can often lead to recessionary conditions in a short period of time.  For that to happen we would need to see a complete collapse in the price of the 10 year bond and I don’t see that as likely.  So who has it right?  The market or the economy?  We’ll see but the most notable condition is the wide disagreement between the two.  Conditions are changing, perceptions are changing but are real conditions changing that much?  Could this be about politics going into mid term elections?  Could this be a yield grab as investors chase income from consumer staples and utilities?  Or might we actually be within 6-9 months of a recession?  We all hate surprises so let’s pay close attention to this argument.

Netflix, Amazon and Yelp Ouch!

I find it interesting that some of our big name technology companies are getting hammered this earning’s season.  They did post some tough earning’s numbers and the market is letting them know that’s not ok (-20%).  But the interesting part is that we may be witnessing more of a long term top in the innovation cycle.  Amazon has a growing number of on-line retail mega portals to contend with like Alibaba.  Netflix is competing with Amazon in terms of distribution of movies and now has to pay much more for fresh content than when they first captured our hearts and eyeballs.  Google, Amazon, Apple, Samsung are all delivering more and more hardware and mobile devices while god knows we’ve all got enough of that junk in our homes now.  Cloud computing, streaming media, search, on-line retail, mobile communications are all going to be part of our permanent household and business budgets for the foreseeable future but the supply side space is getting a little crowded now.  There is plenty of growth opportunity overseas in developing countries for all this stuff but here in the US, we’re more than saturated.  Furthermore, I’m just not seeing the type of earth shaking change since we saw the first Ipad come out or when Netflix put Blockbuster out of business.  The whole space feels like it needs to grow, wants to grow, but can’t as so many mega companies worldwide have crowded in.  In a nutshell, it feels like we are approaching the top of the S-curve for consumer facing technology and perhaps investors will not LOVE the future growth rates.  Still, we need these companies and have no plans to stop using their products and services.  Back end companies that make it all happen in terms of telecom and data networks, cloud storage, software as a service, fiber, routers and switches, cable and satellite, even hardware components might be good bets for continued growth in technology.  We’ll be watching these developments in the coming months.

That’s it for this week – first snow in the Steamboat valley last night.

Cheers

Sam Jones

Yes, they are already coming up with cute names for the latest round of panic in the financial markets – last Wednesday.  I think Watershed Wednesday is going to be an accurate title for its notable extremes in both bond and equity markets worldwide.  Will it prove to be the bottom?

Liquidity/ Short Squeeze Issues

For those in the trenches last Wednesday, it looked very much like we were going to see and experience another mini crash in the markets.  I’ve been through several and it had all the makings.  But as is often the case during bull markets, those extreme moments (at 13:00 hours EST), we saw a reversal and stocks rebounded smartly into the close.  Small caps even finished up 1% on the day!  It’s enough to really shake your tree, to the roots.  I spent the weekend in isolation from all news because I needed to get a grip.  We have known that the financial markets have been operating on a high level of margin debt and leverage since late 2012.  We have spoken about the heightened risks under these circumstances when the leveraged money tries to get unleveraged by selling anything they can – typically US equities and bonds just to cover themselves.  That’s exactly what happened on Wednesday and may very well prove to have been a watershed moment in modern history marking exhaustion and capitulation among the managed money crowd.  Did mom and pop sell?  Not so much sadly.  In fact bullish sentiment among the American Association of Individual Investors (AAII) actually went up on the week from 39 to 42%.  Of course, this makes me nervous now.    For this round of selling, it looks to have been much more on the “professional” side judging from the sentiment numbers and trade sizes.  Big money wanted OUT after taking a massive beating in energy, small caps, and all the other holdings that were already down 20,30 and 40% this year off their highs.  Make no mistake; the carnage in the global financial markets has been far worse than indicated by the S&P 500 or the Dow.  Here’s a snapshot of Bespoke’s sector breakdown showing percent losses from recent 52-week highs.

How is the S&P 500 only down 8% from its 52 week high?  A small company called Apple.  Beware that in a different market, we might see just the opposite as Apple anchors the S&P 500 while specific sectors widely outperform.  I almost expect that event sometime soon.  Today, John Bogle wins.

Pouring gas in the fire, we also saw additional liquidity issues in the bond markets, especially high yield corporate bonds and the CDS (Credit Default Swaps) markets.  Meanwhile, the 10 year Treasury bond yield fell to its lowest level in a couple of years in a dramatic move that forced short sellers out of their positions.  Wow!  What a day when both short sellers (of Treasury bonds) and leveraged investors (of stocks) both got the squeeze of their lives.  I have no doubt that next month you will hear about multiple hedge funds that are now out of business and returning what’s left of their investor’s capital.  Is it all over?

Was Last Week the Low?

You know me better than that.  Of course I’ll dodge that question but I’ll offer a few items to chew on.  If we focus less on noise and more on facts that will help us find answers, we see the following:

1. The markets are extremely oversold and due for a bounce of some sort = Good!

2. Small caps are rebounding along with several of the other most beaten down sectors like energy and materials = Good!

3. Bonds are seeing selling pressure and the US dollar is now headed lower = Good!

4. News headlines (Ebola, Russia, and ISIL) are terrible.  Potential relief rallies to follow? = Good!

5. Interest rates, cost of capital, analysts expectations and now stocks are all low, LOW and LOW going into earnings season  = Good!

6. Cash on the sidelines, Merger activity and buybacks are all high = Good!

7. Seasonality gets very positive in 11 days = Good!

8. No economic reports are even close to recessionary  = Good! (for stocks)

9. Consumer Sentiment just hit the highest level since July of 2007= Good!

10. Economic reports last week were still positively positioned but showing signs of some tiredness (1 month drop in general business conditions was ugly)  = Worrisome but not BAD yet.

11. Slow downs in Europe, China and South America are dragging down the US economy/ markets, messing with currency markets and this is all happening as we’re wobbling around on our new bike without training wheels (see illustration from our annual meeting below) = Bad!

So all things considered, this deep and scary correction in the global financial markets looks highly technical and less about the current conditions of company fundamentals or the US economy.  However, as we can see with little Sammy above, we’re not done with the pain of our Transition Year yet.  The market is going to fall down a few times (more) before getting the hang of life without the Fed (training wheels).  The crazies in the world want us all to believe that there is no life without massive infusions from the Federal Reserve.  Bunk!  QE and every act of the sort has been a unique experiment by the Federal Reserve only seen in the last five years.  We have seen massive bull markets and robust economic growth without Federal Stimulus in the past (50’s and early 60’s, 80’s and 90’s).

Best guess in the short term, it would seem likely that prices will rebound smartly from this level, but fail to make a new high.  Sellers will want out again at a higher level and then we could see more chop lower into the first half of 2015 when the Fed finally does raise short term interest rates.  I do not see the ingredients in place for a massive and devastating bear market at this point.  I see a continuation of this corrective cycle giving opportunistic investors several chances to buy stocks at deep discounts.  This should be the first.

Shifting Into Trading Mode

As I discussed at the annual meeting on October 9^th, when the markets break trend to the downside and trade below the 200 day moving average, we change our tactical approach a bid.  Specifically, our focus orients more toward technical analysis of the markets, watching oversold, and overbought indicators and move more into a trading mode.  Last week we bought several market indices including small caps and other “rentals” for a hopeful rebound ride back up.  I don’t expect to be in these positions for more than two or three weeks.  On the sell side, we are planning to jettison some of our weaker holdings and get as defensive as market conditions dictate – again on a rebound.  At the next cycle bottom perhaps in early 2015, we might do it again.  Trading and paying attention to market internal indicators is going to be our MO until price moves and hold sustainably above the longer term trend lines and moving averages.

Remain calm, turn off the TV and know that you’re in good hands.

Have a great week!

Sam Jones

The purpose of this quarterly update is to help guide our current and prospective clients regarding the design, purpose and results of our various investment strategies. We strive to offer complete transparency throughout our business in hopes that our clients will be empowered by knowledge to participate in the strategic allocation of their investment portfolio. Please enjoy my personal insights below.

NEW* – Explicit Investing Creed of ASFA:

 

We are seeking Success over a reasonable Judgment Period by knowing when to embrace and reject conventional wisdom regarding perceived market trends, Risk and opportunities. Superior, above average, results over time are only achievable through unconventional decision-making, conviction, and discipline.

 

Risk (defn.)– The probability of unrecoverable or semi-permanent loss of capital, not to be confused with variable degrees of periodic volatility.

 

Success (defn.) – Generating asymmetrical results across all investment strategies: to expose ourselves to return in a way that doesn’t expose us commensurately to risk, and to participate in gains when the market rises to a greater extent than we participate in losses when it falls.

 

Judgment Period (defn.) – A period of time that captures a full investing cycle including both bull and bear markets – typically any rolling 5-6 year period.

Our Strategies

Just below the title of each strategy, there is a link to the details page on our website in PDF format which offers a new and absurdly analytical view of each strategy; including risk metrics, risk/ return charts, beta and correlation measures and all the stuff that techy people love.  Complete performance history of each strategy as well as relevant benchmarks can be found by following the link provided “Details”.   Each of our clients will have a different experience with us depending on one’s particular mix of strategies chosen and the amount of money invested in each.  Very soon, we will be launching our web based investor profile tool to help guide our client’s in allocating among our strategies from each of our three categories (Tactical Equity, Blended Asset and Income).  Ultimately, we hope to create an appropriate mix that satisfies our client’s appetite for returns and tolerance of portfolio volatility

Strategy insights are presented within their respective categories of investment;  Tactical Equity, Blended Asset and Income.  All results are shown as 2014 year to date returns ending September 30, 2014, net of all fees.

Tactical Equity Strategies

High Dividend     3.73%  YTD

High Dividend Strategy Details

 

High Dividend has made very few changes to internal holdings all year, remaining almost fully invested through the up and down cycles of 2014.  Given the increase in selling pressure in September and now carrying into October, manager Sean Powers has his upgrade list in front of him and is waiting to strategically replace some weaker holdings with those that are positioned to benefit from the new investing environment (rising US dollar, tighter financial conditions, less support from the Fed).  Typically, during bull market cycles, High Dividend focuses more on company fundamentals and valuations above short-term price trends.  One of the main challenges of any dividend strategy is to remain largely invested and purposely carry little in the way of cash as dividends can only b paid on shares of company stock.  Of course, money markets are paying nothing so we have an inherent interest in owning lots of shares for as long as possible to generate real dividend income.  The trick from a risk management perspective is to own the right stocks and the right mix of stocks seeking a portfolio of non-correlated holdings whenever possible.  Sean has done an admirable job sticking to his discipline through a tough market this year.  Periodic gains (and recent losses) are of the type I would expect in this market; not better, nor worse.  Like our other tactical equity strategies, we are not expecting much in the way of strong performance for calendar year 2014 as global stock markets take a rest and let earnings catch up to the incredible price gains made in 2013.  If conditions continue to deteriorate and a real bear market becomes more likely, High Dividend will take meaningful steps to cut total exposure and orient toward more defensive holdings to stay consistent with our “Explicit Investing Creed” (LINK).  For now, we grind our teeth, take a few antacids and give this bull market the benefit of the doubt.  2014 is not going to be a big year for any stock model as we’ve discussed at length.  But, a nice pause that refreshes could set us up nicely for a more sustainable move higher in 2015 and beyond.

Still relevant comments from the beginning of the year (2014) –

“A smart dividend paying stock strategy is one of the most attractive ways to make consistently strong returns with a lower embedded risk profile.   Logically, it’s hard to beat the combination of dividend income plus capital appreciation as an investment choice for investors who value a relatively conservative stock model.  Furthermore, from a cyclical perspective, companies with growing dividends inherently have several characteristics that investors find very attractive now.  Specifically, these companies tend to have higher free cash flow and lower debt to equity, making them less subject to the risk of higher interest rates (higher borrowing costs).  Second, dividend growing companies are often engaging in share buy back programs which has the effect of reducing the total number of shares outstanding, thereby supporting the current stock price.  Effectively share buy backs give companies more control over their own finances.  Finally, companies that offer dividends are now competing for bond money that is looking for a new home.  A portfolio of stocks paying 3.5% in dividend income is paying more than the 10-year Treasury bond interest rate!  Three great reasons to fundamentally invest in High Dividend.”  This strategy is and will continue to be a winner.

 

Worldwide Sectors     3.02% YTD

 Worldwide Sectors Strategy Details

 

For those paying attention to these insights, you might recall our attempt to rebuild a position in emerging market funds within the Worldwide Sectors strategy last quarter.  Unfortunately, by the end of the same quarter four of our five international positions were already stopped out leaving us with only a small position in India (EPI).  These are called whipsaw trades and I hate them as much as anyone.  No one expected the US dollar to rise nearly 7% in one month creating all sorts of carnage among internationals, raw materials, energy and commodity groups.  We will be back into emerging market funds in 2015, I’m quite sure.  The fundamental and value oriented environment for re-investment in developing countries is already ripe, but technical price trends always dictate our holdings and right now, the tide is still going out.  Our cash position in Worldwide Sectors actually pushed up to nearly 20% in the process.  Beyond an oversized cash position, we still have a nice blend of growth and value oriented stocks and stock ETFs in the strategy that should (knock, knock) hold the strategy together while the broad US market completes this correction.  Those invested in Worldwide Sectors need to understand that this program is one of the most volatile and exposed strategies.  In rising markets, volatility is very much your friend.  In falling markets, you can expect to see some periodic losses.  Over time, Worldwide Sectors is the strategy that will produce results most consistent with any of the broad US stock market indices although with greater downside risk controls and generally higher dividend interest income.

Worldwide Sectors is also a member of our STAMP team.  STAMP is an acronym for Strategic Tax Advantaged Management Portfolios.  Tax efficiency is found by way of generating long term capital gains whenever possible, taxed at lower rates (20%) than income (35%+). For high-income earners in higher marginal tax brackets, long-term capital gains taxes are still a distinct rate advantage.

 

New Power     -1.83%   YTD

New Power Strategy Details

My comment from the 2nd Quarter, 2014, is still very relevant, “New Power could easily see a bit of a consolidation year following the 60% gains of 2013.  No surprise right now so, please set your expectations accordingly.  I have no crystal ball but big years are not typically followed by more big years.”

New Power has slipped into marginally negative territory YTD as of the end of September.  Like several of our other strategies, many of the positions in New Power were stopped out in August and September leaving us with almost 50% cash and only ten positions left in the portfolio.  Strangely, only two of them are in the energy sector, which might sound odd for a strategy called New POWER.  In early 2013, the scope of the investment options was expanded to include opportunities in non-energy industries.  These additional holdings fall into one of three camps; Innovators, Facilitators and Integrators.  All of which are game changers in their space.  Since the entire energy complex entered a bear market (down 20%+) in the middle of September, I am suddenly quite thankful for the flexibility to go elsewhere.  Clean energy and clean technologies are still going to be a large part of New Power, just not at the moment.  Those willing to be patient will see handsome returns but they will come in short bursts.  Our next series of actions will be buys and we’re already making a short list.  For any interested in New Power, conditions are becoming more attractive for new investors in this strategy.  No rush, but I think we’re getting close.

Blended Asset Strategies

All Season      3.12% YTD

All Season Strategy Details

Wow, what a difference one quarter can make.  The 3^rd quarter was brutal for all asset allocation models.  On July 1^st, the financial world turned upside down forcing us to make more changes in All Season than we anticipated.  Europe turned back toward recession with Germany leading lower and the Euro fell apart driving the US dollar higher.  All internationals and any company generating revenue outside of the US (nearly 60% of the S&P 500 companies) saw real selling pressure.  Commodities of all sorts fell off a cliff and the energy complex entered a bear market.  Our remaining income positions that weren’t sold back in July fared well and we still own them.  Most of our “alternative” positions were sold as several hit stops and our equity positions had to be upgraded almost across the board to accommodate new leadership.  Ugly, tiresome and thus far we have little to show beyond knowing that we are now better aligned with market trends.  This is the nature of investing and this is the work we must all endure.  Returns come with correct market alignment, especially those that are earned without experiencing intolerable declines.  Sometimes we can just sit back and collect our returns, other times we work hard just for the right to collect in the future.  This is one of those times.

As one of our most flexible investment strategies, I have no doubt that All Season will generate respectable results as it has done since inception in 1998!  The strategy never has and never will surprise you will huge gains or huge losses.  It will however, produce stable and consistent returns over time and keep your money in the right market, the right sectors, and the right asset classes as conditions change.

 

Foundations   3.13% YTD

Foundations Strategy Details

Foundations has also been sitting with an abnormally high cash position (25%) following the sale of most bond holdings in mid July.  As a more traditional asset allocation model, we tend to remain invested across multiple asset classes but the current market situation calls for a little more dynamic approach.  Following the same protocol as All Season, our Foundations model has also had to make several trades in the last quarter to better align the portfolio with current trends in leadership including sector rotations as well as repatriating some of our international exposure.  Exposure to stocks has remained largely the same through the process and that has hurt returns a bit.  Nevertheless, if this bull market in stocks is still alive, we’ll be positioned well and make it back quickly.  If a new bear market is upon us, we’ll have to play some stronger defense in the coming months.

Foundations is our lowest cost strategy designed for investors with smaller accounts (<$100k). It offers a more dynamic approach than your traditional buy and hold strategy, which is miraculously still prevalent in our industry.  I do wonder what will happen when investors begin to see their “balanced” fund chain itself to a 3-4% annual return as their oversized bond allocations begin to lose money year over year.  I can already see the headlines, “Is it time to get out of your Balanced Fund?”  Foundations is a great alternative, keep it in mind.

Gain Keeper (previously known as Annuity Sectors)   3.27%

Gain Keeper Strategy Details

Gain Keeper followed its Blended Asset category peers in rotating into more defensive sectors and specifically those not exposed to the negative impacts of a rising US dollar.  Predominantly, that meant selling out of international and energy positions this quarter and replacing with Utilities, consumer staples and a small position in banking.  Bond allocations, like our other strategies are still snugly sitting in cash.  We are shifting our prescribed allocations a bit toward stocks and willing to carry as much as 75% in stocks under the right conditions. On the other side of this correction, perhaps closer to the time the Federal Reserve finally raising short term interest rates (April?), we’ll have a strong arm ready to swing the bat at cheap stock prices.   Gains in 2014 are going to be muted as we have discussed at length in all communications (See – “Transition Year” discussions on the Red Sky Report).

As a reminder regarding this Variable annuity, I want to keep the facts of this program out in the open for all to digest to help understand the circumstances under which an investor might find a variable annuity appealing.  We find the annuity attractive for our clients who have recently divorced, inherited money, sold a business or have larger taxable accounts simply by circumstance, especially with the new higher income tax rates!  Variable annuities are one the very few ways to shelter a great deal of after-tax money from future capital gains and income taxes without being subject to contribution limits, (like an IRA or qualified retirement plan).  Growth of investment assets in tax deferred accounts is hard to beat relative to taxable investment as investors only pay tax on withdrawals when they happen after years of tax deferred accumulation. Jefferson Annuity charges a very low $20/ month for virtually unlimited tax deferral of investments.  The rules regarding penalties for early withdrawals before age 59.5 are the same as an IRA (10% + Income tax), but there aren’t any annual contribution limits.

Gain Keeper is a member of our STAMP team of strategies.

Income Strategies

Retirement Income             2.99% YTD

Retirement Income Strategy Details

The main investing tools behind Retirement Income are High Yield corporate bonds and as of the end of Q3, we don’t own any.  We sold nearly all in mid July following our sell discipline and now sit with only a few preferred securities, a diversified income fund and a pile of cash.  Thus far, any attempt by high yield corporate bonds to push higher has been met with significant selling pressure taking prices back to new lows.  However, in recent weeks, especially in October, we have seen corporate bond yields move dramatically higher, while comparative 10 year Treasury bond yields fell to new lows (2.0%).

Our discipline closely watches this comparative “spread” and it’s starting to look very attractive again!  I’m expecting to re-engage with High Yield corporate bonds soon if the price trends give us confirmation.  Other “equity income” type securities are available outside of corporate bonds for potential inclusion in Retirement Income but most have far too much daily and weekly volatility now to be considered.  Treasury bonds are still unattractive. Cash is earning zero and we don’t relish the idea of offering you nothing in the way of returns.  Know that we are committed to making money but also know that we will do so only when the time is right.

Retirement Income is designed for retirement accounts as the name implies.

Freeway High Income     4.17% YTD

Freeway High Income Strategy Details

Freeway High Income was one of the bright spots in the 3rd quarter, producing positive results and rising fast in the face of the stock market drama.  Like Retirement Income, Freeway has not yet reengaged with our corporate bond investments.  However, the strategy has been able to hold onto its overweight position in high yield municipal bonds earning ~5% Federal Tax fee interest plus another 11% in annualized price appreciation.  Of course, that’s an unsustainable return for municipal bonds and I have little doubt we’ll be taking profits soon in this asset class.  But for now, we’re enjoying the ride.  As mentioned in several communication pieces as well as our annual meeting presentation last week, we expect our Income model returns to taper a bit from a long-standing 7-8% down to roughly 5% as an average annual.  This condition should last for another year or two while interest rates reset higher.  At this point, 5% is starting to look pretty good!

The strategy is designed to produce results that are materially very close to our long-standing Retirement Income approach but after tax returns should be more attractive especially for those in higher income tax brackets with higher marginal tax rates.  Freeway High Income is a member of our STAMP team.

That’s it for this quarterly “Change of Seasons” newsletter.  These are our insights and self-critical observations of our own work for your benefit and understanding.  We hope you find this helpful.  Thank you for your confidence in our management service, we appreciate your business  – always.

Sincerely,

Sam Jones
President
All Season Financial Advisors, Inc.

Yes last week was ugly and yes everyone has the same question – Is the Bull Market Over?  While our heart rate quickens and we become more prone to emotionally devastating trading behavior, let’s review some best “risk management” practices.  Hint – I’m not going to answer the question the way you want me to.

 

Should I Sell Everything?

 

We talked about this specifically at our annual meeting last week as a pre-emptive question posed on our “What’s on your mind” section.  Should I sell everything?  Is now the time to “cash out”?  Let’s digest this and use it as a learning tool at the same time.   First of all, the notion of selling EVERYTHING or CASHING OUT,  is really a gambler’s mentality and even a gambling term – cash out your chips right?  We are investors not gamblers – we own companies, sectors, industries and selectively countries that are growing, generating revenue and offer us the promise of capital gains, income and or dividends such that our hard earned capital will do something more than sit in a bank earning zero.  This prospect for wealth accumulation does not end at any time other than when we might need our investment capital or at the point of our deaths.  I don’t like cat food anymore than you do but I also know that failing to invest our savings and retirement funds will not get us where we need to be in terms of our net worth post retirement and that’s assuming you are very diligent about saving.  Back to the point.  Gamblers are in it for entertainment by and large.  They want a quick buck, a big win, some free drinks and a little adrenaline rush.  This mentality cannot find its way into your real money and your investments.  It leads only to sadness and serial mistakes based on greed and fear.    I am the worst gambler in the world and not someone you would want to invite to Vegas because I’ll just bitch all day about the low probabilities of success.

 

Second, when we ask the question of whether “the market” is putting in a top, we’re really announcing our sole focus on market indices and ignoring the fact there is a world of options outside of index investing.  Personally, I am not smart enough to know what “the market” is going to do in the long term and thus I don’t like putting myself in a position to guess at what the market (or my market index funds) might do today or tomorrow or in 5 years.  If you think about it, indexers have an extra burden of making that decision.  They assume that they will know when to get out and when to buy.  Market timing is tough, trust me I’ve been at this for 20 years.  The evidence shows that the vast majority of buys and sells among indexed securities are done quite literally at the most inopportune times possible.  Indexers repeatedly buy high, hold their positions through all sorts of carnage and then sell at the lows (within a day or two) when they can’t stand to lose anymore.  The evidence is just too damning to suggest anyone has the internal discipline to do it well on a repeat basis. Meanwhile, we are all told by the industry that A.  You can’t beat the market indices and B.  All you have to do is buy and hold for the long term.  Point A. may be true but I’ve never met an investor capable of executing point B.

 

So what is our best bet to manage risk in our portfolios without subjecting ourselves to the Sell All decision crowd?  We have lots of options and systems and this is what we do.  One option is to upgrade your positions to things that don’t have as much daily volatility.  Three weeks ago, we sold all of our Internet funds (Green line) and bought Consumer Staples funds (Red Line) on the same day (9/29).  See below

 

 

Since that day, the sold internet funds dropped almost -7% through last Friday while the Consumer Staples funds lost -0.54%.  We are still invested but simply jumped over to a less volatile sector to play a little defense.

 

Another option is to set stops and just sell positions as they break those stops.  Probably the most simply among technical guys like us is the use of the moving average  – shown in purple below.  Moving averages work very well for bond type positions or slow moving securities that tend to trend well in their price action.  The Red line in this chart is the High Yield Corporate bond ETF (HYG) which we sold in mid July (white line).

 

 

High yield corporate bonds rolled over this summer and as one of our major food groups in our Retirement Income strategy we were “stopped out” of many positions.  Since the end of July we have been nearly 80% in cash in this strategy.  We took profits at a great time when the question of Selling All wasn’t even on the table.  Now we’re looking for new buys and have some nice profits booked and safely sitting in cash.  The trick with stops is knowing where to put them for various types of securities and following them on a daily basis.  After nearly 50 days of markets declining around the world, we have been stopped out of many positions in all investment strategies and now sit with 30-50% cash.

 

Finally, perhaps the most important thing we can do to manage risk appropriately in our investment portfolios is to maintain the right mix of stocks, bonds, cash and alternative type securities.  This is the obvious notion of diversification and it matters.  After years of rising stock prices, it goes without saying that some investors have become wildly overinvested in stocks and have not been very disciplined about staying somewhat balanced.  Mind you, I am not a fixed portfolio kind of guy and I do believe that an overweight position in stocks is appropriate – or perhaps an underweight position in bonds is a better way to say it.  Regardless, while we want to own non-correlated securities in our portfolios, we also need to maintain an overweight focus on risk management in all asset classes.  Our own “blended asset” strategies (All Season, Gain Keeper and Foundations) have predefined maximum allocations to stocks, alternatives and bonds.  They are 75%, 30% and 30% respectively.  Today, these strategies are roughly 45% in stocks, 7% in alternatives and 10% in income bearing securities.  The rest is in cash waiting for the next great buy to develop.

 

So is the stock marketing putting in a long term top?  I’m so glad I don’t really need to answer that question J

 

Have a great week

 

Sam Jones

The longer I’m in this business, the more I recognize the importance of investing with the dominant themes of the day.  I’m going to talk a lot about this at the Annual Fire Side Chat on Thursday for those who are attending.  This update will identify and define the concept of themes and how we can position our money to capitalize appropriately.

 

Up or Down

 

This is the easy one right?  Is the stock market going up or it is going down?  While some snicker and think that’s easy, we know that answering that simple question can be tough at times, especially at perceived turning points.   This “Theme” is perhaps one of the most important to identify as an investor.  In our shop, we look at the slope of the 200-day moving of the S&P 500 – shown in purple below on this chart.  The white pole in the middle of the chart dropped on 8/7/2009

 

 

Is the point at which the 200-day moving average turned from sloping down to sloping up.  Now for those who lived through the decline in 2007-2009, we know that the market actually put in the final low six months earlier in March of 2009.  That low point was also 15% below the level in August when the moving average turned up.  During those 6 months, we didn’t really know if the primary trend of the market was still down or whether or not a bottom was in.  We had our suspicions but really everyone was just guessing at that point.  Since August of 2009, the slope of the 200-day moving average has been trending solidly higher with the exception of one month in the summer of 2012.  Now look at the upper left hand corner to today.  We see… more of the same.  We might suspect that the market is putting in a top and this might be the beginning of a topping period for stocks but really we’re still just guessing with no evidence to support our fear.  The primary trend is up and that Theme should largely define your choices, exposure and your general opinion on the markets.  Everything else is truly inconsequential noise.

 

Equities, Bonds, Commodities and Cash

 

Some think that just owning a bunch of stocks or stock index funds is the only way to invest.  That might be true.  I find that’s the case in one of two situations.  The first is a person who is a naturally a gambler and views investing as a source of entertainment.  The second is a person who has little to lose.  Often these two situations are found in young investors who don’t yet know the feeling of losing a large pile of hard earned money.  A typical mature investor’s portfolio will naturally tend to own stocks, bonds, maybe some commodities, internationals and possible some cash.  This is diversification and it’s a good thing for obvious reasons.   Now, the theme-oriented investor also knows that there is no such thing as a static mix of all of this stuff that will do well in every market, every year, bull or bear.  No, we must understand where there are opportunities and were there are risks in each of these asset classes.  The current theme for investors is really all about owning stock on an overweight basis.  This is where opportunity lies on a relative and absolute basis.   Bonds of most types are in a bubble and have been since 2012.  One day, bonds will produce great pain for investors who sadly think of them as safe havens.  That day may be next week, next year or in 3 years.  I don’t know when.  Until then, bond holdings are just going to provide underwhelming results with a high risk profile – no thanks!  Commodities are probably in the same camp of unappealing investments now that the US dollar has launched into a long term uptrend.  Until inflation really begins to show up in the form of higher costs for raw materials and higher labor rates, commodities are going to lag.  So our theme here is about owning a large portion of stocks, but which types of stocks?

 

Cautionary Note – owning lots of stock is not appropriate for all investors especially those with little tolerance for regular volatility.  If you can’t handle seeing your portfolio balance move up and DOWN, you’ll need to wait potentially in cash for other asset class opportunities to develop.

 

Types of Stocks

 

Of course, we can do the simple thing and own stock indices rather than working to stay in the right sector or the right company.  For many DIY investors (most), this is still probably the right choice.  But even in the indexers world, there are winning indices and losing indices.  This year is a perfect example.  You could own the S&P 500 and have no worries (so far) but your Small cap index fund is now down -6% YTD and falling like a stone every week.  You could have everything in a domestic only stock fund and feel swell.  Or you could have a few European stock funds that are also down 7-10% YTD.  When dominant themes today are pronounced and persistent, we find that owning “sector” funds can also provide some outsized returns with less weekly volatility than owning the whole stock market via broad indices.  Of course, you need to own the right sectors.  I’ll provide a lot more detail on this on Thursday including what we think will be the safest and most productive places for your stock portfolio both domestically and internationally.

 

Timing

 

Timing is a theme as well, as in when to invest aggressively or when to play some defense, all the while recognizing that the primary trend is still up.  As you might guess, in a raging bull market, trying to time every little top and bottom is a bit of a fool’s errand, so timing is the last and least important consideration to an investor.  Conversely, when the market rolls over, our 200 day moving average has a negative slope and wealth is evaporating by the minute, timing means a lot more.  In this market, we are considering “timing” from a couple perspectives.  One is when we will deploy new client money into our models.  For the most part, in a bull market time is your enemy when sitting on a pile of cash as prices have an upward bias.  We are purposely more deliberate about NOT sitting in cash with new client money during bull markets and work hard to deploy an account in our strategy holdings within 30-60 days at the most.  In a more adverse market, when timing matters, we are very patient with new client money.  Case in point, we haven’t see more than 5% correction in stocks in almost 22 months!  Waiting for that 10% correction, could be a long wait.

 

Second, we might use seasons to find new entry points for sectors or upgrade positions.  Today is October 6^th and we know that October has seen more bull market peaks than any other month of the year.  It has also seen more market bottoms!  It is also a month that marks the kickoff of the best half of the year from the seasonal perspective (November – April).  Furthermore, this is a mid term election year and historical gains for the next three quarters average 24% in aggregate.  Will it happen again?  Or have we come too far already?  What would derail this market?  What will be the drivers of new highs?  Lots of questions, lots of cross currents here.  As I said, timing is tough in a bull market but there is a theme here that investors can and should lightly incorporate into their decision-making.  For new money or upgrading positions, October is typically a good month for both.  Let’s be focused on that opportunity from a timing perspective but avoid making assumptions about a given outcome.

 

In aggregate, there are definite themes that investors need to be aware of in order to orient a portfolio correctly.  Without a doubt, failure to see, identify and align your portfolio with the dominant market themes (constantly) is the number one reason I see investor’s experience either disappointment or pain.  Our job at ASFA is to match our investors with market themes in a tactical and dynamic way, making buy sell or hold decision every day on every position.  We are paid to keep your money in the right place and out of the wrong place.  This is our value.

 

Look forward to seeing you all on Thursday!

 

Cheers

 

 

Sam Jones

Did I mention that September is typically a tough month for investors?  This one has been no fun.  Thankfully, in the process of 10-15% declines in several sectors, asset classes and international indices, we are seeing some real value opportunities develop.  The market has done a good job of pricing in some future realities over the last month creating some potentially good looking entry points for a 4th quarter rally.  The next two weeks are critical.  Here’s what I’m watching.

 

Possible Buys

 

Energy, commodities, gold, small caps, Emerging markets, China, India, high yield bonds and real estate funds have been crushed in the last 30 days.  We can all probably point to the massive move in the US dollar against foreign currencies as the pain driver (+7% since early July).  As I said, last week, this type of move in a global currency over such a short period of time is very rare and very noteworthy. Why?  Well for anyone who has been at this for more than a decade, you understand the concept of reversion to the mean or more simply, too far too fast.  The move in the US dollar has probably moved too far too fast and it is highly likely that the current rate of change will not persist either in magnitude or direction.  Meanwhile, being the super efficient discounting machine, the market has beat up all the sectors mentioned above effectively pricing in the current level of the dollar, possibly more.  Interest rates have also moved up in sync with the US dollar, driving down the value of REITS, real estate funds, bonds, high yield corporate debt, utilities and anything directly interest rate related.  Last Friday, I think we saw the first signs that things could be in the verge of a change, perhaps in the first two weeks of the new quarter.  I did a one day rank on very basic performance across the entire universe of sectors and indices both domestic and international looking only at Friday’s market action.  The strongest groups where almost exactly those mentioned above, the same groups that have been hammered the most since the peak in early July.   Likewise, some of the biggest losers were sectors that have seen virtually no selling yet in 2014 (healthcare and internet). Relative strength watchers take note, this could be the beginning of a worthy rotation but it’s still too early to make any significant moves.  One day certainly does not make a trend.  There were some exceptions.  Gold, silver and most mining stocks continued to sell off and saw no bounce.  Likewise, high yield bonds saw no love and continued lower.

 

There is a reasonably good chance that stocks in general will find some temporary support at this level and possibly chop higher into the first week of October but we’re not expecting the real low, even a lower low, until the end of the second week in October (10th) based on the very blunt trading instruments of cycle work and seasonality.   During this bottoming process, if it happens, we will be carefully watching the performance horse race to help us get positioned correctly for the 4th quarter.  Now I will insert some stern words of caution.  The market uptrend dating back to the early days of 2013 is in jeopardy.  Make no mistake, there have been significant technical breakdowns in the last three weeks, including a total failure in High yield bonds and small caps both of which often serve as jumpy nerves for the market in general.  Sector leadership is barely hanging in there and strangely consumer sentiment has not yet hit the type of bearish extremes that I would expect following the carnage in September.  Maybe people don’t know yet?  I am expecting more downside in prices before the possibility of a 4th quarter rally emerges.  Selling can often beget more selling in the financial world so let’s continue to respect the downtrend for what it is, live by our stops and take defensive steps as necessary regardless of what we think might happen.

 

Energy

 

I think the energy complex is especially interesting right now.  At the upcoming annual meeting at the DCC on October 9th (Did you RSVP yet?), I’m going to give you four reasons why energy COULD be one of the best buys out there, right here, right now.  So far, the trend is still down but I’m watchful of a turn at any time.  Energy services companies like those in the pipeline space often seen as MLPs, continue to chug higher regardless and we own them.  But I’m talking about the equity side of the sector, those in oil and gas, drilling and exploration.  Many of these names have seen some heavy selling in recent months but as of yet, these still look more like correction patterns within longer term up-trends, than an actually change of trend (see below) .  Meanwhile, I think there is a good chance that the price of oil just very quietly put in a bottom.  Time will tell.

 

 

 

Gentle Reminders

 

It’s been a long time since anyone has lost money in the stock market on a monthly basis.  September will be the first in a while and your first reaction will be something must be broken!  Nothing is broken.  As the stock market moves up over time and this aging bull market just gets a little older every day, it’s very natural to see weekly and monthly volatility creep higher.  Volatility is a natural part of investing and it takes the form of losing money every once and a while.  These are situations that we want to tolerate to a degree.  When such volatility turns into risk, as our various positions are moving below stops, we want to control that volatility and sell or move to more defensive positions.   If we do not, then our volatility becomes risk, risk of unrecoverable loss.  Risk is something we all try to avoid. We’ve been doing just that since mid July.  When we see losses of any kind we usually have two thoughts.  The first is to quantify our losses in terms of something that we could have bought.  “I just lost a car!”.  Yes, that will drive you bananas, try not to do it.   The other thought is an urge to cash out feeling some sense of clairvoyance about the future.

 

Repeat after me-

 

“I do not know the future, I am the weakest link in the investing chain, and I will not make emotional decisions on the basis of my gut instinct because I know that my gut instinct is almost always exactly wrong at exactly the wrong times”.

 

I have said this many times in the last 18 months but here it is again; The market do not typically go up 30-40% without as much as a 5% periodic correction.  Rarely is a better word.  More often, during such a run higher we see 2-4 corrections of 8-10% each.  Let’s all remember that fact and expect to see more normal conditions in the months and years ahead.  I’ll step down from the pulpit now.

 

Have a great week; you’re in good hands

 

Cheers

Today is the fall Equinox, the official first day of fall.  For the cosmically inclined, this is a day of balance with equal emphasis on high energy (the sun) and restoration (the moon).  So as we respect the change of seasons and natural transition to the other side, I’m going to spend this update looking forward and do some investment planning.  Of course with investing, predictive work is just a guide and should not replace prudent action based on real observations.

 

Large Caps to Small Caps?

 

It is no secret that small caps have been in the dog house all year, now down 2% YTD, while large caps like those found in the Dow and the S&P 500, are up between 4-8%.  Historically, in healthy markets, small caps outperform as the sector representing a “risk on” sentiment among investors.  No so this year.  I think there are several things going on that might shed some light on this.  Many are looking at small cap underperformance as an indication that the market is putting in a major top, right here, right now.  If that bit of evidence were surrounded by other bits of evidence saying the same thing, I would agree.  Our longer-term indicators are giving few warnings of a major market top as you know so I think there are other things going on.  One plausible answer is that small caps ran so strong in 2013, they are simply taking more of a rest in 2014.  Coincidently, valuations for small caps coming into 2013 were much higher than large caps and logically investors would take profits, giving the proceeds to cheaper large caps.  Finally, the value of the US Dollar prior to the last 10 weeks was sitting at historic lows.  A low US dollar tends to support large cap multinational companies who generate great gobs of their revenue overseas. Small caps have a tougher time.  But that was all before this quarter when the US dollar rose nearly 5% against a basket of foreign currencies.  This has been an incredible move!  In stock price terms, such a move would correspond to roughly 25 or 30% in the S&P 500 (haven’t done the math, but heard it on CNBC).

 

Now let’s do some planning.  If we recognize that small caps might be simply oversold within a longer term bull market and that current price trends are still reacting to earnings from all the way back in June, then we might be open to the possibility that large caps earnings starting in three short weeks, are going to be adversely impacted by recent events in the US dollar.  We might not be surprised to see earnings from small caps coming in above expectations for the same reasons.  The smart investor will be very careful now about adding to overbought large caps and be ready to shift into oversold small caps early in the fourth quarter.  The only caveat is that small caps must not break trend, meaning trade below the August lows.  If that happens in the next several weeks, I’ll take it as a more bearish indication for the market trend as a whole.

 

Sector Performance Ahead of Upcoming Rate Hike

 

Of course the Federal Reserve will raise the federal funds rate.  They will do so sometime in 2015, probably mid year according to the median forecast.  Strangely, it appears that the market or most market participants are just now starting to orient their portfolios toward that reality.  Let’s do the same right?  So what does that mean?  Well using history as our guide, we know that in the nine months prior to the first rate hike by the Fed, there are certain sectors that outperform and others that underperform (the market).  Now remember, that our market trend doesn’t have to be positive, although it almost always is leading up to the first rate hike.  But for this discussion, be clear that we are simply talking about relative performance.  Less bad, is “outperforming” in other words.  In our world of wealth management and risk controls, we don’t like losing less as an acceptable option.  We look at losing money, or really the risk of unrecoverable loss, as something to avoid.  Short term volatility, is different and something we often put up with as long as the primary trend is up.  Back to the script.  So the best sectors to own leading up to the first rate hike are Financials, Technology and Energy in that order.  On the underperformance side, we have consumer discretionary, healthcare, telecom and utilities in order of best to worst.

 

Again, let’s look forward and do some planning.  If we own big or oversized positions in the groups likely to underperform, then we might consider cutting back or eliminating them from our portfolios in the next month or two.  Consumer discretionary and healthcare are the most overbought of the losing group, so they should be first on the chopping block.  Telecom and utilities are currently neutral so we can be patient about any sells here.  On the buy side, energy is the only sector that is currently oversold and relatively attractive.  Energy has been hit hard by recent geopolitical events and some currency issues but really this sector doesn’t seem to have major structural problems and is in the right place considering the current stage of the business and market cycle.  Financials and Technology are pretty overbought now, so again, the smart investor will be patient about buying until we get some meaningful declines here.

 

Steve’s Notes

 

Steve Blumenthal is the president and CEO of CMG capital (www.cmgwealth.com ) in PA, an excellent money manager and good friend.  He was recently speaking at the Morningstar ETF conference and had the opportunity to listen to the long term and short term outlook offered by Pimco.  I’m going to offer Steve’s notes on Pimco’s Outlook here because they are great ( thanks Pimco) and brief (thanks Steve!).  Use this information to guide your expectations and your appetite for risk taking.  In fact, I would encourage you to read it several times as you’ll begin to get a feel for where growth lives both in time and location.  Hint, the easy money is behind us in both long and short term windows.

 

Secular View (long-term):

• Private debt improving, government debt is not.
• Debt remains a large overhang.
• In developed economies – low inflation and they want more, but can’t get it.
• In emerging market economies – want less inflation and can’t get rid of it.
• EM can drive global growth – Pimco sees it as 50% of global GDP by 2016 (but EM is still dependent on the developed world.
• The eurozone economy should grow by about 1% in the next 12 months, continuing a painfully slow climb out of a double-dip recession.
• We expect Japan will grow by around 1% to 1.5% in the next 12 months and China’s growth is likely to slow to around 6.5%. The outcomes for other developing economies will be tied to what happens in China next year.
• Pimco’s economic forecast for the next 12 months calls for a continuation of a low amplitude, long frequency U.S. business cycle recovery, with growth between 2.5% and 3.0%.
• Demographics are a negative in the developed world as working age population will continue to decline up to 2029.
• A significant growth headwind. Older population spends less and earns less. Pimco expects 2% nominal GDP while Wall Street expects 3½% to 4% – expect Wall Streets estimates to be lowered.

 

Cyclical View (short-term 12 month view)

• Current GDP of 2 ¾% – a bit better than their prior estimate.
• Positive trends have emerged: Consumer confidence is up and they see diminishing policy uncertainty leading to stronger investor confidence.
• US household net worth is improving and higher than the 2007 high.
• US household debt service is now lower than it was in 1980. Better individual balance sheets – more money in the pockets.
• Housing affordability is good – a positive.
• Government spending is becoming less contractionary.
• Corporations yet to spend on capital expenditures have yet to materialize. Pimco is expecting this to pick up and continue to improve over the next two years.
• Central Bank policy to diverge (driving divergent currency moves)

• Federal Reserve – rising rates
• Bank of Japan – flat
• Bank of England – rising rates
• European Central Bank – flat and accommodative

 

Several additional notes:

• What happens when the Fed takes the punch bowl away? Exit the great experiment?
• Regulatory environment constraints: money market reform and Basel III – changes coming in the money markets – going to be gates put up upon exit, money market (MM) funds will move off the $1 peg value
• There are not enough assets available to put into MM funds compared to the large demand. MM portfolios have stepped into greater risks.  It is a demand and supply mismatch.  Risk up, liquidity down.
• In the past, banks were willing to take risks and make markets – that is now GONE (due to increased capital requirements – regulations)
• Banks are moving capital toward higher profit markets. No longer making markets.  Market dynamics have changed.  Few bids in times of crisis.  Markets more apt to dislocate.
• Liquidity continues to decline.

 

Overall:

• 1¾% to 2% modest inflation expected
• 2 ¾% current GDP expectation, longer-term 2% nominal GDP for a number of years
• Fed begins to raise rates in mid-2015

 

Happy Fall Equinox – stay balanced!

 

Sam Jones

September is living up to its reputation as a tough month for investors.  While the S&P 500 and other “benchmark” indices are still trading within 2% of all time highs, the real damage to the markets has been far more severe over the last couple months.  Recognizing when an investment is forming a larger top versus a minor correction is key now.  This is a great moment to cut out weaker positions and upgrade.  I’ll give you some options to consider.

 

Damage Report

 

Consider this.  According to Bespoke Investment Group, the average large cap stock is now down -7.5% from its 52 week high, Mid caps are down -11.1%, small caps are down -17.3% (almost a bear market) and the average stock in the broader S&P 1500 index is down -12.4%.  52 week highs for each of these market segments occurred in different times this year with some setting in March, others in July and still others as recent as September 1^st.  Here’s what the damage report looks like from a sector perspective (Bespoke Investment Group)

 

 

Pretty ugly really remembering that these are averages as well.  We’ve given up a couple percentage points in our own equity strategies over the course of the summer and early fall but all are well within 2% of all time highs – nothing close to the damage above.

 

Nothing to Fear but Fear Itself

 

Since the beginning of September, fear of a change in Fed. Policy seems to be dominating investor’s minds – and trading choices.  Granted, the markets are very efficient at processing information and forecasting economic events months in advance of reality.  Is the Federal Reserve going to surprise everyone with a change in their plan regarding their monetary policy on Wednesday?  Highly unlikely.  But still, the trends being forecast by the markets are as real as the pending change of seasons.  The Federal Reserve is withdrawing from the massive support for the US economy and doing so with a well-projected plan.  Without a doubt, at some point, in the next 6-12 months, the Fed is going to start raising short term interest rates.  At some point in the next 4-6 months, the Fed will end its bond purchase program completely.  At some point in the near future, market driven interest rates and borrowing costs will begin to rise from near zero levels.  I have labeled 2014 as a “Transition Year” for the market or a period where the US market and economy take their first steps without assistance from the Fed.  We are going to get out of the “recovery” room and start walking on our own as economic data now confirms.  Some investors think the US economy cannot take those steps, is not ready, will never be ready.  I am not one of those investors.  So the Transition Year is happening, that’s all.  Fear is just part of investing and a natural feeling for those of us who have been at for 20+ years.  For those attending the upcoming annual meeting on October 9^th, you will see why rising rates (to a degree) are not to be feared and often coincide with very nice price gains in stocks.  Nevertheless, selection is becoming more and more important as we would expect during this phase of an aging bull market.

 

Selection is Key

 

Unlike 2013, this year has not been one in which all ships rise with the tide.  The US dollar has embarked on a new long-term uptrend driven higher by RELATIVE currency value changes in the Yen and the Euro.  Interest rates across the spectrum of maturities, will soon follow higher as mild inflation and global currency exchange rates begin to have an impact.  So what is an investor to do?  Hide?  Sell all?  Hardly.  As I have said many times this year, we want to begin cutting out positions that are going to be adversely impacted by the developing late stage environment.

 

Last week’s market action gave us a clear path forward.  These are the areas of the market that got trashed and should serve as areas to consider upgrading in the coming days/weeks.  Most of these are now way oversold so should be good for at least a bounce this week or next.  Consider selling on the bounce?

 

Real Estate and REITS – Ouch!  Down 5% in 5 days

Consumer Discretionary – already underperforming YTD, will get worse

Precious Metals – Still heading south while trying to find a bottom

Energy – Can’t stop losing money.  Now looks like a long term top

Utilities – Terrible business models and will suffer when rates rise

Commodities – Bombs away, now down 7.5% YTD, might be close to a bottom.

Treasury Bonds – Wouldn’t own them for the next 3-5 years

Corporate bonds – Will be back on the buy list but on a sell now

Russia – No one likes a bully – avoid for now

Europe – Recessionary (again)- shrinking share of global GDP

 

These are areas of the market that should continue to lead the market higher during our Transition Year, possibly beyond.

 

Technology – Buy Dips – we’re getting one now, be careful with internet stocks

Financials – Still a great value

Healthcare – Aging Baby Boomer demand trumps all, be careful with biotech stocks

Emerging Markets – If they hold right here, this could be a great entry point

China and India – Same

Japan – Breakout is still holding, beneficiary of falling Yen

 

Land Ho!

 

While we’re still out at sea, taking on a little water in the 3^rd quarter storm, there is still the very distinct possibility of a robust 4^th quarter ahead.  Remember, the next three quarters are statistically the most productive of the entire 4 year presidential cycle averaging almost 8% each quarter.  That period begins in just two weeks.  Nothing is guaranteed mind you and the nearly 30% market gain in 2013 was also an event that is completely out of cycle.  So all things considered, we want not to give up on stocks just yet.  I think the smart money will use the next two weeks as an opportunity to sell selectively, raise some cash and watch relative strength closely for an indication of what things will lead strongly in the final quarter of the year.  If we see indications of a healthy new uptrend with robust buying, we’ll be fully invested again.  We are following that plan in all strategies and hope to finish 2014 in fine shape.

 

That’s it for this week – don’t forget to pay your quarterly estimated taxes today

 

Cheers

 

Sam Jones

Last week, the S&P 500 closed solidly above he 2000 level for the first time in history.  Last week also marked the 2,006^th day of rising prices if we date all the way back to the final bear market lows on March 9^th of 2009.   Investors have long forgotten what stock market pain feels like but strangely, as a group, they haven’t yet poured cash into equities as we might expect.

 

New Generation of Workers

 

I couldn’t possibly know what goes on in the minds of all people, what makes them act, think or choices they make in spending patterns.  However, I do have a theory about what’s going on that seems to make sense in relation to what I’m seeing and what we know from studying the history of generations and economy.  Here it goes.  When I back out and look at the big picture of the US economy we know several things.  We know that one of the biggest generations of all time (Baby Boomers) is now retiring at an accelerating rate.  We are seeing this show up in Labor Force Participation rate charts, which continue to make new lows, almost record lows, as a percent of current population.  This is the picture directly from the Bureau of Labor Statistics site

 

Meanwhile, we have an unemployment rate stated at 6.9%.  So of course the difference between the chart above showing less than 63% of our AVAILABLE  labor force is working, and the very low Unemployment rate, is captured in retirees.  Retirees are eligible to work as part of the labor force but are not voluntarily doing so and thus they don’t count among the unemployed.  Now, follow this through.  When a large piece of the US population is not working voluntarily, we would expect several things.  One, we will see a more modest growth rate in the economy.  CHECK!  2.5% GDP, steady as she goes although unimpressively so.   A smaller growth rate in the economy yields a labor environment where hourly earnings are also somewhat stagnant.  In other words, those who are working are happy for the job and willing to work for reasonable, even lower, compensation.  CHECK!  Hourly earnings are stagnant over the last 5 years again despite the very low unemployment rate.  Stick with me now.  When hourly earnings are flat, there is no wage inflation to be seen.  If you’ve ever taken an economics course, you know that the cost of capital (K) and the cost of labor (L), are the key ingredients to inflation.  CHECK! There is no inflation and the Fed is in no hurry to raise interest rates.  It all make’s sense if you look through the lens of generations.

 

Now let’s take this knowledge and use it.  According to the work of most demographers, guys like Harry Dent and others, we shouldn’t expect the Baby Boomers to get out of the way (no offense) until the year 2024.  At that point, we should see a real lack of supply in labor and begin to see some wage inflation as employers have to bid up compensation to attract employees.  Until then, we still have a lot of baby boomers willing to stay in their jobs and retire gradually over time.  Here’s the point.  Investors should understand that earnings for corporations should remain very healthy as one of their highest costs of doing business, namely labor, remains low or stagnant.  Better yet, our economy is much more service based than it used to be leading to higher demand for service-based businesses where labor is cheap.  Investors should also be very careful about their assumptions regarding inflation.  Some (many) are still married to the idea that gold and oil must rise and bonds must fall as the inevitable wave of inflation hits the economy.  That might be the case, but you might also be off by a decade or so.  The Fed is ending their QE measures, we know this but we shouldn’t make the assumption that inflation will suddenly and immediately shake the ground beneath us.  I have personally gone completely around the horn on this issue.  I still think inflation will be a large issue for our county but not for quite some time and more closely a bi-product of labor conditions.    With that said, I still find Treasury bonds unattractive as an asset class.  They simply do not offer an investor any reasonable income leaving you with a pile of price risk.  If we need to be tolerant of price risk to be invested, we should own stocks, especially those paying juicy dividends.

 

I’ll finish with an attempt to answer the puzzle of money flow.  Why is there still so much money sitting on the sidelines after 2006 days of rising stock prices?  Why has some of this money NOT found its way into the stock market?  Honestly, I think it comes back to the generational issues.  The retiring baby boomer is not in a mood to add risk to their lives just ahead of retirement.  The next generation is gun shy and thinks it’s too late to invest even as they are accumulating more and more money in bank accounts earning nothing.  Finally, I think there is an embedded sense of doubt regarding what might happen with the Federal Reserve slowly ending their monetary support of the economy.   The consensus view on the street is that when the Fed is gone, the market will go to hell.  That will simply not happen and I’ll tell you why at the upcoming annual meeting on October 9^th at the Denver Country Club.  If you haven’t RSVP’d yet, space is limited!  With that mind, we have to assume that stock prices are going to continue higher until we see some form of bullish capitulation with regards to all that cash or it will gradually deploy on every market pullback just like we saw in March and again in July of this year.  The puzzle will be solved over time.

 

That’s it for this week; get outside for the best three weeks of the year!

 

Cheers

Sam Jones

Why is it that Sept and October are two of the toughest months for investors with such radical differences between winners and losers?  It wasn’t until I ran my own mutual fund that I understood this little dirty secret.

 

Mutual Fund Bonus Time

 

The end of the 3^rd quarter is an important moment for mutual fund portfolio managers.  I didn’t realize how important until I stepped into the dark world of managing my own mutual fund  – the “Integrity All Season” mutual fund – back in early 2000s.  At the time, I thought it was a great idea.  I thought we could steam line our allocation process, cut some separate account costs, improve daily liquidity for our clients and maybe attract some new assets by offering an “alternative” mutual fund.  What I discovered was that most mutual funds are terribly inefficient and costly to run, more expensive than managing client assets through separate accounts in fact.  On top of that, I found myself jaded by the primary objectives of our host fund company.  Real wealth management, including risk and volatility reduction, and consistency of returns, were simply not important.  Beating the S&P 500 or a select benchmark each quarter or each year regardless of risk, was the one and only thing that mattered.  I voluntarily shut down our fund in 2007.

 

Judgment day for most mutual fund portfolio managers is the end of September, sometimes the end of October.  This period is also the fiscal year end for most shops and bonuses or termination warnings are often delivered at that time based on performance against your benchmark.  It’s just that simple and it doesn’t seem to matter if the trend is up or down.  If the benchmark is up 15% over the preceding 12 months and your mutual fund is up 15.5% – money and praise rain down.  If your benchmark is down -15% and you are down only -14.5% – you still get the bonus, maybe even a corner office!  But woe is the plight of the manager who underperforms in any way.  No soup for you!  Now imagine yourself in the manager’s seat approaching the end of September.  Are you going to go out on a limb and buy some sector or stock that is down hard on the year, out of favor and losing money?  No, in fact you’ll probably sell it quickly to get it out of your list of holdings.  On the other hand, you are very likely to sit on your 12 month winners and hope that they continue to reward you for another 30 days.  So the dirty secret is this; Going into the end of September, winning sectors stocks and funds will continue higher while those on the losing end tend to suffer greatly.  Beginning in October, managers (at least those who still have jobs) are now free to be more critical with their holdings often selling wildly overbought and overpriced stuff and reach for more attractively priced sectors, holdings and asset classes.

So how can we use this little secret to our advantage?  Well obviously we want to hold CURRENT market leaders through the end of September but begin making a short list of things that are oversold, better values and likely candidates for the coming wave of reallocation buys come October.  We also want to be very careful about buying more “winners” at this very late stage of the game.  Lets take a look at the current winners and losers, which is now most easily recognized since the last peak on July 3^rd.

 

 

Winners:

Long Term Bonds – way overbought and very ripe for profit taking in the next 30 days.

Emerging Markets – Not overbought by any stretch or metric and still leading.  Brazil, India and developing Asia look best.

China – Same, hard to say this is a developing country anymore.

Technology – Approaching over bought, especially among social media.  Stick with mega cap companies or large cap tech ETFs.

Healthcare – Core position for the next 30 years, but currently overbought

Transportation – Cyclical, overbought, expensive and ripe for profit taking

 

Losers:

Small Caps – Oversold, ready for a rebound associated with a stronger US dollar

 

Gold – Oversold but avoid – still no inflation in site and naturally fights the Fed as they end QE measures

 

Energy – Neutral but could be a rebound defensive sector, lots of cross currents

 

Europe –  Oversold but Avoid – messy and now recessionary

 

Wild Cards

As a Wildcard play, I also like Japan for the remainder of 2014, possible longer.  I need to get a better understanding of the currency, carry trade happening but these are the nuts and bolts.  Japan is now under the regime of Abenomics who is taking his cue from the US Federal Reserve in printing great gobs of money and injecting it into their ailing economy.  Furthermore, as our own QE measures dwindle and money in US Treasuries begins looking for a new home (seen as rising rates) as we approach the end of the year, we can also expect downward pressure on the YEN, which is also good for Japanese stocks.  If we believe and understand the power of stimulus and the impact on currencies, interest rates and ultimately stocks, than Japan is in the early stages of a very profitable bull market.  We have a taken a small entry level position in Japan in our All Season and Foundations models as of this AM through the Wisdom Tree Japan Total Dividend ETF (DXJ)

 

And Wild Cars

 

Still loving our automotive positions in our New Power strategy.  Could also be in the early stages of multiyear bull markets.

 

 

New cars from Tata Motors (TTM) in India, a country exploding with demand for transportation and modern luxury.

 

 

and Tesla (TSLA)  – the coolest electric car on the planet – of course you want one.

 

Happy Fall

Sam Jones

For those in my age group, you remember don’t you?  Prince?  party like crazy because it was all going to end once the clock hit Y2K (Year 2000).  Today, the S&P 500 is having its own party crossing into the 2000s.  Is this the beginning of the end or has the correction run its course?

 

Stealthy Correction Over?

 

The broad stock market indices of the world peaked last on July 3rd and headed lower for about a month declining on average about 4-5% although the damage outside of these large cap benchmarks was far worse.  In fact since the peak on July 3rd, the percentage of stock down over 20% is actually HIGHER than the reading on that date according to Lowry’s research this AM.  Small caps stocks lost an average of 10% and are far from exceeding their May and July Peaks.  And 52 week New Highs continue to show a pattern of lower peaks dating all the way back to May of 2013 (not a typo).  So now that large cap stocks represented by the S&P 500, have impressively crossed into all time new high territory again, we must also respect some increasingly obvious selectivity developing overall.

 

Even so, there is mounting evidence that our summer correction MAY be over.  Many indices like the S&P 500 are pushing out to new highs beyond the last peak on July 3rd.  In fact, 128 of 330 total indices (39%) in my database are now positive since then.  I suspect we’ll see that number expand.  Leading the charge are Technology, Financials, Transports and Healthcare making this a broad based run with our heavy weights doing the heavy lifting.  Commodities are still lagging, gold is breaking down, bonds are still in a steady uptrend and energy is still hanging near the bottom of the correction pattern.  All in, there are enough things to own that we can stay largely invested but I would offer one bit of caution.  The seasonality of buying now is not good from a historical perspective.  September has long been one of the worst months for stocks and prices are now overbought again after a near vertical move off the August lows.  For as much as it seems painful to be patient now as the market seems to be lifting off to new highs (S&P 2000), it might be just the thing to do.  Those who want out ahead of September now have their finger on the sell button so be very careful about chasing this any higher until we see what the next down cycle looks like.  If we just get some consolidation of recent gains at or near the highs, followed by another surge in buying, I would see that as a favorable opportunity to buy new positions with any cash.  If on the other hand, sellers come in heavy and prices head back to the lows in August, we would be grateful that we didn’t buy into the 1999 party.

 

“Millennial Gold Rush”

 

The cover of the August Forbes magazine caught my eye in the airport.  It had this title and seemed to fit with my ongoing research into this group of new investors, so I bought the magazine.  It was the first thing in print I have purchased in probably 4-5 years and it cost $5.99!  Sadly, I found the article on my I pad about 4 minutes later.  Anyway, the main story was not about “rich and scared” Millennials (those born after 1980) as described on the cover, as much as a host of new robo-advisor web based investment websites.  I’m going to spend some time on the value proposition of these services (Betterment, Wealthfront, LearnVest, etc) in the upcoming Solution Series Webcast called “The Real Costs of Investing”.  However, more interesting to me was some of the data presented on trends in Millennial behavior.  I mentioned this first a few months ago in a brief discussion about their rejection of the American Dream (get a job, get married, have children, buy a house, die at your desk working to pay for it all).  I spent a lot of time with Millennials this summer and they do seem committed to their plan of impermanence.  According to Forbes, only 42% of Millennials between the ages of 25 – 32, are married compared to 68% of the baby boomer generation when they were in the same age bracket.  That number was 84% for the generation before.  Millennials in that age range also have the highest percentage of 4-yr degrees – 34% compared to 25% for Gen X and 24% for Baby Boomers.  Also, not surprisingly, homeownership for the Millennials is also one of the lowest in modern history – only 13%.  They don’t seem to want to play the game in general.  Work for money is something that might happen in between trips to foreign lands.  Home ownership is viewed as something that ties you down to a desk for life or even worse, a scam.  And Marriage?  Not high on the list as more than 40% come from broken families themselves with some darkness surrounding the concept of “home”.  Finally, as an investor group, I’m not seeing the rich part of “Rich and Scared” at least not yet or until they hit their inheritance wave.  Most commentary was talking about where to put their $2000 IRAs while still owing $50,$60 and $70k in student debt.  Not a very promising looking investor at this point with exceptions of course.

 

As always, it’s common for every generation to look down at the next and question their work ethic but the Millennials on average seem genuinely not interested in developing careers as much as making a service wage or maybe staying in school.  Perhaps we’re seeing some of what the Fed is talking about with an underdeveloped job market, lacking in career type compensation or opportunities.  Or perhaps this is more of a cultural thing after smelling the rot of corporate greed for the last two decades.  Perhaps this is the birth of a more enlightened generation with more creative and less traditional aspirations.  The answer is probably all of the above.  Either way, if I had to guess, it seems likely that here in the US, we should expect somewhat of a time gap in wealth creation, real earned income and the development of a viable new investor class.  With the baby boomers retiring quickly, that newly available seat might get a bit cold before it’s filled.  Something to consider in the big scheme of things.

 

Those are my musings for the week – now all of you kids get back to School J

 

Cheers

 

Sam Jones