Category: Finding Benjamin

2nd Quarter 2015 | “Best Fit”

By Sam Jones, President

The purpose of this quarterly report is to help guide our current and prospective clients specifically regarding the design, methodology, and process behind our investment strategies.  We also work to offer a higher level of transparency into our investment strategies by showing unique perspectives on returns and risk profiles.  Subjectively, this is a self-effacing report openly critical of areas in which we still need work and similarly patting ourselves on the back when appropriate. While we are proud of our historical returns, future risk-adjusted returns are what really matters.  We believe that investment success the direct result of excellent design, solid execution and regular self-critical evaluation.

This Change of Seasons reports is focused on Best Fit in the sense of which strategies (or combinations of) offer a best fit for your various life stages. Effectively, I hope to address our value as it relates to excellent portfolio design by walking you through the design process itself.  Knowing which of our strategies is right for your stage of life can be a puzzle.  Consequently, we have gone to great lengths to work up prescriptive strategy mixes for different client household profiles based on typical risk tolerance, age, and stage in life.  I’ll begin first by identifying our four “profiles”, including our “prescriptions” by investment category for each and finish with some individual strategy statistics to explain how certain strategies are indeed a Best Fit for their target investor.  Our website is chock full of detail regarding all of the above so feel free to dive in on-line anytime.

Our Explicit Investing Creed

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, experience, 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

Best Fit – Matching You to Our Strategies

 

To understand why a certain investment strategy is prescriptively right for you, it is important to understand the natural volatility of any investment strategy.  Natural volatility can be measured by way of something called the Distribution of Returns where we can clearly see and plot the frequency of gain and loss periods.  Let me provide two very different examples.

 

A younger investor (“Plant” or “Grow”) who is regularly adding to investment accounts and is years away from any form of withdrawals, cares mostly about accumulating wealth with less regard for regular volatility in their portfolio.  In fact regular volatility provides nice clear opportunities to add new money.  These investors are savers from a behavioral perspective and should be matched with higher return, stock oriented growth strategies, like any of our three Tactical Equity strategies.  If we look under the hood at our Worldwide Sectors strategy for instance, we see characteristics in the Investment Allocation and the Distribution of Quarterly returns that make this strategy appropriate for a younger investor.

 

Worldwide Sectors Strategy since inception net of all fees.

As you can see, Worldwide Sectors is an all stock or equity strategy with a blend of stock ETFs, Sector ETFs and a 50% allocation to individual growth company stocks.  These are maximum allocations for each group but all are still subject to our proprietary risk control criteria for Net Exposure, Selection and Position Size on a daily basis.  On the right, you see the distribution of returns, which is broad including gain and loss cycles.  But importantly, the data are skewed to the right where we see the highest number (bar) of quarterly periods with +4-5% gains.  Aggressive younger investors have clear opportunities to add more money into this strategy during any of the quarterly loss periods to the left including some that are deeper than others (-10% or more).

 

Now, compare this strategy, which is a Best Fit for our “Plant” or “Grow” profile clients, to one that is better suited for our “Cultivate” or “Harvest” profile clients like any of our Blended Asset or Income strategies.  These households are naturally older, largely without income and regularly withdrawing money from investment accounts to subsidize living expenses.  Why does downside capital protection matter so much to someone in this situation?  There is more to the answer than the absence of replacement income!  Consider these two different portfolio balance charts.

The blue line shows the results of a fully invested (passive) stock index fund portfolio experiencing the full force of the last bear market in 2008 and 2009 and subsequent four year recovery.  The red line shows the results of the same portfolio but with the subtraction of 6% in annual withdrawals.  Even worse, the red line doesn’t account for the tax liability associated with distributions from an IRA.  A passive index portfolio with the headwind of regular withdrawals, even as little as 6%/ year, is not likely to recover from losses like these, perhaps not in the investor’s lifetime.   However, any well-designed portfolio with an appropriate focus on downside risk controls will certainly make life easier for portfolios under withdrawal pressure as portfolio recovery is always within reach.

 

Our flagship All Season strategy, one in our Blended Asset category, has the following Investment Allocation and Distribution of Quarterly Returns.

 

All Season Strategy since inception net of all fees.

 

What should be obvious is the broader mix of allocations to diversified asset classes as well as the tighter distribution of quarterly returns, again skewing to the positive side of zero.  You do not see quarterly losses in excess of 8% because there are none in its history of nearly 18 years.   In fact, there are only three years in which the strategy has lost money at all on a calendar year basis.  All three were mild and quickly recovered.  Such a strategy is certainly a Best Fit for those who need to make regular withdrawals and don’t have the time or means to recover from a significant portfolio loss.

 

Either of our Income models would also be appropriate for our Cultivate and Harvest profile households for the same reasons as returns are earned even more consistently and periodic losses are mild to non-existent.

 

Retirement Income Strategy since inception net of all fees.

 

As we like to say, the magic is in the mix when it comes to designing a complete portfolio of strategies that serves as a Best Fit for any of our client households.  Our prescriptions and profiles are there to guide us but every household is a bit different with special needs, circumstances and personal biases.  The relevance of this discussion to today’s market should be self-evident.  While we do not believe the long-term bull market in global stocks is over yet, we do know that the risk of significant loss is on the rise with an associated bear market.  This is an excellent time for all investors to revisit their portfolio design and make sure current holdings (strategies) are a Best Fit for where you are in life.  We regularly do this for our clients during our reviews and would be happy to do so for any parties upon request.

 

That’s it for this 2nd quarter Change of Seasons report.  Stay tuned to the weekly Red Sky Report for important updates on the timing of the next developing best buying opportunity.

 

Sincerely,

 

Sam Jones

I have taken a few calls of concern from clients in the last month or so.  The questions are about what if scenarios with China, Greece and the pending move in raising interest rates by the Fed.  More directly, there have been some performance concerns surrounding our Blended Asset models.  For everyone’s benefit, I’m going to tackle all of these questions in a true Q and A format.

 

Q:  Is the new bear market in China going to spread to the US?

A:  The answer is no but let me explain.  The Shanghai Composite index was up nearly 60% YTD through June 12th.  Subsequently, the index fell almost -25% through the middle of last week.  Small caps in China are in bubble territory with a small number of retail investors pushing prices for relatively new company IPOs up to a P/E of 80 using forward earnings.   Large Caps in China by comparison, which have been around for years and sport very healthy revenues and earnings, are now trading at around a P/E of 14 (down from 18) again using forward earnings.  The S&P 500 trades at a P/E of nearly 20 today.  What we are seeing is a bit of an investor frenzy chasing returns in the Shanghai Composite, which has always been a gamblers paradise.  It just a little out of hand and is now correcting sharply.  I am doubtful that the bear market is over as these things can take a while to digest.  The Chinese government is meddling with mother market by forcing companies to buy and hold their own shares to simply avoid pain and support prices.  How could they do something so artificial?  Mandatory share purchases in China with $Billions are just a little less transparent than what our own Federal Reserve has been doing with the purchase of our Treasury Bonds in the $ Trillions.  Keep that in mind before throwing that first stone.  Economically, China is still very strong with a growth rate envied by much of the developed world and they continue to rise dramatically in their share of global GDP – at the expense of the US and developed Europe.  Their story is far from over in the long term but in the short term, we’re just witnessing what real market volatility looks like.

 

Q:  Is the situation in Greece serious enough to move to a more defensive portfolio position?

A:  Again, the question above is really about contagion.  Will the problems in Greece and the Eurozone spill overseas to the US?  I’m going to frame the answer in terms of a homeowner who is bankrupt and asking their lender for better terms of principle reduction before defaulting on payment.  This is exactly the situation right?  Greece is the bad borrower in this analogy.  They are asking/ demanding better terms or debt forgiveness using the only threat left to them;  default (or Exit from the Euro).  The Banker (Germany) did as any of our lenders have done and by working with the borrower who simply has no room to negotiate.  Eventually Greece will agree to payment terms or they be foreclosed on. At present, they have no means to make payments without an extension of loans or even taking on more debt.  As I said two weeks ago, Greece will continue suffering for years at least economically but the pain should stay in Greece.  Remember, there are not many Greece’s out there like there were homeowner’s going into foreclosure between 2006-10.   Furthermore, Greece only represents a very small 2% of Europe’s entire GDP and Europe represents less than 25% of total global GDP – and shrinking.   They can stay or go and frankly, it just won’t matter that much.  As I said before, we are dealing with headline risk and the markets did take a hit on all the Grexit news in June.

What really matters when it comes to Greece is the peripheral impact on the Euro and the US Dollar.  If Greece stays in the European Union and negotiates a continuation of Bail Out Nation, the value of the Euro will continue to fall as it has done somewhat sharply in the last 4-5 trading session.  A weak Euro necessary puts upward pressure on the US dollar as the Euro is one of the largest components in the US dollar index basket.  A falling Euro forces a higher US dollar.  This earnings season you will regularly hear commentary in reports and conference calls about the negative impact of the “Strong US Dollar” on US company earnings.  This will become almost a scapegoat for large multinationals who derive a large portion of their revenues overseas and give up their profits on conversion back to US dollars.  In a nutshell a strong US dollar is a headwind to earnings especially those coming from S&P 500 type companies.

 

 

At the beginning of the 2015, we began oriented our portfolios away from multinational large caps and toward small cap names which continue to lead the way higher.  Small caps naturally have a lot more volatility than large caps which are a perfect segue into the performance question.

 

Q:  Why did my All Season account lose -2.7% last quarter, the market only lost -2%?

A:  Most of our blended Asset strategies took an abnormal hit last quarter for several reasons.  Without making excuses or trying to sound defensive in any way, there is an explanation.  First, let’s remember that we’re talking about less than 3% in terms of a periodic drawdown, much of which has already been recovered as I write.  Second, blended asset strategies necessarily own many things from many different asset classes of course.  Strangely, almost on the order of the perfect storm, each one of our asset class buckets within these strategies took a turn beating up the whole portfolio over the course of the second quarter, especially in June.  As I mentioned last update, diversification only helps control portfolio volatility in 30-40% of all market conditions when systematic risk is present.  The second quarter of 2015, was a perfect example of a type of market prone to non-systematic risks (like wild currency swings, panic 90% down days, headline risk from Greece, China and the Fed).

 

All Season has five investment buckets, we think of them as asset classes.  They are as follows:

High Dividend Equity stocks and ETFs

Equity Index ETFs

Equity Sector ETFs

Liquid Alternative Funds

High Income Funds and ETFs

 

As a point of example, Four out of five of our high dividend stocks lost 8-10% at some point during the quarter, many tripped stops and were sold off the highs.  These were replaced with SDY, the dividend growth aristocrats ETF, a much lower volatility fund that still pays a healthy dividend.  Nevertheless, the damage was done.  Similarly, our Equity Index and Equity Sector funds all gave up as much or more than the broad US market during the June selling.  This was to be expected but also contributed to the small loss.   As I mentioned above, we also own a bunch of small caps which naturally have more weekly and monthly volatility, both on the upside and downside.  In addition, three of our four liquid alternative funds also suddenly became highly correlated with US stocks after marching very nicely higher with nearly zero correlation for months.  And finally, our High Income allocation was already 100% in cash after hitting a sell signal in late May.  Very often, our high income bonds act as ballast to our equity side of the portfolio providing stability and some gains when stocks are losing.  Not so this time as our bonds were sold to cash.  The situation has improved dramatically since the middle of last week and we’re back on the upswing in terms of returns but the damage to our very well-diversified and well designed blended asset strategies was both unwanted and somewhat circumstantial.  We have made only a few changes to our holdings during all of this turmoil which is exactly what our Net Exposure system dictates as it sits directly on “neutral”.  We are to hold what we have and upgrade as necessary to maintain exposure unless we can find no viable options.  Given the fact that the markets just put in three of the strongest up days in the year, I’m glad we didn’t cut exposure radically.  That day may be coming soon but for now, we remain shaken, but not disturbed.

 

Q:  Is the beginning of the bear market?

A:  That question is always a tough one as every real bear market begins with something that looks like a standard market correction.  Here’s what our system is telling us.  Our technical indicators in aggregate have been deteriorating since last April down to the current neutral status, that condition still exists.  Sentiment measures (bearishness and bullishness) hit extremes with the panic selling on July 8th.  Selling pressure and other measure of panic selling also hit extremes on June 29th and again on July 8th.  Historically, these events have been enough to mark intermediate term lows.  Yesterday (Monday), our system actually generated both short and intermediate term buy signal for US stocks following three very sharp rally days in the markets.  Volume has been unimpressive on this up day however so we should expect some consolidation of prices this week and then hopefully a very robust blast out to new highs for most major indices.  Meanwhile, the fundamental picture continues to improve and recover from a nearly recessionary status over the course of the last two quarters.  We may very well see another economic surge higher in the coming months and earnings are poised to beat a very low bar in expectations this quarter. All in, I do not see the environment as ripe for the beginning of a bear market now but the situation is tenuous.  Several things need to improve now if this bull market is to continue higher including stronger leadership, big buying volume, improvement in the breadth of securities moving higher, participation by the transportation and utilities sectors and a pile of strong earnings that support higher prices.  A tall order but not out of the question.

 

I hope that answers some of your primary questions.  As always, we’ll do our best to keep your informed and up to date with full transparency regardless of the situation.

 

Have a great week!

Sam Jones

As I said last week, the markets were “On the Edge” where buyers would either step up to support the market or we would have to start taking defensive steps.  Thankfully, it looks like buyers stepped up giving us a little breathing room to sit with our current (high) market exposure.  Still, when I look at the guts of the recent buying pressure and the larger context of the current market, I would have say, this isn’t my favorite set up.  It still feels like we’re going to see a better real buying opportunity later in the summer.  With that in mind, there is some opportunity for actionable steps now and until we see a more significant downside correction in stocks.

 

Options

This is one of those markets that offer investors a lot of options.  We can simply buy cheap to own, index ETFs that match “the market” hoping that this six year old bull market will beat the historical odds of producing a seventh year of gains.  That is certainly a popular option but one that should come with a warning label about staying too long or playing too much golf this summer and not closely monitoring your holdings.

Another option is to diversify across the globe, building in some international exposure in Europe, Asia Pacific, Emerging markets and Japan.  Currently, we’re holding about 12% in internationals now. YTD, most foreign markets are outperforming the US by 4-5% despite the strength in the US Dollar.  That leadership seems to be resuming again after a healthy correction in the last 30 days so this could be a reasonable entry point.  Some of the more attractive new ETFs offer international exposure that hedges out currency risk, like HEDJ or DXJ.

There are also a number alternative investments that are still trending higher but doing so with almost no correlation to any of the major US benchmark indices.  These are probably my favorite options right now.  Investors need to really understand what they are getting into with alternatives and few really do.  They come in many different types but generally involve an active trading strategy under the hood that tries to capitalize on some inefficiency or extremes in the markets like Long/Short strategies or managed futures.

My advice is to remain invested in here but pay special attention to owning a more diversified portfolio of investments that are trending higher but move in a non-correlated fashion to any of the US stock market indices.   Our tendency now is to gravitate all holdings toward one thing or another that looks just like the Nasdaq Composite or the S&P 500 because that’s where the gains seem to be.  Spend some time looking elsewhere and you find you can scrub out a lot of the portfolio volatility.

Bulls are Few, But Not Enough Bears Yet

From the investor sentiment perspective, there is something that still gives me an uneasy feeling.  Again, I respect the new market strength and select new highs we’re seeing but this set up just isn’t one of my favorites.  Bullish sentiment is sitting at one of the lowest levels we have seen in several years (roughly 25% according to AAII sentiment polls).  Sentiment figures are of course contrarian so we might read that very low bullish number and think the market has substantial upside from here.  I like to watch Bearish sentiment myself when looking for good meaningful lows.  Looking at the bearish sentiment numbers (below from Bespoke), I see a market that still needs to scare a lot more people before I’m going to get excited about a good new buy.

If Bearish Sentiment could push up to 50% level or higher, I could get really excited but it would certainly take something other than all time new highs for that to happen right?  More evidence to me that we still have more “corrective” work ahead probably surrounding the Federal Reserve and their choices about the timing of the first interest rate hike.  Remember the average market loss before the first rate hike is around 8.5% (down).  Haven’t seen anything close to that yet and earnings season is right around the corner.

 

Sectors, Styles and Special Situations

If you are like us and have a full plate of investments, we should all make sure our money remains in the right place.  Sector strength is still fairly consistent this year with Healthcare, Biotech, and Pharma leading the way to bold new highs again last week.  We have owned Healthcare and Pharma for several years now.  Technology, Internet and Semiconductors are also still in the drivers’ seat and should be core positions for all.  Financials are also leading again thankfully especially insurance and banks.  We especially like the valuations now among the financials relative to healthcare and technology, which remain fully valued by historical standards.

 

On the Style side, the market still likes growth – small, mid cap or large caps.  This is typical of this stage of the economic and market cycle where value can just become deeper values while investors bid up for growth and are willing to chase it higher.  Speaking of growth, our New Power model (www.newpowerfund.com) is once again leading the charge among our investment strategies as an almost pure stock only growth strategy, investing in disruptive game changers with very high growth rates and yes real earnings.  New Power is angling toward +10% gains YTD, making another new high last week and continues to outperform the S&P 500 since the end of 2011 net of all fees.   New Power is not risk managed like our primary core strategies but relies on price momentum and selection to make returns.  I continue to actively encourage participation in this strategy but to do so with a light portion of total portfolio assets given the exposure and inherent volatility.

 

Special situations are also available.  As I mentioned last week, I continue to like the homebuilders even though they have had tremendous gains off the 2009 lows.  Take a look at this chart and ask yourself if homebuilders are in a good position now.  I think so – so does the market.

What we have seen from real estate in the last six years has been a complete depletion in the inventory of homes.  Existing homes for sale are nearly gone if one is measuring available inventory.  Furthermore, in the Northeast, bad weather created some very high pent up demand for homes with almost no building.  Last month we saw a near explosion of new permits issued for building in the Northeast.  These will sell because buyers have nothing else to buy.  Here in CO, 10 and 20 “bids” for home for sale are now common.  I don’t see this as the same situation as 2006 when such an event marked a top.  In this case, we’re talking about real homeowners that simply have no supply rather than “investors” chasing real estate prices higher.  With that said, I wouldn’t be a buyer of REITs or mortgage agencies as both are now highly prone to interest rate risk.  But Homebuilders have surprisingly low interest rate risk and are now in full swing helping meet the new demand.

 

What They Don’t Want You to Know  – Issue 1, Part 1

Starting with this Red Sky Report, I’m going to try to include a weekly segment that attempts to educate anyone who cares about investing realities.  I will do so until we recognize the next bear market is in place at which point, you will either be in good shape or not.   Frankly, I still see and hear too much misinformation out there for me to remain quiet.  Investors are poised to get burned badly again and they need a better understanding of how to manage their money so they can survive as an investors over the long term.  This is especially timely as we approach the End Game of nearly 30 years of falling interest rates.  The future will not be like the past on this basis alone.   You can put this knowledge into the camp of what the industry doesn’t want you to know.  You will not hear this from your Edward Jones guy who wants you to buy and hold commission based American funds forever.  You will not here this from any of the Robo advisor options out there because algorithms that rebalance index funds don’t write newsletters J  You will not hear this from any custodian like TD Ameritrade that suggests you “fire your broker and hire yourself” because you are the only one that really cares about your investment future?  Caring about your future does not mean that you are going to be successful in the least.  Knowledge, experience and discipline are what deliver consistent returns in all markets, so let’s get to it.  Today I’m going to throw out some bear market facts.  The intent is not to scare you or suggest that a bear is imminent but rather to understand the raw, quantifiable facts about their magnitude, impact and frequency.  This is about being prepared for known risks, as they will come as surely as an afternoon rain shower in Colorado.

 

Consider This – with special thanks to recently retired investment magician, comedian and historian, Greg Morris.

The Dow since 1955 to 2015 has drawdowns (loss periods) that look like this graphically.   60 years of data.

Statistically speaking, here are the stats:

Average Decline from the Peak                   -41%

Return Required to Recover                       +71.78%

Average Days in Decline                               557

Average Months in Decline                           32

Average Days to Recover                             1174 (gulp)

Average Months to Recover                         70.81

Average bear market duration in Months     103

Frequency of Bear Markets                          34% of the time

Now ask yourself if you, your broker or your Robo digital money machine is ready for this.  Do you plan to ride this out knowing these statistics?  If not, when will you act? Do you have a system that cuts exposure early in the decline or like most will you sell only after you “can’t afford to lose any more”.  Now look at the right side of the chart in the Red area.  Do you see a pattern that shows nearly zero drawdowns?  I do.

 

What can we expect next?  I’ll leave it at that.

 

Have a great week and know that we have the knowledge, experience and discipline to manage your investments appropriately in all market conditions.

Sam Jones

After six months of very junky action in the world’s financial markets, it’s safe to say that investors are getting tired and frustrated.  As of June 11^th, the Dow Jones Industrial Average is exactly 1 point higher than where it was on Dec. 29^th, 2014.  At the same time, it hasn’t been as quiet as you might think.  This is a market of winners and losers and I wish the list would remain consistent.  As of this moment, the market situation has moved to “the edge”.  This is that place where we need to see buyers step up and support the market or we should be read to act defensively as further losses become a reality.  This update will give a quick market snapshot so you can see the edge I speak of as well, map out a possible bottom this summer and identify sectors, countries and investment styles that still look compelling to me now.

 

Volatility is low?

 

As a quick note stemming from the fine work of Lowry’s Research this AM, we are told that market volatility is extraordinarily low thus far in 2015.  Let’s take a look at volatility because the market doesn’t feel calm to anyone.  Here’s why.  On a point-to-point basis, with nothing more than 1 point to show for gains in 2015, one could argue that the stock market has flat lined.  Again, only looking at point-to-point numbers, that is the case.  As of June 11^th, we have seen 112 market days.  During the time the Dow Jones Industrial average has moved a total of 12,669 points however!  Doing the math, we find an average daily move of 113 points/ day, just over .60%!  The same calculation for the S&P 500 shows an average daily move of 12.68 points, again around .60% daily moves.  These are relatively large numbers for a flat line market.  What we are seeing a market that has as many negative drivers as positive drivers giving it little reason to move sustainably in one direction.  But make no mistake, part of our collective anxiety has to do with the very high daily volatility we are seeing and feeling.

 

Net Exposure Model  – Neg to Neutral short term,  Favorable long term.

 

After swinging slightly negative in the first week of June, our Net Exposure model actually improved slightly last week to almost exactly neutral (50 out of 100 points).  This calls for a “hold” mandate meaning stick with what you have and avoid the temptation to buy or sell until we have more directional reasons to due so.  Upgrades are ok.   One interesting development caused the improvement in the model.  It came from the contrarian sentiment piece where we saw a dramatic shift in the sentiment of the “Big Money” commercial hedgers.  According to Jason Goepfert of Sentiment Trader.com , the “Big Money” commercial hedgers showed a huge $10 Billion swing in their net exposure to be the highest level of exposure to stocks in more than three years.  What do they see?  I couldn’t say.   Meanwhile mom and pop, the small do it yourself investor, has simultaneously become as extremely bearish as we have seen anytime in the last 4-5 years.  Sentiment trader did some great work looking at forward returns for the S&P 500 when the spread between “Big money” and Mom and Pop become this wide (+100).  It has happened only 5 times since 1990 and the results are pretty incredible for the market.  In the short term (inside two months), the S&P 500 has run into trouble with some periods of loss ranging from -1.3% to -10.5% (1998).  Gains over the same time period were also pretty meager showing 2-3%.  But starting in the 3^rd month after the +100 spread event (now), we see the S&P 500 put up some very nice numbers finishing with median gains of 12% after 6 months, 17.9% after 9 months and 20.8% after 12 months.  Again, these results are only looking at things from a sentiment perspective.  Much can happen both technically and fundamentally to change these outcomes.

 

Timing a Bottom This Summer

 

I’m going to take a stab as at a possible timing scenario for a potential buying opportunity this summer.  Don’t hold me to it.  Given the current trend, which is messy and generally negative, I don’t see much catalyst for a big move higher between now and the end of the quarter.  July will usher in a new earnings season chuck full of more winners, losers and surprises.  Given the persistent strength in the US dollar and weakness of most foreign currencies, I think it’s still very likely that large cap earnings will continue to disappoint while domestic small caps that are not as exposed to currency risk, should continue to surprise to the upside.  Meanwhile, we have the Federal Reserve angling closer to lift off with raising the Federal Funds rate and they are still likely to do before Halloween by most measures, perhaps even September if we continue to wage inflation in the system.   Being the excellent forecasting mechanism that it is, the market may very well find one of those great tradable buying opportunities between now and the middle of August when most earnings reports are done and out in the public.  Greece will be behind us at that point one way or the other and most will have oriented to a Fed Rate hike by then.  So while you’re sitting on the beach, not thinking about the market, in the very heat of the summer, we could very well have a great moment to buy stocks.  Between now and then, we’re playing defense.

 

Resilient Investment Options For Now

 

Here’s the stuff I still like and intend to hold in our strategies as they have good ingredients and are not likely to be impacted by any of the above.

Small Caps – For reasons outlined above – mostly growth

Homebuilders – Benefitting from low inventory and high demand for real estate.

Building material companies – same reason as above

Furniture and appliances – same reason

Japan – like the GDP growth and like the massive stimulus – devaluing the Yen.

Financials, Banks, Insurance, Brokerage – Benefit from higher rates

Broad based Healthcare – Demographics and Obamacare supportive for a long time

Select Technology – Cyber security, social media and internet mostly

I can’t say there is much I like outside of this short list so naturally, we’re going to be raising cash until that situation changes.

As a final note to all clients, please remember that market returns do not come in a straight line.  This is one of those times when big chunks of the financial markets are going to slip negative, many already have and moved into double digit losses.  Several of our strategies have slipped slightly negative YTD but I’m not worried about it.  That’s the nature of the beast.  We work hard to make the right choices for the future.  We keep our periodic losses manageable and recoverable and we make adjustments as necessary.  In five years, I don’t know if the markets will be higher or lower than they are today. Perhaps we are staring straight into the jaws of the next bear market; maybe this is just a pause in the great bull market. No one can know the answer beyond speculation.   But my confidence level for our strategies is much higher within that time frame as the vast majority of strategies and client account balances tend to make all time new highs regularly and within 18 months following major bear market declines.  Where will we be in five years?  Higher.

I’ll leave it at that – have a great week

Sam Jones

Back in the late 90’s, I ran a series of articles and presentations called, “Crossing Wall Street… and learning to look both ways”.  I should have written a book but that’s far too sensational for my personality.  Anyway, as the market approached extremes in valuations and money was flowing into stock funds at $70 Billion/ month, it was pretty obvious that investors needed some healthy reminders about risk and investing realities.  Of course, less than 6 months later, we saw the bursting of the dot.com technology bubble and thus began a period of nearly 13 years of frustration for investors.  Then, the content of Crossing Wall Street was clearly a warning.  Now, I have a similar type of message about investing realities in the current state of the financial markets.  Think of this as a more gentle warning.

Bad Behavior is Back

The chase in on.  Investors are looking backwards at returns, seeking out the largest, most outrageous gains over the shortest time period and yes, you guessed it, plunking down good hard earned capital on that pony.  With past returns like that, what could go wrong right?  You know the answer.  Reality check number 1;  returns made yesterday are gone.  You cannot go back in time and wish yesterday’s returns into your portfolio regardless of how much you want or need them in your life.  Furthermore, buying shares of something that has already moved meaningfully higher without waiting for at least a short-term correction is a recipe for you to continue losing money. The good news is that opportunity will develop again for those who are prudent and patient.

Also in the bad behavior camp is the siren song of portfolio misallocation.  At this stage of the game the concentrated stock model sales guys come out in waves, tidal waves (Ken Fisher and the like).  They point to their backwards looking performance after nearly six bull market years and say, yes Mr. Retiree or person without income, you need to be in a concentrated stock portfolio.  The justification is always the same.  They say that the best returns have always come from stocks and “we own the best of them, yessiree”.  Stocks have traditionally offered investors the best returns…. As well as the greatest losses.  In the last 15 years, we have seen not one but two market cycle losses of 50% or more.  In 13 of those 15 years, the markets did nothing but trade in a wide range of loss of recovery with zero net gain (January of 2000- Feb. 2013).  Many of the “Best stocks” of 2000 have just started to recover their multi-year losses.   The sales pitch says that losses are part of “the game”.  Well some degree of volatility needs to be tolerated but I don’t have any tolerance for games in which I lose 50% of my net worth ever.  Here’s the reality check;  This is one of those times when we need to tolerate some volatility in the markets.  But when volatility turns into the risk of permanent or difficult to recover type loss, then we need to take action by becoming more defensive.  We may also be nearing that point in the markets today.  On the other end of bear market declines (near the lows), we tend to build more concentrated positions in stocks and sector ETFs.  Now, in this late stage of an aging bull market, we are doing just the opposite by spreading out and diversifying our holdings across non-correlated assets.

Bonds are No Longer a Conservative Investment

Bonds of all types are under heavy selling pressure and it does not appear to be the end.  Intermediate term Treasury bonds (7-10 year) are now down almost 5% from the highs in February including all income payments.  Long-term Treasury bonds are down almost 6% YTD and -14% off the highs in January.  The reality check comes home when we realize that there is no such thing as a safe investment unless you are talking about pure cash and even that is subject to currency and inflation risk.  All things in the money world are subject to varying degrees of risk (stock, commodities, bonds, real estate, etc).  Bonds, especially US Treasury bonds, have a long been considered one of the safest investments in the world.  In fact, trillion of dollars of investment capital lives inside Treasury bonds assuming the full faith and guarantee of the US Treasury (+ unlimited printing of US dollars).  Retirees and sovereign countries assume that they are “conservative” and out of harms way by owning bonds.  As Bill Gross and others will attest, that assumption may be challenged with the next cycle.  Why are bonds losing money?  Economically, they tend do so on a cyclical level when signs of inflation are present, like the mid to late 70’s.  Today, we have very little inflation in the system but there are whispers.  The real drive behind sellers is simply a game of relative opportunity.  There is just little to no opportunity left in Treasury bonds after nearly 25 years of rising bond prices and falling interest rates. Bonds are going down for technical and fundamental reasons and they should not be considered conservative or safe investments to anyone at any age.

Withdrawals are Regular, But Returns are Not

These cycles of flat returns or even mild losses in one’s portfolio make retirees very nervous, especially those who are new to it all.  When we are making income and salaries, in the back of our minds, we sleep with a sense of security knowing that we don’t really need our investment accounts as we can make ends meet with current income.  In retirement, of course it’s just the opposite.  Retirees who are living off of their investment accounts, might have a reasonable 4-5% withdrawal rate against their balances, which is never a problem when stocks are making 5-15% annually.  Since July 3^rd, 2014 the NYSE has lost 1.31%.  The Dow Jones World Stock Index, our benchmark and one of the best performers YTD is still down 0.82% since July 3^rd of 2014 – approaching one year.  So far, 2015 is angling toward the reality that stock markets rarely complete seven consecutive positive years without a correction or newly established bear market.  The odds are increasing that anyone withdrawing from their investments in 2015 is simply going to be dipping into investment capital this year rather than essentially skimming off returns to cover living expenses.  If returns could be earned with the same consistency as withdraws, there would never be an issue and after the last two years, it almost felt like that was the case.  For those who attended the annual meeting last October, you might remember my commentary about No Free Rides From Here On including the silly little graphic below.

What I meant was that returns would not be as consistent or dependable looking forward as they have been in the past several years.  Retirees and those living off of their accounts will need to get used to that reality and grind through cycles of flat returns trusting that gains will come again (and they will!) to refill the hole.

Bull Market Alive As Long As Rates Remain Low

For now, the trend of the world’s stock markets is still up.  However, we are in the midst of a new correction cycle, which is spreading across sectors, countries and asset classes quickly.  We have made some minor internal changes in our strategies to accommodate the new weakness and respect some of the technical problems we’ve been talking about for the last several months (new lows in Transportation and Utilities, lost leadership, rising rates, high margin debt, higher valuations).  As a bull market ages, we start to see deeper corrections develop before the final peak and this feels like just such an event.    Trends in interest rates are going to be the determining factor in the longevity of this bull market.  If rates can settle down a bit and hold near or below the 3% level on the 10 year Treasury bond, I think stocks can push on to new highs.  A strong rate move above that level would indicate a long term trend change for interest rates and stocks are likely to struggle, perhaps enter a new bear market.  Given current valuations, I see more sensitivity in stocks to rising interest rates and borrowing costs.   Beyond an obvious fear based reaction to the Fed’s first rate hike, which may be happening now, the real risk to earnings and the economy will come from higher borrowing costs and potential inflationary pressure in the form of higher wages and material costs.

So here’s the short list if you need a recap

Reality Check (list)

*  You cannot wish yesterday’s returns into your portfolio.  Do not chase!

*  Keep your portfolio allocated according to your risk tolerance and angle toward diversification, away from concentrated holdings.

*  Being conservative does not mean investing in bonds

• *  Withdrawals schedules do not always match your return stream
• *  This is likely to be just a stiff correction in an ongoing bull market
• *  Watch interest rates, not the Federal Reserve
• *  Remain focused on risk management in this aging bull market!

Sincerely,

Sam Jones

I keep a journal of my market thoughts and observations each day.  It’s just a cheap bound writing journal book like any you would use to write essays back in school.  I date each page and literally scribble stuff like which sectors are leading, important lines in the sand for certain stocks or market indices.  It’s a mess but strangely I like it that way.  I make special notes about ideas I’d like to research further.  I circle things 20 times if it’s a WOW thing.  Softer ideas are barely legible.  The value of the journal is that I often find many of these scribbles to be predictive clues about real opportunities and threats even if they were just hints at the time.  They act as my own early warning signs giving me a chance to watch and wait for confirmation from our more defined investment process.  In a way, the journal provides a mechanism to build confidence for that important moment when we must act.  It also serves to remind us of lost opportunity when we fail to do so.  Here are a few relevant notes from my journal that you might find interesting.

2130

I circled this number many times on my April 24^th Journal entry.  I can barely read my own writing these days but above it, I also wrote Break out or Fake out?

On that day, the S&P 500 made a valient attempt to make a brave new high but ultimately closed at 2117, the same close that we saw on March 2^nd.  Intraday, the index did move out to 2130, so that was my new line in the sand to mark a real breakout from this very long and unproductive flat spot in the global stock markets.  Almost one month later during the entire week of May 14^th, I read one headline after another revelling in the glory of ALL TIME NEW HIGHS for the market.  So I flipped back to this page in my journal and saw 2130 circled.  No, the market did not make a new high! They got it wrong – another clue.  Yesterday, the S&P 500 lost over 1% taking the index back below all of the closing high levels of the year (again).  The markets are still treading water and what was sold to us all as a clear break out to all time new highs so far has proved to be just another visit to the top of the 2015 price range.

Looking for GARP stocks

Also in my notes was a clue to look into growth stocks selling at a discount  (GARP= Growth At a Reasonable Price).  On the same note page from April 24^th, you might be able to see he symbols QCOM and BABA noted near the bottom. While the global stock indices continue to sit idle waiting for some catalyst to break out or break down, I continue to see some reasonable opportunities developing in individual stock names from the GARP perspective.  Conceptually, investors are probably conscious of the fact that summertime can be troublesome for the markets as a whole and might be searching around for relative value not to be confused with deep discount value stocks.  Remember, this is still a growth market, we’re all just looking for a few things to buy on sale.

Thankfully, there are lots of names out there that have been beaten down for a variety of reasons. The situations that we find attractive now are those companies that have been market leaders for much of this bull market but have recently gone through healthy consolidations in price offering us a potential entry point for new buys.  These are growth companies selling at a reasonable price.  We are looking for trailing 12 month P/E ratios below market or below their historical norms.  We are looking for companies that have reasonable debt to equity so as to not make them overly dependant on financing in a potentially adverse interest rate environment.  Similarly, we are looking for high free cash flow to enable shareholder dividends, organic growth or possible acquisitions.

Today we bought into Qualcomm (QCOM) in our All Season strategy in the dividend payers bucket after “noting” signs of high volume buying on the 14^th and 15^th of May.  The stock retraced a bit in sympathy with the US stock market over the last several session providing us with a nice entry point today.  Qualcomm fits the bill for the type of growth stock we are looking for.  For those looking for a solid growth stock subscription service, I have found the CheckCapital.com, Blue Chip Investor to be an excellent source.  Author Steven Check sticks to his guns with his fundamental work but doesn’t even try to mitigate market risk or do any sort of technical price trend following.  That can be tough in a bear market.  We do own several of his recommended stocks in our strategies but wouldn’t hold most through a nasty bear market.  I clipped this graphic of the relative P/E values for Qualcomm dating back to the early 90’s from his May Newsletter.

Today’s P/E of 13 is obviously pretty darn cheap for a company that has an18% trailing 5 -year earnings’ growth rate, zero debt and returned $8.1 Billion to shareholders in 2013 as dividends from free cash flow.  Furthermore, Qualcomm is in the right sector for this market (semiconductors) and has a 97% market share in 4G LTE chips for smart phones.  Pretty good looking at this level; now if the price will just do a little jig higher for us.  There quite a few other growth names out there all with different stories and developing opportunities while the global stock indices are stuck in the mud.  But the theme of looking down for growth stocks is one that has been notable since March.

Asia/ Japan

 

My notes have scribbles everywhere about Japan and China.  These countries continue to sit solidly at the top of our weekly rankings.  Honestly, it’s been a tough train to catch which probably means both have a long way to go higher.  The longest and strongest bull markets are always the hardest to find good entry points.  Japan in particular is coming out of a three DECADEs long recession.  They have become as lean and mean in the process as possible given their very high values in the Yen.  Now that the yen is in reverse, we have that situation where Japanese stocks can be wildly profitable with a nice currency tail wind, especially those in the export business.  I wish we owned more pure Japanese funds and ETFs and we may just have to chase this one.   I had to break into my 2012 journals to find the first “clues” about the rise of Japan.  I even wrote about it on the Red Sky Report in early January of 2013 “Watch the Rising Sun”.  But damn if I haven’t ignored the clues.  I don’t think it’s too late but wanted to call out the fact that writing down a good idea means zero if you’re not willing to act on it.   China is in a long term bull market and now leading other world markets higher.  I do not find a 7% GDP number to be bad in any way despite coming down from 9% in the last few years.  The shear magnitude of a country the size of China emerging from its status as an undeveloped country to a global leader has long term bull written all over it. We are building long term core positions in Asia/ Pacific and Japan in all strategies now.

 

The point of maintaining a journal comes home during these periods when opportunities lie outside the mainstream index mania.  We need to listen a little more closely to subtle clues and recognize where to look and when to act.  In fact, several of my recent journal entries are circling around the very concept that our markets have rewarded overly simplistic passive index strategies for too long, perhaps another larger change is coming.

That’s it for this week – Monsoon season seems to be coming to an end up here in Steamboat Springs.  Looking forward to something called spring.

Cheers!

Sam Jones

Here’s the deal.  You have a one in six chance of winning.  It costs $10 to play and you have the chance to win $1Million in cash.  Pretty good odds right?  If you want play, read on.  (hat tip to recently retired Greg Morris for this)

The Cost of Not Winning

The game is called Russian Roulette.  Still want to play? Hmmmm maybe not.  Despite the favorable odds of winning and the bountiful reward for doing so, we just don’t like the cost of not-winning (death) enough to play that game right?  You know where I’m going with this.  After 12 back to back meetings with clients over the last two days, I heard a common theme emerge.  Everyone had noted the “flatness” of returns over the last 6 months or so.  True many market indices did peak in July of last year when the US dollar developed a very strong uptrend taking down earnings for the last two quarters substantially.  Domestic stocks have simply moved in a pattern that reflects a soft spot in the economy and a zero sum game among dollar related winning and losing sectors.  Take a look at the chart below.  In Red, I show the NYSE Index and in Green, I show UUP, the rising US dollar ETF.

 

Notice how the NYSE went flat starting almost exactly at the time when the US Dollar started to rise dramatically.  Also notice that the stock index is trying hard to break out of the flat zone with the recent weakness in the US dollar but has yet to do so meaningfully.  Our own strategies have followed a similar pattern to the US stock market albeit with a slight upward bias and less weekly volatility.   So the flatness and the lack of returns since last July is being noticed and there are two ensuing questions that emerge.

The first is, is the market getting ready to crash as so many predict?  We have no way of knowing that answer, so I shrug and say, “I don’t know”.   Anything can happen at any time in the investing world.  However, we do our have our indicators that help us assess overall market risk.  At the moment, we don’t have much indicating that this flat period is anything more than a healthy digestion period or an adjustment cycle as investors get ready for a less accommodative Federal Reserve (read rising rates) and the realities of a stronger US dollar.  Frankly, I’m very impressed with how well the market is behaving considering recent economic reports and earnings!  This is an overly simplistic assessment but so far, we don’t see this pattern as anything other than a long pause in a long but aging bull market.

The second question is always about taking on more risk to generate more returns.  These are the emotional strings that pull us toward risk when perhaps the COST OF NOT WINNING that game are now too substantial.  I think the situation in the market calls for a hold strategy from here on out frankly.  In other words, if one feels compelled to make money every week and every month, then it will require a lot of return chasing at this point. The odds of being rewarded for that additional risk taking (buying more stock or stock indices) are still reasonable but I do wonder how much of that return you will ultimately keep?   Back to our game-riddle.  There is likely more return available in the markets.   But as I clearly stated at the annual meeting last October, there are no more free rides.  Returns will be earned in a much higher risk environment from here on out for reasons that I will outline below.  We are comfortable remaining fully invested in our various strategies because we are also quite confident in our system, which will lead us to become more defensive at the appropriate time.  But for those who think they are capable of passively holding their investments through thick and thin, you should understand the real cost of not-winning this game.

According to the excellent research of Jim Stack with Investech Research, over the past 85 years of market history, every bear market except one (1956) has recaptured or repossessed close to one-half or more of the previous bull market’s gain. Out of 15 identified multi-year bear markets, five of them repossessed more 100% or more of the entire previous bull market gains.  He estimates the potential loss in the broad based S&P 500 index to be something close to -34%.  Of course, that’s just an average so the carnage in certain areas would be far worse.  Again, I am not suggesting a bear market is immanent at this time but simply pointing to the costs of not-winning.  Even if the odds of winning were 1 and 6, the costs of not winning (like Russian Roulette) suggest this is not the time to take on additional risks in your portfolio without a robust downside protection system to guide you. Passively owning a bunch of low cost stock index ETFs is the absence of system despite what the media tells you.

 

10 Real Risks to the Market

I’m going to keep this brief and in bullet point fashion to get it out without pushing your patience.  They are as follows (again, thanks to Jim Stack for the top 6):

1. 1. The age of the current bull market – one of the longest and strongest in history – all behind us.  What’s next?  Another super strong bull market?  Not likely before a substantial correction.

2. Margin Debt –now at the same levels we saw in the year 2000 and 2007, both peak years for the last bull markets.

3. Sentiment is too bullish among Advisors – Again at levels seen at significant market peaks.

4. Corporate profit and earnings may have peaked – while still positive the rate of change in earning is now turning negative from a historically high level.  Investors only care about the direction of earnings, not the absolute value.

5. Market momentum may have peaked as far back as March of 2014; many prices may have done so in July of 2014 as well.

6. Valuations are high – Same level as many other major market peaks.

7. Cyclical sectors like Transports are not confirming recent highs in the Dow.

8. Utilities are also not confirming the move in the Dow – Dow Theory sell signal.

9. Fed is going to raise rates in 2015 – Market typically experiences an 8-10% correction at or before that event.

10.  Market may be losing its leadership – Tech and healthcare have been the leaders.  Keep your eyes on both.

All in, I would have to say that market action over the course of the next 2-3 weeks will be critical to watch as an strong indication of whether or not we are headed for deep correction this summer or whether we can see another surge higher to Dow 20,000.  We continue to hold and hope for the later but also ready to cut and run if necessary.

Have a great week and know that we are very carefully watching this situation.

Cheers!

Sam Jones

President, All Season Financial Advisors

In 2014, we conducted one of our Solution Series webcasts called “Getting Out of Balance”. The webcast was predictive at the time suggesting that investors avoid becoming complacent about the safety and security in things call Balanced Funds, or Life Strategies or Target Date funds. These types of funds tend to own a prescribed mix of stock index funds and US Treasury bond funds usually in a 60/40 split respectively. These funds represent $ Trillions of dollars inside 401k and other retirement plans as they have successfully appealed to investors who like the idea of robotic investing solutions. Historically, these funds have done well as bonds have done their job in providing healthy returns plus a safety net when stocks fall. I firmly believe those days are coming to an end and investors are going to need to consider a more unbalanced solution if they want to continue making reasonable returns in the future.

 

Where’s My Safety Net?

 

For nearly the last 25 years, investors have grown accustomed to the fact that bonds move inversely with stocks. When stocks fall, bonds rise right? And with that relationship, we can easily build a well-diversified portfolio of stocks and bonds (aka balanced funds) that move ever higher with tolerable portfolio volatility. But the success of this magical portfolio relies on a few key ingredients. The relationship between bonds and stocks must generally be one that is inverse on a weekly and monthly basis. But more importantly, we must also have longer term rising trends in both stocks and bonds (prices). After all if one of our two major food groups enters a protracted decline like something we have seen in real estate, Japan, or Gold, then that major food group fails to carry it’s weight in our balanced portfolio or fund. Treasury bonds have been in a 25 year bull market through all types of economic environments. The bond uptrend has only seen periods of acceleration when stocks move into bear market declines as they did twice in the 2000’s. Now fast forward to today. Treasury bond yields are (were) very nearly approaching their lowest levels in history and offering close to negative rates net of real inflation (2% ish). The same thing has happened to the bonds (Bunds, JGBs, etc.) of all developed nations around the world. All have approached the zero line in terms of yields with literally nowhere to go but up. Some countries are dabbling with negative real yields in the context of desperate attempts to spark economic growth but of course this is not sustainable. German Bunds are now reacting to nothing more than the underlying unattractiveness of this asset class and global investors are dumping them as quickly as possible. In the last couple weeks, German Bunds, once thought to be one of the world’s greatest safety net type investments have just caused incredible wealth destruction. Here’s a five-year picture of the 10-year German Bund Yield. The recent move up in yields, down in price, is significantly more meaningful as these rates are coming off of the zero line.

The same story and the same risks are now present in the US Treasury bond market. The US bond market safety net might very well be broken already. Since the end of January, the 20 year US Treasury bond is down almost 12%, -4.5% YTD. Balanced fund investors haven’t really noticed yet as stocks are up about 6% since the end of January, but only up 2% YTD. They are looking at monthly statements now with a quizzical look wondering why their account is still stuck at zero or more likely negative YTD depending on the stock/ bond split. The message to all investors is this. Be aware of the fact that developed country bonds are now under heavy selling pressure. These have been the safety nets to global investment portfolios for years. Consequently, I believe there is a strong likelihood that developed country bonds are going to become dead money for quite a while until rates move substantially higher over the course of years and all things resembling a “balanced” fund might get very unproductive from a return prospective.

Good News for Tactical Stock Investors

While I hate to lose an asset class as large and as giving as the US Treasury bond market, I’m happy to say that the End Game for the US bond market might be an enormous tail wind to tactical shops like ours. In the last year, we have tactically reduced our exposure to bonds of all types in our blended asset models to less than 20% and moved to other types of bonds and income bearing securities in our pure income models. All stock models are always all stock of course. In place of bonds, we have beefed up our allocations to alternative securities all of which are doing very well in providing stable, non-correlated returns to our portfolios. We are also carrying a higher weight in stocks versus bonds, as that is where returns are still available. The relative performance has become more pronounced in recent weeks.

Our tactical methodology identifies relative strength among asset classes, styles and sectors and dynamically allocates our client’s money accordingly. We are not stuck in a prescribed 60/40 mix of market indices of any type. Many are of the belief that rising bond rates are bad for stocks. Historically, that isn’t true until interest rates move well above 5% (10 year). We are currently hovering just above 2%, so a long way away from 5%! In the current environment, rising rates are almost constructive to stocks outside of those sectors dependent on forever-low rates or companies operating with high debt to equity. Selling pressure in our bond market will factually drive investor capital to new investments probably those paying some interest like equity dividend payers again, so the event sort or creates underlying buying pressure for stocks. At the same time, we’re seeing investor sentiment numbers at some of the lowest readings in years as of last week. Very low “bullishness” readings are often excellent buying zones for stock investors. For those in the tactical world, considering the new selling pressure in the global bond markets, we might now be ready for a healthy stock rally through the summer perhaps into July. Lowry’s Research just gave a new “Buy” signal for stocks at the close on Friday, just as everyone was getting comfortable with the idea of Sell in May and Go Away. It’s never just that easy is it?

 

Now get outside and enjoy the springtime!

Sam Jones

President

For the moment, the widely heralded breakout to new highs on the 24^th by a select few stock indices may have been just another short visit to the top of the trading range established in both December and February.  The US stock market is just not ready to get off the treadmill quite yet.  We are starting to see some dramatic moves and rotations in other asset classes and select sectors that are worth our attention in the meantime.

US Stock Market Still Range Bound

This is about that time when we all start to get a little tired of not making real headway in our portfolios.  Range bound markets are tough, especially ones that trade within a 5% band like today.  By the time you might consider buying something, the market is already at the top of the range.  And just when you’re ready to sell, like last Thursday, buyers show up again at support.  YTD, the S&P 500 has been trading in a range of -3% to +2.86%.  Our strategies in aggregate have a slightly better looking range of -1% to + 3.5% .  Remember of course, that statistically our returns are earned with a fraction of the embedded risk inherent to any fully invested stock only index like the S&P 500.  Investor sentiment figures and consumer confidence are sort of telling the same story as I believe the two are highly correlated now.  Both say that the guy on the street isn’t expecting much and tends to carry a negative bias toward the future.  Fundamentally and technically, it’s hard to disagree with that opinion.  The US economy really stalled out in the 4^th quarter of 2014 and has been statistically working its way lower on practically every measure since.  Technically the deterioration that began in February is still in place showing up in the price treadmill.  Selectivity continues to be the theme of the year, consistent leadership is hard to find and cyclical groups are reflecting the obvious soft spot in the economy with consumer, transports and others still under selling pressure.  But all is not lost.

The most important thing for all investors to see and understand now is that the primary trend of the GLOBAL financial stock markets is still up, thready but up.   Some will suggest they know the future.  They will appeal to your sense of fear and present speculative evidence that the market has peaked;  time to get defensive! Sell in May and go away!  Maybe they’re right, but we should also respect the fact that we have been in this situation four times over the last five years with economic conditions that were quite a bit less attractive (weaker labor market, soft housing market, stimulus propping things up).  And from these moments of despair, the market found buyers.  Prices subsequently pushed higher and higher.  This is quite literally, the Wall of Worry that defines long term bull markets in stocks.  We have been expecting a normal correction of at least 8-10% for over two years now and yet the US stock market hasn’t been able to pullback more than 5%.  Even today, the S&P 500 is only 1.5% below its all time high.  All of this talk makes me sound like a pure market timer which I despise so let’s get back to our regular focus on (Dynamic) Asset Allocation, Selection and Position Sizing to make sure our money is in the right place.

New Rotations and Possible Trend Changes

The big news is the short term reversal in the trend of the US dollar, which seems to be driving returns in many different areas of the financial markets.  The new correction in the US dollar is probably just that within a longer term move higher in my opinion but for now, we have to respect the correction and what it means to our holdings.  Small caps benefit from a rising dollar and large caps benefit from a falling dollar.  In the last week, we have rotated from small cap growth to large cap growth and value positions.  Also a falling US dollar tends to be supportive of commodity groups including oil and gas.  Here again we have found good reason and solid entry points for new buys in the oversold energy sector, which offered some nice positive diversification to falling stocks and bonds last week.  Energy and oil positions were up 2-3% on the week while everything else saw red.  We aren’t yet ready to buy pure commodities funds, as our system doesn’t allow us to own things in defined downtrends.  Commodities are still in a downtrend but working hard to find a bottom.  Maybe soon.

Finally, a falling US dollar gives bonds sellers one more reason to dump and run.   As I write, the 20 year US Treasury bond is now negative on the year, down 1.47% and most aggregate bond funds and ETFs are also slipping negative YTD.  Bonds are in a tough spot with more than just the falling US dollar to worry about.  They have additional headwinds coming from new inflationary pressure coming from wage growth and they have a potential bottom in the price of oil and gas, which is also inflationary.  They have a Federal Reserve that has just told the world “Any time now” and finally they have their true value proposition, which is just unattractive from a risk and current yield perspective.  As I have said many times in the last several years, bonds, specifically sovereign debt, will not offer investors the same safety net they have over the last 25 years.  Perhaps as a sign of things to come, Euro zone bonds were crushed last week erasing over $60 Billion (USD) in value in just one day while their stocks markets sold off harder.  Our own multi-Trillion dollar Treasury bond market is down over 10% now from the February highs.  Again, both stocks and bonds sold off together here at home last week.  I think we’re going to see more of that looking forward.  Every pension plan, every foundation, every endowment and every investor who is relying on the long standing role of Treasury bonds as their only safety net, may be sorely disappointed.  Returns for the standard 60/40 portfolio (stocks to bonds) are already tapering to an average annual 2-3% which may even fall below the inflation rate in the coming years.   Those with conviction might even consider a short position against bonds now as small hedge and complementary diversifier.  Right now, our hedges in both Income models represent almost 30% of the portfolio.  They are by way of floating rate funds (Hartford and Guggenheim) and a single diversified Income fund with a net negative position against the 7-10 year Treasury bonds (Putnam Diversified Income Fund – PDINX).  The chart below shows the 10-year Treasury bond in Green to our Floating rate funds in yellow and red and our Putnam fund in Purple over the last three months.

In addition to the obvious price trend advantages shown, our holdings are also paying 4-5% annual income while the 10-year Treasury bond rate is only 2.14%.   All charts above reflect total returns including capital gains and income payments.

Dynamic Asset Allocation, Selection and Position Sizing

Most sophisticated asset management firms are now lightly moving into true alternative positions as a risk diversifier.  We have been doing so ourselves for years and it’s nice to see so many liquid options now it the alternative space.  We have nearly 400 investment choices in our evolving universe of alternative securities. These funds march to their own beat, have very low correlations to either bond or stock markets and offer an investor true diversification where it’s becoming scarce.  But as you know our system also has a tactical foundation, which sort of makes our entire shop “alternative” to a degree.   The dynamic changes in our asset allocation, described above, respond to changing market conditions.  The selectivity of owning leading sectors and securities is also tactical and alternative.  Position sizing is another of our dials in our tactical system but at the moment, we don’t have strong conviction in anything so nothing is really notably overweight or underweighted.  I mention this in light of the current and future market conditions, which to me are clearly going to reward more sophisticated asset management systems.   Treadmill conditions might persist for longer than most investors would like but there are other more sinister risks to ones portfolio especially for those relying on asset class relationships of the past.   I am grateful to have my personal assets right next to those of our employees and all of our clients under the umbrella of our well seasoned system.  I hope you share my enthusiasm and confidence.

Have a great week

Sam Jones

Last Friday marked an important day in the financial markets – to some.  On that day, the Nasdaq Composite finally made an all time new high from the level set in March of the year 2000.  Yes, it took fifteen (pronounced Fif – teen) years for this brave index to recover from the losses incurred through two devastating bear markets in the first decade of the 21^st century.  I have that same feeling when I see a child get a ribbon for getting last place in a competition.   Not to sound heartless as I have two children of my own who have their share of last place finishes, but what message are we sending when we celebrate failure.  I’ll give the Nasdaq composite a nod for participation, but let’s certainly not congratulate one of the worst investments in the stock market history!

Lessons in the Value of Risk Management

I won’t belabor this point as we all know it well, but the final recovery of the Nasdaq Composite index has to be highlighted as a classic example of why a robust risk management system must be part of every investor’s approach.  Fifteen years is a long time considering the average investor only has the bulk of their investment assets at work for 22 years on average.  I feel badly for the mass of investors who bought into the technology craze of the late 90’s just as the dot coms turned to dot bombs.  Did they have the strength and the will to hold their Amazon stock through a 92% decline from the peak in early 2000 to the low in August of 2001?  Of course not.  They sold, at or near the lows and we know this by looking at the sell side Volume in 2001.  Now, fast forward to today.  Amazon just made another all time new high and is up nearly 400% from the highs in early 2000.   I’m picking on Amazon because I got a lot of calls last week wondering if Amazon was a buy (now).  The answer is no.   The most recent and obvious buy was in late 2014 around the $300 price level when everyone thought Amazon was dead for good.  In full disclosure, we did buy a position in Amazon for our New Power strategy on November 11^th, 2014 after Amazon had completed a 12 month consolidation in price.

Risk management is a two-sided thing.  One side protects us from the downside by telling us when to sell holdings that are reversing into negative price trends.  The other side of risk management protects us from buying things that have already moved far beyond the scale of reasonable.  At the moment, there are lots of stocks making significant moves higher, especially in the limelight technology names.  Some are way out there and not attractive anymore.  Others are just now waking up and breaking out of long consolidation patterns like the chart of Amazon above earlier in the year.  Remember, buy low, and sell high right?  As we watch the Nasdaq Composite finally break out to an all time new high, we should all use the event as a strict reminder that simply putting money into the stock market is not a guarantee of success, especially if one is in the hold an hope camp.  Entire countries (Greece), sectors (Energy) or asset classes (Gold, Commodities and Real Estate) all have their days.  Our job is to execute our system, to stick with leadership, invest in things trending up (not down) and avoid the permanent loss of capital (aka Risk).

Back In Gear

Last week was a good one for the US stock market and I will celebrate that!  Many of the issues I discussed last week including high selectivity, unproductive results and lack of leadership, simply went away with a single week of quiet trading.  Now, technology is back in gear as is the consumer discretionary sector.  Transportation finally found a bottom and is trading higher.  Even the sad and pathetic NYSE finally pushed out to a marginal new high in a race for last with the Nasdaq Composite.  Technically, we saw a surge in volume with confirming breadth and participation and now the rest of the world is also leading higher including emerging markets, China, Europe and Japan.  Still early in the earnings season, we also see 77% of companies beating VERY low expectations and over 50% are beating revenue estimates so it looks again like analysts have been far too pessimistic toward earnings.  Investor sentiment is still pretty bearish to neutral which tells me there is more upside ahead.  The US dollar has been blamed for much that has inhibited growth among US companies in the last 9 months.  Now it seems the trend of the rising US dollar is slowing down thankfully, even correcting some.  Is the uptrend in the US Dollar over?  Not likely.  If history is our teacher, major currency trends tend to last a minimum of two years so we’re probably not even half way.  Don’t bet against the rising US dollar unless the US economy slips solidly into recession.  As discussed last week, there is a growing risk of that event but no clear signs of recession yet.

Don’t forget, stocks and stock markets simply reflect a basket of expectations about the future of earnings and the economy.  As such, stocks tend to put in a peak at least 8 months ahead of a formal peak in the economy.  With all time new highs in several key US stock indices again, the “expectation” is that the US economy will not peak for at least another 8 months.  With many economic reports at the zero line and threatening to turn negative, we might therefore expect a robust economic bounce from this level.  We’ll see.  What would change the picture would be a swift and severe decline right now, right here, erasing the breakout of last week and taking us back under the highs set last July which happens to be….. 10 months ago!  I’m doubtful of that outcome given the complete set of positive action last week but I sure would like to make sure this break out isn’t a fake out at this stage of the game.

I’ll leave it there for the week – Have a good one!

Sam Jones

As I happen to be traveling across the great deserts of the west in Utah and Arizona for our family spring break mountain bike trip, we found ourselves quite literally in the middle of nowhere with no cellular service.  At a cross roads, we had to make a bit of a blind choice and one that could lead us for 100’s of miles in the wrong direction before knowing any better.  I was reminded that it’s always good to have a solid understanding of the big picture (map) as we go through our journey to help us make good choices each day.  Let’s get out our investor’s map.

Economy – Still Getting Weaker

For months, the gurus have pointed to weather related economic weakness, especially in the Northeast, caused by an unusually severe winter.  Maybe that’s real or maybe a bit of a cover.  Either way, the US economy is getting weak enough that several important indicators could slip into negative territory (read recessionary status) in the coming months if they don’t spark up soon.  This includes everything from general business conditions, manufacturing and services, industrial production, on and on.  Building permits across the country were very soft last week especially in the west and home prices seem to be losing momentum in more than a few markets.  The bond market typically provides a great signal for rising recessionary pressure but I find it notable that even with the strong dollar tilting the flow of global cash toward toward the US, the bond market is NOT yet giving us the nod that recession looms.  Everyone is optimistically holding their breath and hoping for some better reports but we’ll let the road signs tells us where to go.

Cheap Gas  – Not Going Into Spending

Looking at the spending map, we see now that cheap gas at the pump is not going into consumer spending – at all.  In the last several quarters, they say that $112 Billion has been saved at the pump due to extremely low gas prices.  Where did it go?  Savings accounts just saw an increase of $129 Billion.  Walmart and other typical recipients of low prices at the pump, are not getting the boost that everyone expected.  Without the bump to consumption, the whole big bang theory of cheap oil and gas starts to look like energy sectors just becoming more of a drag on the economy.  The rising US dollar is having the same negative impact on corporate earnings.  As Stan Druckenmiller said in his Bloomberg interview this week, the US dollar is not done rising and the Euro is likely headed to 80, almost 20% lower than today.  I never like to challenge Stan’s convictions.

Markets – Still Thin and Unproductive

There are pockets of strength in the US markets but they are thin and only there for those willing to really root around the edges.  Financials and technology are just barely hanging on to their uptrends and industrials are still under US dollar pressure.  Healthcare and Energy are leading the year (yes energy) but that’s about it.  Small caps are better than mid caps which are better than large caps.  As I have reported many times, the valuation of the US stock and bond markets suggests a 7-10 year average annual return of around 3% from these levels until we see a mighty correction of some sort that creates new value and opportunity.  Set your expectations accordingly.  Foreign markets are much more attractive on these basis with focus on Europe, Japan and China.  It also looks like emerging markets in general want to run higher but I remain a bit skeptical.  We’re doing our best to focus client money in these pockets of strength both domestically and internationally.  It seems like the market wants to favor things that we need outside of the consumer sector – think wireless carriers and insurance type sectors many of which pay healthy dividends.  The market also wants growth and speculation – think solar and Netflix.  The market doesn’t want anything in the middle – think domestic indexes, consumer staples and Utilities.  The main road is bumpy and unappealing, seek the alternative route!

Seasonal Travel Advisory

Just ahead we have the dreaded month of May which has that giant question mark of whether we should just sell in May and go away.  April is typically a great month for stocks, one of the best.  But this year, investors just don’t seem to be in the mood to bid up prices with all the current and future unknowns.  Seasonal strength which runs from October until May is coming to a close.  But remember, seasonality is a blunt trading tool and not something we ever act on by itself.  It is just one of the many road signs we observe.

Looking at the whole map, I still see a tough road ahead.  But a tough road does not make it impassable.  There are still pockets of strength, enough to keep our portfolios largely invested and diversified.  We still have some leadership and some very attractive sector opportunities developing like those in energy and commodities.  It does feel terminal and certainly investors sentiment concurs (bearish).  But fear is part of investing and we accept it when it comes without making an emotional decision against our system.  More often than I care to admit, it is from these moments, when the whole system seems to be backing over the cliff, that it regains strength and surges out to another all time new high.  Let’s not forget one important fact.  The primary trend of the global equity markets is still up and our portfolios should work to remain engaged for as long as that condition prevails.

Have a great week

Sam Jones

We began 2015 with our Change of Seasons report describing in absurd detail, how our investment process works.  Specifically, that report started with a big bold statement of our goals across all strategies where we define what we consider “Success”.  As market risk is clearly on the rise and the estimates for future returns in US equities and bonds ratchets lower, we are making important and intentional asset allocation changes in order to hit our longer-term goals.  I think this is a very important time for investors to avoid complacency and pay attention.

How Do We Define Success?

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.

The concept of asymmetrical results has always been amazing to me.  Why every investor wouldn’t work toward this goal is a mystery to me.    In the industry, this goal is the same as generating “alpha” or effectively more return for a given amount of risk (volatility) than what would be naturally be available through an unmanaged portfolio.  Why is this important?  Well there are several answers to that.  First, we try to control portfolio volatility so you can sleep and night and not worry if you are going to be eating cat food in retirement.  A portfolio that generates high risk adjust returns is also one that can handle regular withdrawals easier while continuing to make consistent returns that effectively feed those regular withdrawals.  Many of our retirees find this attractive.  Finally and most importantly, when we generate asymmetric returns, we let the favorable effects of compounding work to our advantage.  Remember a 50% loss requires a 100% gain just to break even.  If we contain our losses to recoverable levels, we minimize our recovery periods and let positive compounding do its magic as we make all time new highs more often.  As we say in our materials, we are in the business of wealth creation, not just managing money.  You would be surprised how many portfolios I see with values well below the high levels of year 2000.  This is the antithesis of wealth creation; this is wasting time.

Are We Successful?

Looking backwards, the answer is yes but this is not one of those “mission accomplished” things.  There is never really a moment where we stand proud and proclaim victory.  Rather, this goal is an ongoing pursuit across all strategies each day, week and year.  If we do our jobs well and execute according to sound judgment based on solid evidence, the results should follow.  Of course, some cycles have been better than others and we are not perfect, but we’re always evolving and looking for a better way to skin the kitty.  As the risk/ return chart of our flagship All Season strategy shows statistically, we’re pretty good at generating asymmetrical returns.  Since we began tracking our data like this in year 2000, you can see the compound Rate of Return is almost three times that of our Benchmark Stock Index (DJTSM – Dow Jones World Stock Index) with less than half of the risk.  Against the Barclays Aggregate Bond index (AGG), All Season still generates a more favorable return but with higher risk.  Of course, All Season is blended asset strategy made up of stocks, bonds, alternative securities, commodities, internationals and everything in between so we should expect our results to fall somewhere between these two benchmark extremes. Full details and stats on ALL SEASON

Angling Toward Success

As I said earlier, this feels like an important time for all investors.  This is a time to respect market risk, to avoid chasing high-risk returns, to embrace risk management systems and to be patient!  Remember, valuations are high and no longer attractive but neither are they extreme – yet.  Reputable research shops like Case Shiller, GMO research and Ned Davis are all looking critically at current valuations and developing forward looking estimates for various asset class returns based on multivariable historical regression analysis.  They all paint the same picture pointing to a 7-10 year compression of returns for both US equities and US bonds.  See below.  As we are knocking at the door of next quarter’s earnings announcements, we should all consider this possibility.  In a nutshell, until we see deep corrections in both US stocks and US bonds which will lower valuations for both and create new higher estimates for returns, we need to do something different than simply sitting in stock and bond index funds and hoping it all works out (aka Modern Portfolio Theory).  To me, this is like sitting on the railroad tracks as you can hear the train in the distance.

Your question is of course, “So how to do we do that?”.  How do we generate Asymmetric Results?  Back to the beginning.  We lean on our well defined risk management process explained in our last Change of Seasonsreports, which tells us when to cut exposure (Net Exposure Analysis), which sectors are leading (Selection Criteria) and how much to put into each security (Position Sizing).

For example, tomorrow in our All Season strategy, we will formally reduce our allocation to equities by another 5%, down to 55% now from a high of almost 80% in early 2014.  We are slightly cutting down on our Equity Sector exposure to 18% and reducing our Dividend Stock exposure to 12%.  The extra 5% is going to our Alternative securities allocation where we continue to find more and more options to invest in things that are moving higher with little to no correlation to either stock or bond markets.  These are funds with names like Managed Futures or Multi-asset Alternative funds.  The chart in Red is the Guggenheim Managed Futures fund, which we have owned since late 2014 and the Green line is the benchmark Down Jones World Stock Index.

Our Alternatives allocation will now be increased to 25% of total assets with this change leaving our Income allocation the same at 20%.  Cash should still be held to a minimum as it generates almost no return and an effective negative yield net of mild inflation.  These types of risk reduction moves are taking place both in magnitude and timing across all strategies as conditions warrant.  In the end, we hope to be in a position to continue making consistent returns without adding unnecessary risk while “market” returns for both stocks and bonds might perhaps follow the less attractive path of those estimated future returns.  Remember, once we get a reset in prices lower, then we can add risk back into our strategy, recover any mild losses quickly and get on with our business of wealth accumulation.

 

There will be no Red Sky Report next week as I’ll be writing the quarter end Change of Seasons.

 

Happy Easter!

Sam Jones

Janet Yellen and the Federal Reserve must be terrified of saying the wrong thing.  So much so in fact, that they continue to tell the markets exactly what they want to hear giving investors every reason to continue pumping money into stocks and bonds.  Indeed, last week the market got a breath of new life from Federal Reserve commentary suggesting that they will not begin raising rates any time soon.  Our best guess is still in the Fall (November) as it has been since the beginning of 2015.  While we can almost hear an audible sigh of relief, the only thing that has really changed is the direction of the US dollar.

Highlights from Last Week

I Posted These Bullet Points Last Week – And Nothing Has Changed

The Big Picture for Stocks

• *              Many “stock market” indices peaked last July
• *              But there are still lots of things to own that are making new highs
• *              2015 is already a year that should benefit tactical/ active management styles
• *              The bull market is still intact but adjusting to the prospect of higher interest rates.
• *              It is too early to get really defensive but selection is critical now.

Stock Market is STILL Range Bound

For all the frenzied headlines in the last week, it’s important to see what is and isn’t really happening in the US stock market.  What is happening is that small caps continue to push out to new highs as they have been since mid February.  We are also seeing the same leadership in place, notably growth sectors, cyclical sectors and healthcare (including biotech and pharma).  Again, this is nothing new and the strength in these areas continues today.  But we should also recognize that despite the Fed’s breathing some new life into the credit markets, the S&P 500, the NYSE index and the Dow Jones World Stock indices are still range bound, meaning trading below a previous peak.  Only small caps, and very marginally, the Nasdaq Composite have pushed out to new highs, much of which has to do with the strength of the US dollar since last summer.  The Nasdaq Composite tends to track small caps as the index is broader than something like the Dow Jones Industrial Average, which has only 30 stocks.  I will not be surprised if the US stock market does indeed make a new high soon but thus far, this simply hasn’t happened.  Returns for the S&P 500 on a YTD basis have been +3% to – 3% and we are simply approaching the top of the “range” with today’s move.  Selection is still key to making solid risk adjusted returns and getting more so as times goes on.

Financials Participating Again

Thankfully part of the surge in buying enthusiasm last week came from the financial sector which still represents one of the largest cap weighted roles in the US stock market.  When financials are running, the primary trend for the US markets tends be up as well.  I find this constructive and provides more evidence that the uptrend has further to run in the short term.

Probabilities Still Favorable

Bespoke Investment Group did some nice work this week on historical returns for everything from years ending in “5”, 3^rd year of the Election Cycle and the current price pattern for the US stock market.  On all three gages, it seems the odds are largely in our favor for another healthy stock market year.  Years ending in “5” have an average return of +13% for instance.  The 3^rd year of the Election cycle also has a high probability average return of +13% and the current price pattern for stock in 2015 closely matches the pattern of several other stock market years which have yielded an average return of nearly +8% in the past.  Of course, the past never repeats but the stats still show promise for the stock market in 2015.  Now, I would not forgive myself if I did not mention two other things here.  First, the US stock market has NEVER completed six consecutive years of higher prices.  2015 is potentially the sixth year of this bull market.  Second, the market loves to disappoint investor expectations.  If everyone is expecting yet another 8-13% year in stocks, the market will find a way to surprise us all.

 

Europe, Asia and Far East (EAFE)

Europe is looking better every week now, perhaps even better than the US in terms of valuations, growth rates, newly supportive QE from the European Central Bank and potential jettison of Greece from the Euro.  Greece’s demands against Germany for WWII reparations in the form of current debt forgiveness are …… sad, pathetic, etc.   Meanwhile, the Shanghai Composite has just made a new recovery high with nothing but blue ski between here and the highs set in the year 2007.  I think China is back in gear.  Finally, the strength in the Japanese market has been notable since last year.  Yes, I see the impact of the declining Yen but we certainly didn’t seem to care about our stock market rising while the US dollar was in a death spiral either did we?  Conveniently, we have a very nice index, which can be bought 100 ways through any inexpensive ETF call the EAFE index that stands for Europe, Asia and the Far East.  Last week, we bought IEFA in several portfolios following the new leadership and replacing the emerging market positions we sold in late February.  I do like the theme of expanding our international exposure but we’re trying to do so delicately considering the strength in the US dollar, which acts like a headwind.  After a performance disaster in 2013, the EAFE looks much healthier and has been outperforming the US market since early January.

US Dollar Uptrend Stalling

 

This is perhaps one of the most striking changes in the last couple weeks.  The US dollar has been in a frighteningly strong uptrend since July of 2014 creating numerous “dislocations” in the market.  You might remember when the Swiss lifted the cap on the Swiss Franc causing their currency and markets to plummet sending several currency trading operations and hedge funds into bankruptcy.  They simply could not artificially control their currency any more in the face of the strength in the US dollar and they paid the consequence for meddling with market forces in the first place.  The rising US dollar has also been hard on companies with larger portions of their revenue generated overseas as they lost big repatriating their revenues back to the US.  Small caps, which tend to be more domestically oriented, don’t have that issue, thus their recent relative strength to large caps.  And who doesn’t know about the carnage in commodities and the energy complex both of which are directly negatively impacted by a rising US dollar.

Now, it seems the US dollar has moved too far too fast and the Federal Reserve has put their rate hike cycle off for a while giving US dollar investors a reason for pause.  I do NOT believe the uptrend in the US dollar is over by any means but we should expect the currency to take a break from the near parabolic growth rate of the last 8 months at a minimum starting now.  For investors this creates a huge opportunity.  Now, we can consider adding back in some energy, energy service, metals, gold, silver and commodities positions if so desired.   The buying opportunity is right now as prices are sitting almost at the lows of the year and of the last 5 years.  Valuations are obviously incredibly attractive after 40-60% declines but remember this is just a place to grab a small toehold if you want it.  We are not loading up by any means as we still expect higher highs from the US dollar over time.  This is simply the first logical opportunity to take even a small position in the hard asset world as a nice diversifier to any investment portfolio.

Have a great week!

Sam Jones

We’ve all heard the joke about the quest for the one armed advisor – The one who will give us advice without saying “on the other hand”.  This commentary will be chuck full of two handed type guidance.  Such is the nature of messy markets and this one is no different.  If you want to skip to the “Big Picture” of each section, you might find this easier to digest.

Bonds Now on a Sell Signal

Bonds have once again gone to a sell signal for virtually all types including corporate, high yield, emerging market debt, short and long term Treasuries.  Our last sell signal was in mid August, 2012 so this is not something that happens very often.  Our system generates asset class signals on an intermediate term basis only so naturally, this sell signal is coming after Treasury bonds and the like are already down a bit.  In 2012, long term treasury bonds were down -7.2% before our sell signal tripped.  Likewise, the same bond is now down -7.99% from the high for this year set on January 30^th.  Also consistent with any sort of intermediate term signal is the fact that they often occur at the bottom of a short term decline making the signal look a bit silly as we often see reflex rallies.  In 2012, the reflex rally brought long term Treasuries up nearly 5% before restablishing the down trend.  On the other hand ! I won’t be surprised to see the same sort of reflex rally now remembering that there is likely more carnage ahead longer term.  Steve Blumenthal of CMG posted his regular bond carnage chart again over the weekend showing what happens to your investment in a bond fund when rates move either up or down from current levels.  The important thing to note is how much price damage could be done to your bond positions when rates are coming UP from our current historically low level.  Take a look.

Impact of Rising Interest Rates

So we have bonds on a sell signal.  What does that mean to most investors?  Should we make changes to our holdings?  How does this impact other asset classes?

As a quick reminder, bond prices and interest rates move in opposite directions.  When interest rates rise, bond prices fall as do the value of our any of our bond type holdings (shown in the chart above).  Last week, we sold the majority of our high yield corporate bonds as well as our emerging market debt bond funds as both went on sell signals in sync with the Treasury bond market.  Sadly, we were hoping for more bang from these trades taken in January.  As I have said repeatedly in the last two years, our income model returns are going to taper to around 4-5% annually net of all fees (from 7-9%) until the bond markets see a reset higher in interest rates, both long and short term.  Given all the chatter about the Federal Reserve raising rates this summer, our wait might not be that long.  So yes, we are following our discipline and cutting bonds out of our investment portfolios as needed.

Rising interest rates are also a negative headwind to equity prices as the current high valuations in the vast majority of stocks are only supported by very low, near zero interest rates according to most analysts’ pricing models.  Now, remember that back in 2012 when we had our last period of rising interest rates, stocks were not as overvalued as they are today following some pretty healthy gains in 2013 and 2014.  The impact of rising rates in 2012 would not therefore have been as significant then as they are today.  You begin to imagine why Wall Street might be a little obsessed with specific words found in the Federal Reserve minutes these days – due out Wednesday by the way.

The Big Picture For Bonds

 *Bonds are now on a sell signal

• *Falling bond prices and rising rates making for tough sledding in stocks
• *Expect a reflex rally in bonds BUT remain wary of investing in anything interest sensitive (utilities, real estate, etc) at this point.
• *Income models should be in defense mode now waiting for a developing buy later in the summer.

Stock Market Still Range Bound

I am going to make a bold statement that might be eye opening to you.  The majority of the stock markets across the world put in a peak in July of 2014.  In March of 2015, most developed countries made another stab at breaking out to new highs but that effort appears to have failed.  I think there are still some lingering perceptions that “the markets” are charging strongly higher week after week.  That is simply not so.   Take a look at the chart below showing the NYSE index in Red and the Dow Jones World Stock index in Green.  Notice the final high in July of 2014 with now four failed attempts to move out to new highs since.

This could either be just a healthy consolidation from an overzealous bull market in 2013 or it could be predictive of the typical 8-10% decline we see prior to any cycle of rising rates.  Either way, gains and growth in most broad stock market indices has not been what you might think.  So where might we find productive investments in this environment?

 

Remember that we should view things as a market of stocks not a stock market.  There are lots of things still moving higher that don’t look like the chart above but they are found in individual stock names, sectors and size boxes only.  Healthcare, biotech and pharmaceuticals continue to blaze higher.  This is our largest sector exposure in almost all strategies.  Technology as a sector also looks good as do financials and potentially banking stocks.  One could find gains in a rising US dollar or by way of many managed futures funds that play macro currency moves.  We also have positions in cyclical leaders like transportation and consumer discretionary sectors that are benefiting from the massive price declines fuel costs.  Finally, we can also continue to own select stocks that are simply marching to their own beat.  The only “market” type investments we are holding in our blended asset strategies are small and mid caps index funds and ETFs which are also beneficiaries of a stronger US dollar.  So there are enough things moving higher in a non-correlated way to the broad stock markets of the world that we can remain largely invested.  At the same time, we’re naturally playing some defense at the same time, careful to avoid much exposure to indices that look like the chart above.

The Big Picture for Stocks

• *Many “stock market” indices peaked last July
• *But there are still lots of things to own that are making new highs
• *2015 is already a year that should benefit tactical/ active management styles
• *The bull market is still intact but adjusting to the prospect of higher interest rates.
• *It is too early to get really defensive but selection is critical now.

*I’ll leave it there for this week as I’m sure your patience for the two armed advisor is wearing thin.

Enjoy the early spring!

Sam Jones

One of the things I truly cherish about our methods and style is the flexibility it offers when market conditions change.  Last week, I suggested the primary bull market uptrend was still intact and a strategy of buying short term dips was still a good one.  One week later, I am staring straight at conditions that look like a significant market top is now behind.   This is not a call to panic but to respect conditions as they are newly unfolding, gradually and with intentional subsequent action.   Remember, Darwin’s rules of natural selection were not as much about survival of the fittest but rather the sustainability of those species which are most adaptive to changing environments.

Conditions Getting Worse

As you may know, our process that identifies opportunities, risk and ultimately our investment exposure, is largely driven by the weight of evidence presented by technical, fundamental and sentiment conditions.  We are both “bottom up” and “top down” in our observations.  The art of our practice comes from years of experience understanding how to read and interpret all of this stuff.  For instance, during the early and middle stages of a new bull market, technical and sentiment type indicators are less important as rising and favorable fundamental evidence trumps all.  At the later stages of a bull after years of rising prices and a fully recovered economy, we begin to pay more attention to technical and sentiment driven evidence.  This is one of those late stage moments when we need to respect a significant technical breakdown.  Here’s what has just happened with last week’s selling in bonds, stocks and commodities – a rare event by itself.

First, we saw several key indices like the Dow Transports, Dow Utilities and the NY Stock exchange, fail to make a new high with the rest of the benchmark indexes in late February.  All are now headed lower below the late 2014 highs and did NOT confirm the recent new high in the Dow Jones Industrial Average.   At the same time, we saw the 20 year treasury bond move from a leader YTD in price to a loss on the year sending long term rates to one of their highest levels in months.  Also on the technical front, one of our longer term market momentum models just put in a double top and is heading lower toward a long term sell.  A double top in this indicator has a very long history of preceding bear market declines (-20% or more) with a near perfect track record.  Also, for those who care, breadth oscillators both daily and summation, have turned negative as of Friday’s close.    Empirically, we also know that the US stock market has never managed to put together six consecutive calendar years of gains.  2015 is the 6^th year of this bull market, which is on track to be one of the longest and strongest bull markets in history.  While this will be one of the history books, that statistic was earned in the past.  The question on everyone’s mind now should be how much of that will you keep?  Remember – “Create Wealth, Defend It” is our company motto.  Historically, since 1956 according to Jim Stack of Investech Research, every bear market has “repossessed” 50% or more of the previous bull market run.  At the moment, a repossession of that magnitude doesn’t seem possible but who knows.

Second, from a sentiment perspective, the Nasdaq Composite did make an new high last Monday pushing it above the 5000 mark for a psychological victory – for a day.  In doing so, sentiment figures blew out to extremes and investors capitulated on the buy side.  Bearishness hit a very low level of less than 30% briefly confirming the bullish frenzy we have been looking for (warning shot).

Third, from a valuation/ fundamental perspective, we know that the market is and has been expensive but it has been something we have felt tolerant of as long as rates remain low.  The S&P 500 index as a broad brush metric, is trading over 19 on a price to earnings ratio.  This is about 17% above the long term average and nearly 30% above what many would consider a neutral reading.  At the same time, we are seeing more evidence that corporate earnings from an absolute perspective may have peaked in the 4^th quarter of 2014.  So even while earnings are coming in ahead of expectations, their absolute levels are now declining.  The rising US dollar is certainly a factor here hurting overseas sales.  Remember, almost 50% of earnings in the S&P 500 come from overseas now!  And now rates are rising and no longer supportive of that lofty valuation.  Also in the fundamental front, we have margin debt for stocks that seems to have put in a peak and is also heading south as of the end of February.  The massive carnage in the energy complex can be blamed but the staggering level of margin debt is right up there with all major market peaks in the last two decades.  Also, continuing the discussion from last week, we are continuing to see a troubling string of weaker economic reports now.  Last week 16 of 28 reports could be considered negative.  I still believe this to be a short term thing but would also appreciate some stronger numbers about now.

Finally, we are also facing a less accommodating Federal reserve as they have clearly put an end to our own domestic QE measures and are now getting closer to raising the Federal Funds interest rates as the economy and employment picture threatens to bring inflation back.   When the Fed plans to raise rates is hotly debated but it is not uncommon for the stock market to put in some sort of peak within 6 months of such an event.  Importantly, these peaks in the past have not yielded painful bear market but typically 8-10% declines only.  Real bear markets come in well after the Fed has raised rates sequentially.  In light of that, all of these warnings may be just for the pre-rate hike correction and not a more protracted bear market (yet) giving us more reason to move sloooowwwwly.

With last week’s selling, many of the indicators we watch regularly took a decided turn for the worse adding negative input to our weight of evidence model.  If prices are able to recover smartly and make a new high right away, then all of this negative evidence will dissipate for the time being.  If not, the probabilities increase that a top may be behind us for much of the market.  Again, please remember that bull markets do not end in spikey affairs.  Bull market peaks tend to unfold over time with a long painful period of failures that form rolling, rounded top price patterns.  We are seeing those rolls now so we want to start “unrolling” our exposure to the markets, selling weaker holdings to cash, increasing our alternative holdings that move counter trend to the equity markets while holding our winners for as long as they want to run.   We hope to make this a gradual and graceful process, avoiding reactions or fear based decisions but selling individual holdings only as they cross below our stops.   Remember, market corrections and bear markets serve a purpose.  They offer smart investors, who have their emotional and physical capital intact, an opportunity to make a lot of money on the other side.  We will be there ready to jump.   Stay tuned and keep both hands on the wheel if you are managing your own money, this is not a time to get complacent.

Sincerely,

Sam Jones

Would you believe I was on an airplane last Wednesday evening after meeting with a dozen or so clients in Denver, Monday and Tuesday and realized that I never wrote the weekly Red Sky Report?  Wow – I’ve been writing weekly for almost 7 years and I don’t think I’ve every forgotten!  I apologize,  let’s get to it. Things are a bit wonky at the moment between what the market is saying and the economic reports coming to us each week about the state of the economy.  This happens periodically and it’s important to understand the mechanics of the relationship between Wall Street and Main Street.  Let’s do that for this update.

Weak Economic Reports

Last week, we saw more than 50% (15 of 27) of the economic reports come in below expectations or just outright weak relative to their comparisons.  The Chicago PMI (Purchasing Managers Index), a closely watch leading index for business activity, was just awful, second only to October of 2008 in recent history in terms of its month over month drop.  Also raising eyebrows was a surprise increase in the jobless numbers, which created a bit of an unattractive upward spike in the falling pattern of the last few years.  So what are we to believe?  The idea being kicked around now is that the US is slipping slowly toward recession again after a four year weaker than normal recovery.  I don’t see that outcome and neither does the market (more in a minute).  I think there is a good chance that we’re seeing some post holiday seasonal weakness come into play and some nervousness among consumers as they just paid the Christmas Credit Card bill and have taxes staring them squarely in the face.  On the employment front, it’s hard to dramatically improve on a nearly full employment situation so we can expect the rate of decent in the jobless claims to also taper a bit which includes a few surprises like we saw this month.  Interest rates continue to rise slowly especially on short end and the Federal Reserve is still preparing the raise rates to curb potential inflation at the economy HEATS UP.  For the last several years, Europe and China have been exporting their deflationary environments to the US giving us more time to raise rates.  But now that virtually all foreign countries have embarked on new and robust easing measures, that pressure is off.  The Fed will still raise short term rates likely in October or November of this year all things considered.   Aside from the late February slate of weaker than expected economic reports, I don’t see the US economy trending toward recession yet.

Market Telling Another Story

Stocks in the US and around the world had one of their best Februarys in many years, up 5-7% for the month leaving almost all indices out at all time new highs and up 2-3% YTD.  That strength was lead by the “good” sectors, those that reflect cyclical strength like technology, consumer retail, healthcare, biotech, transportation, materials and industrials.  Meanwhile those sectors that typically reflect a weakening economy, defense and fear, like consumer staples, gold, bonds and utilities, all had a terrible month. So the market story told YTD and especially in the month of February is out of sync with the notion that the economy is angling toward recession, quite the opposite.

As I said, understanding the typical relationship between the markets and the economy is critical to investors.  Stocks lead the economy by about 6-9 months as they represent a basket of expectations for future earnings.  When the market senses future earnings will be weak, smart investors take profits, stock indices put in peaks and start to head lower even while the economy seemingly expands.  Today we have the opposite situation.  Markets and indices are at all time new highs almost across the board, while high level “economic” reports are showing some short term weakness.  Earnings are still very strong!  We are fully employed and cost of capital is at a 55 year low.  I’ve seen a lot of bad economic environments in the last 21 years of managing money and this is just factually not one of them by any stretch.

Let’s look at the latest PMI report as an example

As I said the last time the PMI came in this weak month over month was October of 2008.  Now everyone remembers that time as a bad one for everything (stocks, credit, real estate, and eventually the economy).  What you might not know is that the stock market peaked not in 2008 but in October of 2007, a full year earlier.  October of 2008 was the turning point for when the US economy actually buckled into recession.  Now compare that to today.  Today, we have one bad PMI number akin to October of 2008.  But here instead we see a stock market that just made an all time new high last week.  Wonky!

The condition we need to be watchful of is when the economy is raging higher, the Fed is working hard to put on the brakes after raising rates 3-6 times and yet stocks won’t go higher.  This is not that situation.  Use any pullbacks in prices as opportunities to upgrade positions and buy the dips.  We should be getting one here shortly after an unseasonably strong February.

That’s it for this week

Sam Jones

New Highs for the markets last week and a major shift in leadership to go with it.  This appears to be the rotation into late cycle (Stage III) leadership we have been waiting for and its typically good time for smart investors who know where to go.

Revisiting Our Predictions

Last October at our annual client dinner, one of the major themes we discussed was the current state of the aging bull market in stocks.  Most had that expected sense of dread after nearly six years of gains wondering when (in 2015), it would all come crashing down?  Hopefully, we did a good job of instilling a little shot of confidence suggesting this bull had further to run.  These were the bullet points behind our reasoning:

• * Confidence in the economy and the markets is largely neutral and bull markets rarely, if ever, end without a sense of total euphoria.
• * Valuations are high but not extreme yet.  Expecting deeper corrections within an ongoing bull market from these levels.
• * Cash is plentiful both in household and corporate balance sheets and acts like fuel for higher prices, spending and corporate mergers.
• * The economy is recovering and now getting STRONGER.
• * Markets do not run into trouble until rates are above 5% on the 10 year Treasury.  We are no where near that level.
• * Healthy new fund flows into stocks are barely 18 months old, most money has gone into bonds throughout this bull market in stocks!
• * Not 1 of our 6 primary trend indicators is giving us a warning of a bear market ahead (yet).  Recession risk is not on the radar either.

Our thesis is that the market will experience corrections, normal bull market corrections, but they should be used as opportunities to adjust exposure slightly and upgrade positions as necessary.  A normal correction would be 8-10%; under the circumstances, I would even accept 12-15% as a “normal” correction.  So far, the markets cannot seem to pullback more than 5% before buyers come swarming in again.   We suggested in our 2015 predictions that volatility would be much higher and it has been but that investors should not confuse periodic volatility with risk of permanent loss.   Volatility we tolerate and risk we avoid!

We also suggested that investors be on the look out for a move into a Stage III market cycle, which appears to be happening now without much guesswork.  Stage III is a very positive environment for investors but one in which selectivity matters a lot.  There are clear winners and losers among sectors so let’s look at the new leadership established since the beginning of February.

Stage III

Martin Pring, the guru of market cycle work and the inspiration behind the name of our firm with his book, “The All Season Investor”, establishes a Stage III environment generically as good for stocks and commodities, bad for bonds.  That seems to be the case now at least starting this month.  Treasury bonds are down nearly -7.5% and I think this is just the beginning of the pain.  Commodities are working hard to find a bottom including energy, oil and gas stocks.  I still feel like it’s early for the energy sector but materials, gold, silver, food, timber and other commodities are starting to move up strongly from a very deep discount level.   I’ve heard so much noise in the financial media about the end of the commodity super cycle and massive global deflation that my inner contrarian is starting to look seriously at taking a pure commodity position again after nearly 5 years of little to no exposure.  I’ll let this one prove it a little more but I’m watching.  Stocks are still in the limelight and worthy of a full position, perhaps overweight still as we have been since 2012.  But the leadership among stocks just took a sharp turn in a new direction.

Late cycle leadership found in Stage III is typically good to technology, materials, industrials, non-interest sensitive consumer groups, energy, and financials.  Healthcare can do ok but not typically better than the averages.  On the weaker side, we often see consumer staples, utilities and defensive names lag behind.  Growth is still dominant over value and mid caps seem to be in the sweet spot but there isn’t much difference among the difference size categories.  The last two weeks has really been a case study in a Stage III environment and we have made a lot of changes to follow the new leadership.  Please excuse our dust!

Internationals continue to lead the US market, slightly.  Here we have to be a bit careful while the US dollar is still in a new long-term uptrend but there are an increasing number of options if one is inclined to add some diversification.  I have weeded through the list of countries filtering out those with weak economics, weak fundamentals or heavy dependence on oil and gas exports as well as those that are just way overbought in terms of their stock markets.  These are the countries and regions that I still find attractive and those that I’m watching for a potential buy

Attractive Now

Turkey

Pacific Ex Japan

China

India

Europe minus the PIGS

On the Buy Watch list (waiting for oil to find a sustainable low)

Russia

Brazil

Canada

Still, we’re limiting our total exposure to internationals to 10-12% per strategy.

Chugging our Savings

As a final note, I thought it was interesting and funny what good Americans are doing with all of their savings at the pump in the last month.  According to Bespoke, Gasoline revenues YTD are down nearly -23%.  Last week, I filled my empty Suburban and it cost less than $40.  Typically, it would cost $90-$100.  I don’t fill up very often but I did notice.  What is didn’t do is what many Americans seem to be doing – hit the bar!  The percent of total retail sales going to bars and restaurants shot up to 11.3% so far in 2015.  I chuckled when I saw this chart.

 

When times are tough (2008), the tough hit the bar.  When times are good, the tough apparently also hit the bar.  We should all be in the bar and restaurant biz eh?  I guess eating and drinking is a consumer sector but I don’t think that’s what the media had in mind.

Have a great week and would someone in the east coast please send us some snow.  This is nuts.  I’m afraid people will start calling snow “Powda” if this keeps up.

Cheers

Sam Jones

If you didn’t spend the time to read last week’s Change of Seasons report, you should do so.  At the request of our advisory board, made up of client households just like you, we have made a great effort to explain our methods and define our unique process behind investment decisions.  What you’ll learn is how our system identifies opportunities to adjust “Net Exposure” to the markets, uses “Selection” to keep assets in the leading sector and asset classes and focuses holdings on our strongest convictions through “Position Size”.  All three variables tell a similar story in terms of the conditions of the markets and where you should be (and not be) invested.  Today, that plot has seen further deterioration from conditions at the end of the year.  I see a lot of complacency toward the markets now and I want to say WAKE UP! with this update.

Excerpt from Change of Seasons Report –   January, 2015

Summary With Confirmation Across our Process

There is increasing evidence that the US financial markets are approaching the final stages of long bull markets for both Treasury bonds and Stocks. Economic fundamentals are still healthy but valuations and technical indicators are not as constructive so our Net Exposure screen dictates a less “exposed” allocation. Instead of carrying more cash, we are actively moving assets to become less correlated with the US stock and bond markets now. When markets approach the final stages of a bull market, there are fewer and fewer sectors making new highs. We are seeing this happen now. Therefore, proper security Selection is going to highly dictate relative performance in 2015 at least for the first half of the year. Our only overweight positions now based on favorable risk adjusted returns are real estate and healthcare. All other Position Sizes are normal as real value with strong price trends, is becoming harder to find. Net Exposure, Selection and Position Size results are all confirming the same story. If the story changes, our allocations will adjust as needed.

Well the story is changing a bit and for the worse.  Many of our intermediate term indicators have moved down to the make or break position as of last week.  All things considered looking at fundamentals, valuations, technical and sentiment figures, a break down below 1975 on the S&P 500 would change the picture from a technical correction (now), to a significant market trend change angling toward real bear market conditions.  I am doubtful this will happen now but that’s a line in the sand.   There are important things to understand regarding cycles now both long term and short term.  It is highly likely that years of quantitative easing from our own Federal Reserve have accelerated the natural price gains of the market relative to the state of the economy.  We should all expect the markets to rest, fall, consolidate or whatever while the economy plays catch up now.  It is also noteworthy that the US stock market has rarely generated 7 consecutive years of gains.  It has happened once in the last century in fact.  2015 would be the 7^th year in our current bull market so I am expecting a negative year for the US stock market, contrary to the very widely accepted view of a +8% “steady as she goes” year for investors.  In the shorter term, there is also some erroneous thought regarding the month of January.  Common thinking is that January is typically a good month for stocks.  That’s not the case anymore – not for the last 20 years in fact.  Bespoke did this nice analysis of monthly gains over different periods of times.

So a negative January is not necessarily a death bell for the market trend (January was negative in 2014 as well).  In fact, February, March and April are still some of the most consistently positive and strong months of the year.  From a cycle standpoint, I won’t be surprised to see a nice rebound over the course of the next 2-3 months, but unless our story line improves, we would want to sell into that strength and cut net exposure further. Remember, major market tops are long and bouncy affairs spanning months and quarters and recent action is just what we would expect to see.  Conversely, bear market bottoms are easy to spot but nasty, dark and spikey events.

Sectors/ Asset Classes/ Specific Ideas

Our “Selection” screens are also confirming the same deteriorating story based on leadership and relative strength winners and losers.  Financials are a critical piece of the US stock market and its weakness as a sector is literally weighing down the S&P 500 performance (now -3% YTD).  Technology has also been an under-performer this year which is frankly a bit of a surprise considering it is one of the truly non-interest sensitive sectors out there showing robust growth still.   Combined, the Financials and Technology sectors weigh in at over 34% of the S&P 500.  It will be hard for the US stock market to make any sustainable new highs without some leadership from either or both groups.  In 2007, the last major market peak, Financials (shown in Red below) put in a secondary peak in late May and never recovered.  The stock market (shown in Green Below) put in a final peak four months later in early October.  Are we seeing a repeat?

Healthcare, Utilities and Consumer groups are still the leaders in the market but also the most overbought, overvalued by a long shot.  These situations are a bit difficult for investors as it becomes a bit of a game of chicken – who can hold on to the most overbought sectors the longest?  Meanwhile, energy, telecom, materials and financials are now the most oversold and offer the best values.  Everything else isn’t really much different from the S&P 500 or any other major market index.  We’ll be watchful for any signs of relative strength shifting to the more attractive groups and ready to rotate if necessary.

Asset class analysis shows that bonds and stocks are still in uptrends, commodities of all sorts are still in down trends.  Our money should be allocated as such and it is.  But those married to the notion that modern portfolio theory (MPT) will hold the line again in terms of mitigating portfolio losses might not be happy with the next down cycle.  You see, bonds and stocks have been trending together with very high correlation now.  When bonds finally peak and head south, stocks will follow.  MPT suggests that owning a magical combination of stocks and bonds will keep an investor diversified and buffered against major losses.  I will say, this time is going to be different.  I think we’ll see losses in both asset classes and real diversification will only come from our style of tactical asset management and alternatives generating real non-correlated returns.  Thankfully, there are now plenty of options here.  Who knows, maybe we’ll even get a run up in commodities (hint).  We’re still not expecting any sort of bear market to materialize in either bonds or stocks until later in the year.  When the Fed puts off raising rates in June  – until November, bonds and stocks should respond favorably or at least put off the next bear market for a while longer.

Specific ideas for investors should be concentrated among things that have had a hard period recently.  Amazon is a great example of a stock we talked about late last year.  Amazon was down over 20% in 2014, consolidated some very strong gains of the previous 3-4 years and was up a shocking 11% last week.  Google had a similar experience in 2014 and now looks poised for an upside breakout as well.  Growth At a Reasonable Price (GARP) is one of my favorite investment themes for stock buys next to Dividend growth and there are some attractive looking plays developing now.  Overall, we are also closely watching high yield bonds, real estate and small caps for an indication of the primary market trend.  All three are now canaries and worth our attention.

Hurray! For Denver Real Estate

As a final note for our Denver clients, you might be happy to learn that Denver is now one of two cities that has now fully recovered its real estate losses dating back to 2006.  The other is Dallas.

Denver did so, not through robust growth and crazy price appreciation in recent years but, by avoiding the large losses and disastrous price drops seen in places like Arizona, Nevada and Florida.  Chasing gains, chewing off too much, selling in fear and looking for get rich quick schemes always end badly.  Denver has proved to be a very boring and very profitable real estate market over time.   Remember, successful wealth accumulation comes from the balance of avoiding major losses and earning modest consistent gains.  Sound familiar?

That’s it for this week

Cheers

Sam Jones

With the exception of the Federal Reserve in the US, Central banks across the world have embarked on an almost unified effort to stimulate their economies by firing up the QE machine (again). What does it mean for US investors?

 

Let me first say that I don’t believe this grand experiment in central bankers buying their own debt and expanding balance sheets on this scale ($Trillions) is going to end well.Like many, I’ve been expecting some form of serious decline in the price value of government issued bonds but that simply hasn’t happened yet.Since 2009, following the lead of the USA, the rest of the world has been working to fill economic holes with freshly printed currency through direct purchases of their own bonds, forcing long term interest rates down and cutting short term rates artificially at the same time.The logic goes that easy money will encourage investment, borrowing and stimulate financial markets.To some degree, these desired effects have occurred offering central bankers more motivation to continue and now double down on the program. Does it stimulate real economy?Hard to say.The US is going the other way and has already ended their Quantitative Easy program, for now.Effectively, central bankers are shifting private economic hardship to themselves and tax payers as a whole.As Europe finally admitted their economies were headed even further into recession, the ECB hit the panic button and fired up another round of QE last week.The Bank of England issued some stiff warnings of their own on the same day while the Bank of Canada and Bank of India also cut rates by .25%.The Peoples bank of China followed as well doing something called a “reverse Repo” in their liquidity markets, which I don’t understand but is similar in focus.In the previous week, the Danish Central Bank cut rates to NEGATIVE .20 basis points.

 

Courtesy of Bespoke.com

 

Of course, we also saw what happens to a financial system when any of these banks makes any attempt to unwind their growing debt bubbles (bombs).The Swiss National Bank shocked their financial markets by lifting their currency cap all at once causing massive distortions in their stock and bond markets not to mention the peripheral carnage among hedge funds and Forex trading firms that got caught on the wrong side of that trade.There is no such thing as gracefully deflating a financial bubble and that is what makes me QuEasy as I watch these government debt bubbles inflate even more.I will reiterate that investors of any kind, from this point forward, must have robust risk control systems in place to protect their capital.“Holding and hoping” once these bubbles begin to unwind will be an unrecoverable experience.Now let’s look at the bright side in the short term.

 

New and Old Opportunities

 

For as much as we might hate the nature of these drivers of stock market price appreciation, they are good for stocks.I have spoken in recent weeks about the NEW relative strength of the internationals and developing country funds.Now, these economies have the strong tail wind of their central bank policy and prices are much more attractive on a valuation basis than the US.Investors would be wise to consider re-engaging lightly with international exposure as we have already done on our client portfolios.Preference should be given to those countries with the strongest economies, younger demographics, relatively lower total debt, high growth rates and more attractive stock market valuations.Our short list for now is Asia Pacific, ex japan, Eastern Europe except Russia, Emerging markets, South Africa and India.These countries all rank higher than the US on all metrics and offer much more upside in our opinion.

 

Domestically, all the QuEasy money spraying across the globe is going provide additional strength for the US dollar.Beyond short term corrections, this OLD trend is likely to continue as it has since July albeit at a slow pace.A rising US dollar is supportive of cyclical stocks, growth, small caps, interest and dividend paying securities, healthcare, technology, utilities, and consumer groups.It is bad for commodities, metals, gold and silver and energy as we have seen grotesquely over the last 6- 9 months.There is a slight rotation in relative strength in the last few weeks toward material and industrial names so be watchful for the markets to show preference for late stage cyclical groups.I’ll give more detail on this in coming weeks.In sum, we should remain focused on our leadership groups from the second half of 2014 for domestic issues as the rising trend of the US dollar is dominating most price trends still.

 

Adding some international exposure to a portfolio now is a smart diversifier as correlations to the US market are much lower and now the price trends are stronger.Against a rising US dollar, these internationals do have a bit of a headwind so keep position sizes smaller if possible.

 

Watching Claims for Unemployment in the US

 

As a final cautionary note, remembering that we are NOT bearish on the financial markets, there is some slight concern coming from recent reports on Claims for Unemployment in the US.Last week marked the third weekly report showing claims above 300k.The same thing happened in 2007 when “Claims” sat at that level for almost a year refusing to fall lower before the US economy headed dramatically south in 2008 -and saw Claims rise to almost 700k weekly.This is not a cause for alarm but simply something to watch closely for change as Claims have tracked the performance of the S&P 500 almost exactly week to week (inverted)

 

All Time New Highs Again

 

I’ll finish by taking a moment to reiterate our value proposition to our clients.In our communications we often talk about our mission as building Wealth, rather than simply managing money.Our motto is “Build Wealth, Defend It”, right there embedded in our company logo and images.We are about generating consistent modest returns in all markets, adjusting to risks and opportunities as they come, in whatever magnitude.Managing money can mean many things but I often find myself looking at portfolios of prospective clients which are hovering near their high levels of 2007 and some at the same levels as 2000.These portfolios have been “managed” but they have not seen any real wealth accumulation year over year.They are simply churning in place year after year, making money and then losing it over and over again.Today, we are facing a market that is high by any standard but has yet to break down.The odds are strong that some portion (average retracement is 48%) of gains made in the current six year bull market will be given back in the next bear market.Are we close to that event?I have no idea but I do know that we have the systems in place to recognize when and to what degree we should be cutting exposure.Last week, our flagship strategy, “All Season” (shown in Red) made another all time weekly new high on top of the previous weeks’ all time new high.The US stock market did not (nor the Global Stock index shown below in Green).We do this by focusing investor capital dynamically toward the strongest asset classes, sectors, countries, and securities.Sticking with leadership is a good way to stay out of trouble and make those consistent returns we all want.

 

 

That’s it for this week.If we don’t get some snow soon, we’re all going to become experts in Xeriscaping this summer.Time to do the dance!

 

Cheers

 

Sam Jones

The purpose of our year end update is to help guide our current and prospective clients specifically regarding the design, methodology, and process behind our investment strategies. Subjectively, it’s probably more important as an investor to understand a well-defined process than it is to make judgments on past performance. While we are proud of our historical returns, the future is what really matters. We believe that returns are the residue of excellent design and execution so please take the time to educate yourself about what we are doing with your money.

How Do We Match Investment Strategies to a Specific Client?

Generally, we rely on information gathered from our clients regarding personal data, objectives, financial status, risk tolerance, return appetite, tax situation, etc. After nearly 25 years of working with various households through all stages of life, we have developed four specific client profiles that offer guidelines in this process. Each profile has a prescribed weighting among our various investment categories described above but ultimately a client’s individual situation is the most important directive. These are our four primary profiles. Which one are you?

When Do We Change Investment Strategies For a Client?

After a portfolio of accounts is allocated among a mix of appropriate investment strategies using the profiles above as a guide, we tend to leave the mix alone unless a client has a significant life changing event (death, divorce, retirement, new windfall, selling a business, etc). Of course aging is a factor and a valid reason to make slow adjustments to the strategy mix as well. However, the desire to affect portfolio results by changing strategies based on future perceptions of potential market risk or return are NOT valid justifications for changing the prescribed mix of strategies. Fear and greed are part of the human investing experience, and in all of our firm’s history, we have never seen a client improve their results by acting on either emotion. Remember, under the hood, each one of our strategies adapts to current market conditions within it’s own domain relieving our clients of the need to game the strategy mix itself.

Our Investment Process Applied Uniquely to Each Strategy

We believe there are only three primary variables that can truly affect an investor’s ability to achieve Success (defined above). These three variables are overlapping, complimentary and self-reinforcing to each other giving us redundant confirmation when action is needed (buy or sell). They are as follows:

Net Exposure – Dynamic Asset Allocation based on:

Overbought/ Oversold Asset class analysis

Fundamentals – Economy, valuations, monetary policy in place

Technicals – Primary trend analysis, Breadth, Leadership, Volume

Relative value, risk and opportunity analysis

Relative strength to cash*

Time frame – Intermediate term (3-6 months)

Selection –  Choosing the right securities within asset class allocations

One month risk and return rankings

Relative value and strength analysis

Growth and income prospects

Technical price patterns

Time frame – Short term (1-3 months)

Position Sizing – Focusing capital on highest conviction positions

Reducing position size if fundamental or technical evidence is not supportive and vice-versa.

Guidelines for maximum position sizes based on inherent volatility of individual securities.

Time frame – Short term (weekly)

*Cash or money markets are considered a viable “investment” within a portfolio but only employed during protracted market declines or when cash is outperforming on a monthly basis (rarely).

Secondary variables are tax strategies or tax based decisions, transaction costs and desired frequency of trading. We’ve seen too many examples of investors who experience significant wealth destruction in the name of avoiding taxes, taking a small loss or incurring a small transaction fee. Make sure you check with us before taking any investment advice from a CPA or tax preparer.

An Example of Our Investment Process –

The All Season Strategy (as of 1/2015)

Net Exposure – Slightly reduced standard allocation to equities again by 5%-down to 60% from 75% in mid 2014. Increasing our allocations to liquid alternatives again by 5%, up to 20% seeking up-trending securities with low correlation to US stock market. Maintaining allocations to high-income securities (20%). Cash held to a minimum if possible.

Selection – Shifting equity exposure slowly from overbought US stock market to select oversold international and developing country funds. Index exposure favors large and mid caps over small caps, growth over value and dividend payers over non-dividend payers. Equity Sector selection favors a blend defensive groups and cyclical groups, especially those benefiting from a strong US dollar and low energy prices. Alternatives favor managed futures and Real estate funds. High Income allocation favors preferred securities funds, municipal bonds, investment grade corporate bonds and emerging market debt funds.

Position Sizing – New entry level (small) positions in Emerging markets, India, Asia – Pacific, Transportation, High yield corporate and emerging market bonds. Planning to reduce larger positions in utilities, consumer staples and healthcare with large unrealized gains from 2014 once technical patterns become less attractive.

Summary With Confirmation Across our Process

There is increasing evidence that the US financial markets are approaching the final stages of long bull markets for both Treasury bonds and Stocks. Economic fundamentals are still healthy but valuations and technical indicators are not as constructive so our Net Exposure screen dictates a less “exposed” allocation. Instead of carrying more cash, we are actively moving assets to become less correlated with the US stock and bond markets now. When markets approach the final stages of a bull market, there are fewer and fewer sectors making new highs. We are seeing this happen now. Therefore, proper security Selection is going to highly dictate relative performance in 2015 at least for the first half of the year. Our only overweight positions now based on favorable risk adjusted returns are real estate and healthcare. All other Position Sizes are normal as real value with strong price trends, is becoming harder to find. Net Exposure, Selection and Position Size results are all confirming the same story. If the story changes, our allocations will adjust as needed.

What if the Market Turns Sharply Lower?

First, you must know and believe that protracted bear markets do not show up without warnings, often months in advance. Investors who choose to ignore these warnings often pay the price. We are keenly aware and watchful for such warnings and yes we are seeing them begin to appear now. However, warning type evidence can go away as they have several times since 2012 yielding higher prices. Warnings are to be given due respect and set a standard for our willingness to cut risk once prices confirm to the downside. If the market turns sharply lower after months of evidence (Net Exposure, Selection and Position Size confirming) suggesting this outcome, then our risk management system kicks in across all strategies often driving our portfolios to carry higher cash positions, bonds or positions with negative correlation to the financial markets.

Second, each position in every investment strategy has a hard and fast rule that is simple and easy to follow dictating the condition under which we continue to hold or sell. The rule is as follows; we cannot hold a position that is in a confirmed intermediate term (3-6 month) downtrend. When “the market” turns sharply lower, it often drags all sectors and asset classes lower in sync. Subsequently, many of our individual positions will also reverse course and begin downtrends as well forcing us to follow our rule and sell to cash. Some positions buck the market trend and continue higher allowing us to continue holding. Honestly, we don’t really care if the Dow is down 500 points or not, we really care about the impact it may have our individual positions. Also, we do not have hard any rules for portfolio downside loss limits (selling everything if the strategy is down 5% for instance). Systems that attempt this type of risk control find themselves selling everything at the bottom of each short term correction within a longer term bull market. It simply doesn’t work.

Finally, it is important to understand the difference between RISK and VOLATILITY. By definition, risk represents significant or semi-permanent loss of capital that requires many years to recover. Volatility is something we must all put up with periodically as investors as the markets simply do not move up in a straight line during long bull markets. We do not want to sell our investments each day they experience a drop in price. We do want to stick with our investments as long as they are in long term uptrends. Our job is to determine the point at which normal volatility becomes real portfolio risk.

Our process is well defined and well tested through the most volatile markets we have seen in the last century. If we can continue to execute our process, we will add to our impressive 15 years of real performance using real client money. I will close by reiterating the final sentence of our explicit investing creed. Superior, above average, results over time are only achievable through unconventional decision-making, conviction, and discipline. Thank you.

Samuel Jones

President and Chief Investment Officer

All Season Financial Advisors, Inc.