Friday, November 30, 2007

Quotable Quotes: Needless Worry

If the market embarks on yet another rally phase, some will consider the recent decline a case of needless worry.

“All of your ills you have cured
And the sharpest you have survived
But what torments of grief you have endured
From evils, which never arrived”
Ralph Waldo Emerson

“As a rule, what is out of sight disturbs men's minds more seriously than what they see.”
Julius Caesar

“There are more things that frighten us than injure us, and we suffer more in imagination than in reality.”

“Don't worry if you're a kleptomaniac, you can always take something for it.”

Have a good weekend.

Thursday, November 29, 2007

Searching For The Magic Formula

To some, the powerful two-day stock market rally was all about the prospects of the Fed cutting rates. While this no doubt was a contributing factor, the larger issue that may have been lost in the noise of rate cuts is the attempt by the Fed and other interested parties to secure the core of the financial system (i.e. big banks). Those at the periphery of the system can break down (hedgies, private equity, mortgage bankers and brokers, even investment banks), provided their problems do not metastasize inward toward the core of the system.

What seems to also be lost in all the noise re rate cuts and traditional real economy stuff is the concurrent effort of the Fed and other interested parties in fixing what got broke. Specifically, the financial model that gave us the Great Moderation (lower rates, low inflation) and all the wonderful real economy benefits complements of Globalization.

Perhaps it is the street kid in me but I find it rather curious that earlier this week the Fed pumped $8 billion into the system followed by ADIA (Abu Dhabi Investment Authority) pumping $7.5 billion into Citigroup (a core of the system entity) at the same time Fed Vice Chairman Kohn gives a speech widely interpreted as communicating the Fed’s intention to do whatever it takes to maintain the monetary boat. Random events? Reactionary decision-making? Maybe not.

In my view, what is happening is an attempt by the Fed and other interested parties to find that magic formula that can both secure the core of the system and invent a new and improved financial model, one that will enable the Great Moderation to live another day.

The core of the system cannot break down. The Fed has stated as such many times over (read just about any speech by Bernanke and other important Fed heads and you will hear this theme stated explicitly or implicitly). Now, this is not to say too big to fail is part of the policy solution currently being orchestrated the Fed and other interested parties with its attendant moral hazard implications. However, failure in the core of the system has very different meaning as in a managed transition to another entity that can ensure the system functions effectively. Think ADIA and Citigroup.

Investment Strategy Implications

The big equity markets' hurrah of the previous two days was about more than a simple rate cut. It was about the perception that the Fed and other interested parties seem to be making progress toward reestablishing a secure core of the financial system and reinventing the magic formula of economic peace and stability to the system, the markets, and the real economy.

To be sure, more pain is headed the markets way. Yet, unless one believes that the mark-to-market pain will aid and abet a US recession, which will precipitate a global slowdown or worse, which will thereby produce a double-digit decline in corporate earnings (see the Expected Return Valuation Model in my reports*) while at the same time the Fed and other interested parties are too dumb and lack the innovative wherewithal to work their way out of this mess, the credit derivatives problems of yesterday and today are fast becoming old news. And old news does not move markets. New news does. And the new news is the progress made toward reinventing the magic formula.

*subscription required

Wednesday, November 28, 2007

Lunch Money

Okay, you got me in. Now, when do I get out?

The buy call on Citigroup made yesterday required judgment. The sell call for the trade (it is only a trade as the mega trend indicators are decidedly negative) will also require judgment.

For black box types*, all this talk about judgment is unacceptable. After all, the whole point of quant trading is to remove that human element called judgment from the equation. But the timing tools employed for this (and other such trades and investments) isn’t black box stuff. So, judgment is a key component, just as it is when trying to make mega trend calls like the recent spate of Dow Theory “sell signals” by certain market strategists and pundits. (See prior blog postings on this last point.)

To be clear, judgment is an important component of the timing tools described and employed yesterday (and in prior calls). However, the parameters for the calls are the timing tools themselves. Yesterday, I described how to get in. Now, I will describe when to get out.

What we are looking for in a lunch money trade like the one made into C is when our short-term timing tools – momentum and MACD – achieve the following conditions:

• Momentum gets to zero.
• MACD gets to zero, which is when the two lines re-converge at a higher point.

Now, let’s talk about the length of time it takes to get to these levels.

As the above current chart on C shows (click on image to enlarge), momentum has already almost reached zero. At same time, MACD has actually gone somewhat flat. Both suggest that this will likely be a very short-term trade (as in days not weeks) due to the fact that momentum is close satisfying its requirement of getting to zero (which signifies a degree of lessened selling pressure and, therefore, a move more closely to a balance between buying and selling pressure). Re MACD, its failure to turn the lines upward signifies very poor upward pressure.

Trading Action Implications

Here are the advisable action steps:

• If momentum gets to zero and MACD fails to turn upward, sell the entire trading position.
• If momentum gets to zero and MACD turns upward, sell half the position.
(Note: If this second step occurs, when MACD finally turns down sell the remainder of the position.)
• If momentum fails to get to zero and turns downward and MACD turns downward, sell the entire trading position.
• If momentum fails to get to zero yet MACD does not turn downward, hold the position. Actionable steps on what to do next will follow in a future blog posting.

As I said, this is not black box stuff and does require judgment. However, that judgment component is made within the context of the parameters of the reliable short-term timing tools – momentum and MACD. Now, let’s see how this trade turns out. Maybe we can make some lunch money.

Note: It helps, of course, to have a larger conceptual framework, a fundamental framework, that can makes real economy sense out of the market decisions made. For technical analysis purists, this is unacceptable. But the methodology employed here is a blended approach, both of which have their value added features to contribute to the decision process. For fundamentally-oriented investors/traders, this is unacceptable.

*The same applies to what I call “info junkies”, those investor/trader types who rely to great degree on information (I am not referring to inside information) that can give them an edge. This information often comes in the form of a thought leader who has taken a certain course of action and others follow in his/her steps.

Special Notice: Both yesterday and today’s blog postings are for informational purposes only and should not be construed as a recommendation to buy or sell. Please consult your financial advisor.
Neither Vinny Catalano nor any member of his family owns the above referenced security. Clients of Blue Marble Research have established positions in the above referenced security after yesterday’s blog posting.

Tuesday, November 27, 2007

Trader Alert – Buy Citigroup

Boy, I hate doing this. But ya gotta do what ya gotta do.

The high profile sovereign wealth fund decision by the Abu Dhabi Investment Authority to make a $7.5 billion deposit in Citigroup’s piggy bank was certainly done with the long-term in mind. However, since most active investors are much more short-term oriented, the decision process for this group tends to be a tad different.

For this more twitch oriented audience, I refer back to the very successful technical timing tool that I have noted on frequent occasions – momentum and MACD.

To make this work, the two must be viewed in concert with each other. One alone will not produce the kind of reliable results an investor needs. Taking Citigroup and its economic sector, Financials (which include other financial institutions), the above charts* show that Citigroup is actually fairly close to outright short-term buy call, while the Financials are not quite there.

C’s momentum is not confirming its lower price lows while MACD is right at its crossover point. In other words, while MACD has not exactly flashed a buy call it is close enough and, therefore, anyone thinking of buying C for a trade should do so.

XLF presents a slightly different story. Its momentum is also not confirming the price action lows (a sign of slowing downward selling pressure) but not to the same extent as C is. Its MACD, however, is not quite ready to produce the crossover. Until both conditions are met (or at least close enough), XLF remains off the short-term buy list.

It is important to note that the buy call on C and the potential buy call XLF are within the context of its downward mega trend, as noted in the moving averages principle.

Investment Strategy Implications

If the stock market stages an end of year rally, ADIA will be noted as prescient in their decision to buy into Citigroup. What will likely not be noted outside this blog is that the short-term timing tools noted above concur.

*Click on image to enlarge.

Monday, November 26, 2007

Fear as Leftovers

excerpts from this week's report:

"As someone who wrote about the risks of credit derivatives way before it became mainstream, I find it quite intriguing to watch the angst build to extreme levels of fear as “rational” investors get swept up in a loss aversion mentality throwing the risk aversion baby out with the bathwater.

To be sure, there will be more pain to endure as mark-to-myth pricing of illiquid credit instruments is replaced by mark-to-market. And in that process, it is useful to note that the mark-to-market process for illiquid instruments may punish a balance sheet today, but out of the pricing debris of today will come a future revaluation upward of same instruments enhancing the balance sheets of tomorrow..."

Investment Strategy Implications

"There is much to be concerned with the current state of affairs. But as with all such periods of fear, the trick is not to get too drawn into the emotional (a/k/a loss aversion) aspects of the phase. As the expected return valuation model on the next page shows (see report), we are well into undervalued territory. This, combined with the aforementioned points (see report), strongly suggest that the US equity markets are near the end of this corrective phase. Now we await the near term timing tools to generate a buy call. That point has not been reached but we are close..."

also in this week's report:

* Model Growth Portfolio
* Investor Sentiment Data
* Sectors and Styles Market Monitor
* Key US Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.

Wednesday, November 21, 2007

Quotable Quotes: Giving Thanks

We could all use a few words of thanks.

“Sometimes our light goes out but is blown into flame by another human being. Each of us owes deepest thanks to those who have rekindled this light.”
Albert Schweitzer

“On Thanksgiving Day we acknowledge our dependence.”
William Jennings Bryan

“Mrs. Lindsay - "You certainly look cool." - Yogi Berra - "Thanks, you don't look so hot yourself."”
Yogi Berra

“Thanksgiving, man. Not a good day to be my pants.”
Kevin James

“I love Thanksgiving turkey. It's the only time in Los Angeles that you see natural breasts.”
Arnold Schwarzenegger

Have a great Thanksgiving and a good weekend.

Tuesday, November 20, 2007

Liquid Refreshments

To paraphrase the old Johnny Carson/Ed McMahon schtick: "The punchbowl is dead. Long live the punchbowl. The punchbowl lives!"

There is an argument being made by some investment strategists that money, while abundant, is not as readily available as others have claimed. With bankers on the run, credit conditions are tightening and the US economy is feeling the effects. This may be true in the real economy but there is another side to the liquidity story that should not be ignored – money available for investment in the financial economy. Here the facts go in the opposite direction.

Hedge fund and private equity funds remain flushed with liquidity. Investors have not only not taken funds out, but have actually added to their existing and new positions as reported by various sources, including in yesterday’s Wall Street Journal.

A fascinating aspect of this hedge fund and private equity bounty is the argument made by activist investors (like hedge funds and private equity) to corporate management that capital should be deployed to earn a rate of return in excess of their required return. If applied to the equity markets, that means the capital in the hands of professional investors (mutual fund and other portfolio managers included) must earn a rate of return in excess of at least the historical return on large stocks, which is 12%, or some other appropriate benchmark. If this cannot be achieved, a return of capital is the prudent thing to do. Now I ask you, what do you think the odds are of that happening?

Investment Strategy Implications

The anchor under the global stock market is two-fold: the global growth story and abundant liquidity. The global growth story is likely to survive a US slowdown, this despite the groaning from certain Chinese officials re the “devastating” effects such a slowdown will have. Think politics.

The second anchor is the abundant capital that must be deployed by professional investors to earn alpha. This capital has to find a home, which is not the bank account of the investors who are not asking for their money back. Moreover, the liquidity is also abundant in two other areas that are beneficial for equities – sovereign wealth funds ($3 trillion and counting) and corporate balance sheets (non financial).

Perhaps, it is the abundant liquidity available for investment that explains why 7 of the 10 economic sectors have not violated their moving averages principle, why in the style cateory only the Micro Cap style has, and why on a global markets basis only Japan has*.

*see prior blog postings and reports for more details on the moving averages principle

Monday, November 19, 2007

Hold Your Fire

excerpts from this week’s report:

"Keep your powder dry. Wait until you see the whites of their eyes.

Whatever the cliché that suits your mood, the bottom line is that the short term technicals to the market are not set up for a buy call.

As the chart on the next page show (see report), the short-term indicators of momentum and MACD, which have been nothing short of excellent market timing tools, are not signaling that its time to enter or add to the market.

Enabling an investor to pick the close to ideal entry or exit point for a position has been the hallmark of knowing how to read this investment tool Therefore, as much as I want to add to current positions, the indicators argue against doing so until the above noted cliché moment arrives.

Here are the specifics re what these tools are saying about the market right now:..."

Expected Return Valuation Model

"What is glaring is the fact that over the life of the current bull market adjusting the basic Fed Model by increasing its capitalization factor by 80 to 100 basis points has proven to provide a realistic expectational valuation level. If that be the case, then the current capitalization level (noted in yellow) produces an $82 operating earnings number for the next twelve months, which is a nearly 11% decline in operating earnings from the 2007 consensus of $92. I know of no one except the super bears who are..."

also in this week's report:

* Model Growth Portfolio
* Investor Sentiment Data
* Sectors and Styles Market Monitor
* Key US Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.

Friday, November 16, 2007

Quotable Quotes: Crunch Time

With all the talk about credit squeezes and crunches, a few words on squeezing and crunching.

“The California crunch really is the result of not enough power-generating plants and then not enough power to power the power of generating plants.”
George W. Bush

“There are some oligarchs that make me want to bite them just as one crunches into a carrot or a radish.”
Eva Peron

“Who was the first guy that look at a cow and said," I think that I'll drink whatever comes out of those things when I squeeze them?”
Calvin & Hobbs

“I'll squeeze the cider out of your adam's apple.”
Moe Howard

Have a good weekend.

Thursday, November 15, 2007

Technical Thursdays: Tech vs. Financials – Two Horses of Very Different Colors

There is a temptation by some to view the recent correction in Tech issues as signaling something more ominous lies ahead for the group. From a moving averages principle, don’t buy that argument.

There is also a temptation by some to view the recent bounce by the Financials as an indication of a bottom and a reason to invest (versus trade) in the group. Again, from a moving averages principle, don’t buy that argument.

As the two charts above* show rather clearly, one (Tech) is merely correcting its bullish mega trend while the other (Financials) has enjoyed its’ dead cat bounce within its’ bearish mega trend.

In the case of the large cap Tech and Telecom (XLK), the moving averages principle says stay in the issue as price is above the moving averages, the 50 day is above the 200 day, and both moving averages are pointing up. As the chart shows, the recent correction has pulled price back to its 200 day, a typical corrective action in a bull mega trend. However, should XLK trade below its 200 day, one should add to the position as the 50 and 200 day must cross and turn down to send a reversal signal of the bull mega trend. That appears to be unlikely anytime soon.

Re the short term indicators, momentum and MACD, they are in deep oversold territory and will require a few days to a week or two to repair the recent damage done. If all unfolds as noted, it then should be off to the races as XLK will be in good technical condition to make a strong year end run.

Now, compare this racehorse to the nag known as Financials.

On a longer-term basis, the opposite conditions exist for the Financials. Applying the moving averages principle, price is below moving averages, 50 has crossed below the 200 day and both are pointing downward. The exact opposite of Tech and Telecom and of its own prior multi year bullish mega trend.

On a shorter-term basis, XLF, like XLK, is in deep oversold territory, which was good for bottom fishing bounce traders (that trade seems to have come and gone) but bad in the sense that it will take a few days/weeks to repair the damage.

Investment Strategy Implications

Tech (specifically big Tech plus Telecom) and Financials are two horses of very different colors. One is in race to new highs benefiting from the weak dollar and the global growth story while the other is, at best, fishing for a bottom hampered by credit woes and large losses still to be reported.

Which horse will you place your bet on? Seabiscuit or Swampnag?

*click images to enlarge.
Note: all charts sourced from

Wednesday, November 14, 2007

Here Come the Vultures


At my last hedge fund/alternative investments seminar in Austin on October 25th, I sought the views of my expert panelists re the current credit crunch and what they thought the severity of the damage would be. The response by two of my panelists was most interesting, to say the least.

The two panelists, both credit experts, were nearly beside themselves with joyful anticipation. Why? Because they planned to exploit the situation by scooping up bargains from the chaos and fire sales unfolding.

So, when we hear stories re the hedgies and private equity boys and girls working overtime to reallocate their assets to join the bargain hunters seeking to benefit from the pain caused by the credit squeeze, we should not be surprised. Thanks to abundant liquidity, the hedgies, private equity, and asset managers with similar interests and abilities as my two panelists are forming a floor under the current credit debris and, in the process, are helping to bring to it to closure.

It is, therefore, reasonable to assume that the primary point made in yesterday blog posting re Sarbanes-Oxley and the cleaning up of the books before the year is out will likely become some of the prime assets the bargain hunting hedgies and company will be interested in. The CEOs get what they want – clean books and no personal lawsuits – and the hedgies and company get what they want – great bargains. A win win. As for the investors in the affected companies and the sub prime and other credit borrowers, however, one can only say, “You’re din din.”

Investment Strategy Implications

Winston Churchill, a man well acquainted with times of stress, once said, “The pessimist sees difficulty in every opportunity. The optimist sees the opportunity in every difficulty.” I think it is fair to say that, despite their unsavory reputation, vultures are opportunistic.

So, equity investors should rest assured that these scavengers will help facilitate the end of the current credit crunch thereby enabling all to rejoin the liquidity party.

Come and get it!

Tuesday, November 13, 2007

Clearing the Decks

Here’s something no one seems to be commenting on – the impact that Sarbanes-Oxley will have on the reporting of the sub prime and other credit derivative problems lurking on the books.

There are 48 days and counting until the end of 2007, which means that the books will be closed for the year. The significance of this simple fact is this: CEOs have to sign off on their company’s performance and the data contained in the financial statements, including the balance sheet (and off balance sheet) items therein. According to Sarbox, that means they are personally responsible for the results generated.

Now, you tell me: When it comes to potentially hidden credit-related bombs what CEO is going to sign off on a statement of company performance that is not squeaky clean?

Before we are into 1Q08 you can bet that the bean counters and other appropriate company experts will be working extra hours to uncover any and all credit related problems that may still lurk in the shadows. Clearly, no CEO is going to sign a document that puts him/her at greater personal risk than is necessary.

Interestingly, as this information unfolds in the pre-announcement phase and then when the actual reported earnings season gets underway, the timing of the disclosure coincides rather neatly with the expected trough in the US economy that most economists are calling for – first and second quarter of 2008. That is also the time when many of the ARM resets begin to occur in earnest.

Therefore, despite the current angst and worrying, the end of this phase of the credit related crisis is in sight. The US economy will then rejoin the global growth story and fearful memories will fade as liquidity does it magic once again thereby setting the stage for what lies ahead - including the most likely next bubble.

Investment Strategy Implications

In the coming days and weeks, watch for signs that the equity market does not decline on bad news. If that occurs, buy into those moments.

Monday, November 12, 2007

Expected Return Valuation Models

excerpts from this week's report:

"For the most part, market prognosticators start with a point of view and then declare the market to be in or out of synch with that view. What happens less often is when an investment strategist starts first with what the market says is the expected return (based on variety of inputs) and then asks the question, "Do these scenarios make sense?"

On the following pages (see report) you have exactly this second approach described in the form of two valuation models – adjusted Fed Model and the Discounted Cash Flow Model.

Beginning with the assumption that the market return over any given twelve month period for large cap issues such as the S&P 500 approximates its historical long-term rate of 12%, the earnings and interest rate assumptions produce that expected return of 12% in a range of scenarios. This is expressed in the adjusted Fed Model.

From this point, we now have an easy-to-view framework from which such assumptions can now be compared with the assumed growth rate in earnings beyond the next twelve months and the implied Return on Equity that such an assumed sustainable growth would infer. This is noted in the Discounted Cash Flow Model.

As you will note, in both cases the current level of the S&P 500 assumes earnings growth, interest rates, sustainable growth, and return on equity that is at odds with most recessionary forecasts and more in line with the doomsday scenarios of deflation and depression..."

also in this week's report:

* Valuation Models
* Model Growth Portfolio
* Investor Sentiment Data
* Chart Focus: Styles
* Sectors and Styles Market Monitor
* Key Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.

Friday, November 9, 2007

Quotable Quotes: Perspective

With so much emphasis on the short term, perhaps a little perspective would help.

“There are as many nights as days, and the one is just as long as the other in the year's course. Even a happy life cannot be without a measure of darkness, and the word 'happy' would lose its meaning if it were not balanced by sadness.”
Carl Jung

“The most pathetic person in the world is someone who has sight, but has no vision.”
Helen Keller

“If the only tool you have is a hammer, you tend to see every problem as a nail.”
Abraham Maslow

“To be sure of hitting the target, shoot first, and whatever you hit call it the target.”
Ashleigh Brilliant

“It's good to shut up sometimes.”
Marcel Marceau


Have a good weekend.

Thursday, November 8, 2007

Technical Thursdays: This Thing Called Moving Averages

click on images to enlarge

To paraphrase Ronald Reagan: "There they go again."

Every time the stock market’s major indices slump to their 200-day moving average, the bears come out of their caves to announce the end of the bull. As interesting as a price trade below the 200-day might be, it is a misuse and misunderstanding of how to read such trading action.

As noted numerous times before, it is far less important when the current price trades below its 200-day moving average than it is if the 50-day moving average crosses the 200-day. And even that is not as important than if both the 50 and 200 day point in the opposite direction of the established trend, which in this case is up.

Then, and only then (price below moving averages, 50 day below 200 day, both 50 and 200 day pointing downward), do you have a trend reversal.


* Price below moving averages
* 50 day below 200 day
* 50 AND 200 day pointing down

Now to take this one step further, when seeking to identify a mega trend reversal, it would help if other key indices were also experiencing a similar such episode. For example, if the twins of the Dow Theory (Industrials and Transports) or the NASDAQ and the NASDAQ 100 or the Russell 2000 were in synch with the angst perhaps then an investor might suspect a mega trend reversal was in the works.

At present, aside from the Dow Transports (second chart), the other indices noted are either at a similar juncture (Dow Industrials, Russell 2000) or nowhere near such a potential turning point (NASDAQ (third chart) and NASDAQ 100).

One additional way to evaluate the potential of mega trend reversal is to view the three market cap segments – mega, mid, and small – to see if a mega trend reversal is at hand. Once again, the data says no trend reversal has occurred, although the small cap style is in the worse shape with the price 4% below its 200 day.

Lastly, let’s go global. Here’s a short list:

EAFE (EFA) – nowhere near
Europe 350 (IEV) – nowhere near
Emerging Markets (EEM) – nowhere near
Latin America 40 (ILF) – nowhere near
Japan (EWJ) – on the verge

Naturally, other reasons to be concerned exist in some of the above noted markets, specifically overbought levels in highly speculative markets like the emerging markets. However, overbought conditions in speculative, smaller markets, while likely to experience substantial market corrections, are not systemic threats to the global mega trends in place. Only a massive plunge in concert with a breakdown in developed markets would give cause for serious concern. That is not the case thus far.

Investment Strategy Implications

For the umpteenth time: It’s a bull market ‘til it ain’t.

The momentum lemmings may scare the bejesus out of some investors with days like yesterday. However, it is advisable to keep in mind that as swiftly as the pack runs for the hills so, too, do they race right back in the game when the money flows in an upward direction. (See yesterday’s blog for the latest comment re our little furry friends.)

My advice: Never lose sight of the fact that mega trends are what matters most first, foremost, and always. The call re a mega trend drives the single most important decision any investor needs to make: the Asset Allocation decision. From that point of view come the strategic and tactical decisions of where to allocate one’s assets and when to expand or contract current and prospective positions (what I call modified market timing).

The great value in technical analysis is keeping one in or out of the game when emotion, personal circumstances (a/k/a loss aversion), or fundamental logic dictate otherwise.

Investing is a dynamic, perpetual social science experiment that is both rational and irrational. Therefore, to the best of one's ability - Identify then Exploit the behavior.

Wednesday, November 7, 2007

The Difference Between Motion and Movement

Allow me to add to yesterday’s blog posting with a thought re the difference between motion and movement.

If Bill Miller’s comment noted on yesterday’s blog posting is correct (that the equity market is “remarkably serially correlated”), then perhaps it would behoove investors to appreciate the forces that swing equity prices to and fro thereby producing what might seem to some as a range bound market. Big up, big down, no net change.

Yet, in the midst of the seemingly manic/depressive mode of equity prices certain clearly defined trends are well established and, given the points made in yesterday’s posting, are likely to enable an investor to capitalize on the market's atmospherics.

Investment Strategy Implications

There’s money to be made in exploiting the behavior of the momentum lemmings. And, as the markets enter their final weeks of 2007, that behavior is very likely to be in the arena of the year-to-date winners, like Tech, especially large cap Tech (XLK).

Bottom line: The mega trend is intact. A top may be in the process of forming but it will take a lot more than the angst and pain experienced by investors stuck in the Financials sector to put an end to the very mature bull.

Key point to remember: As long as there are trillions of actively managed dollars desperately seeking alpha along with massive amounts of global liquidity, supportive valuation levels, and a solid global growth story, nuggets of gold can be found in sectors that benefit from the current circumstances. It’s like knowing the difference between motion and movement.

Tuesday, November 6, 2007

The Dog Days of Contrarian Investing

In his soon to be published quarterly report, legendary value investor, Bill Miller, makes the following observations:

“This market has been remarkably serially correlated. In plain talk, what has gone up keeps going up, and what has not, does not. Valuation has not mattered at all. What has mattered is price momentum. This is very similar to what we saw with tech, telecom, and internet names in 1999. It is not yet that extreme, but it is pretty extreme.

The best quintile of stocks based on traditional valuation factors such as price to earnings, price to book, price to sales, and dividend yield, has underperformed the market by over 1000 basis points this year. The best quintile on price momentum alone, using 3 and 9 month price trends, has outperformed by 1400 basis points.”

Mr. Miller’s comments highlight several points that have been repeatedly raised on this blog and in my reports – namely the highly correlated nature of the equity markets. Two questions are related to this point: Why are markets so highly correlated and how should an investor exploit the situation?

As noted many times before, the highly correlated nature of the equity markets is due in large part to the enormous sums of actively-traded money that is in the hands of the hedge fund and other momentum lemmings. Bereft of original ideas, many hedge fund managers have little recourse than to chase the trades that ensure their relative performance record does not fall so far behind their counterparts (code for keeping my house in Greenwich).

Naturally, it should be assumed that these very same hedge fund managers believe that they have systems and investment strategies designed to gain alpha. At least that’s what the marketing material says. The sad fact is, however, the results are just not there. Since the proliferation of hedge funds, the performance results has regressed to the mean, so much so that there is little to no difference between the on average underperforming hedge fund manager and the on average underperforming mutual fund manager. (The only real difference is the compensation scheme.)

Moreover, logic dictates that there are only so many truly original strategies thereby limiting the arbitrage and other alpha generating strategies available. Put another way, how many brilliant 20-something money managers can there be? Hence, lemming-like momentum investing.

If this be the case, how does an investor exploit the situation?

Investment Strategy Implications

There is every reason to believe that hedge fund managers pressured to justify their high fees will be even doubly pressured these last two months to produce as much alpha as conceivably possible. Therefore, if price momentum investing is the dominant approach taken by many such market players, the odds are that, from now until December 31st, what has worked will continue to work meaning that bottom fishing and contrarian plays will likely underperform and the winners of 2007 will remain so, if not accelerate until the books close for the year.

The momentum game is here to stay. At least through the end of this year and likely into the early part of next year. Contrarian strategies, like the kind that Bill Miller advocates, will likely remain the least attractive approach to investing for some time.

No doubt, the day will come when being a contrarian will pay. However, for the reasons stated above (and others noted in prior blog posting and reports), I don’t believe that day is today.

Actionable steps: For predominantly US investors stay overweight the weak US dollar and global growth story of Info Tech, Industrials, Energy, Gold, and Large Cap Growth. Stay underweight the US consumer related themes of Financials and Consumer Discretionary. For global players sell China into strength, stay long Europe large and mega cap (Europe 350 – IEV) and a proportionally balanced mix of emerging market issues.

Specific investment recommendations can be found in the Model Growth Portfolio (MGP), which is available only to subscribers. MGP performance results are noted on the upper left portion of this blog.

Monday, November 5, 2007

Living with Angst. Exploiting the Fear.

excerpts from this week's report:
"Halloween may have passed but when it comes to credit derivatives and the like it is the tricks and not the treats that keep on coming for investors.

The black hole that is credit derivatives continues to haunt the slowly awakened investor masses. And there remains much in the murkiness of the less-than-full disclosure world of the hundreds of trillions of dollars of leverage upon leverage debt. Moreover, collateralization and securitization combined with leverage upon leverage ensures that more shoes will likely drop before we are safely out of the woods. As noted many months ago, “it is unwise bordering on imprudent to assume that terrible will not follow bad.”

So, why am I recommending that investors not only hold onto their positions but begin to step back into the market and selectively add to key positions? In a phrase, it ain’t over ‘til it’s over.

The positive offsets to all this credit-derived pain are threefold:..."

"Model Growth Portfolio Results

What a week!

Thanks to the underweight in Financials and Consumer Discretionary along with the Gold, the MGP produced one of its best all-time weekly relative performance results of 63 basis points and, in the process, has pushed up the year to date alpha to 223 basis points (see report)..."

also in this week's report:

* Valuation Model
* Model Growth Portfolio
* Investor Sentiment Data
* Chart Focus: Productivity and Unit Labor Costs
* Sectors and Styles Market Monitor
* Key Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.

Friday, November 2, 2007

Quotable Quotes: Bad Habits

The disappointment the market demonstrates at the prospect of no new rate cuts (to the exclusion of other factors) implies some bad habits have formed. Therefore, a few sage words on the addictive nature of bad habits.

“Chains of habit are too light to be felt until they are too heavy to be broken.”
Warren Buffet

“Habit is a cable; we weave a thread each day, and at last we cannot break it.”
Horace Mann

“Just cause you got the monkey off your back doesn't mean the circus has left town.”
George Carlin

“Little minds mistake little objects for great ones, and lavish away upon the former that time and attention which only the latter deserve. The strong mind distinguishes, not only between the useful and the useless, but likewise between the useful and the curious.”
Philip Dormer Stanhope, 4th Earl Chesterfield

Have a good weekend.

Thursday, November 1, 2007

Technical Thursdays: The Dirtier the Dollar, The More Gold Shines

Blog entry from July 12th: “Forget Goldlilocks, Think Gold”
Blog entry from April 24th: “Gold: The $1,000 Investment”*

The first chart** shows the performance of the yellow metal versus S&P 500 since July 12th. No question about that call.
The second** is the price performance of Gold since the Gold tracker began trading. So far, so very good.

However, being right is always yesterday’s news. What about now? Is $1,000 achievable? In a word: youbetcha.

A few follow up thoughts:

Since my March 2005 report on Gold, the central argument for Gold has been the US dollar and its diminishing role of the world’s reserve currency. That view not only remains unchanged but is actually accelerating. The debasing of the American currency (via the Fed and its propensity to run the printing press to avoid even the slightest real economic pain) coupled with the strong growth in foreign reserves is driving many holders of dollar denominated assets (US Treasuries, in particular) to think twice (three times, four times?) about adding to a losing position. Yesterday’s ¼ point rate cut, the Fed's second best decision, contributes to the situation.

To leave the Fed funds rate unchanged was the better choice. However, the Fed's intentions are clear - rates are headed lower. And no matter how you slice it, lower US rates only reinforce the downtrend in the dollar. So, while the dollar may be poised for a crowded trade, short covering rally, the mega and cyclical trend is unmistakable: Down and dirty. And the dirtier the dollar gets, the less inclined foreign buyers will be to own more of a poor performing asset and more inclined to diversify their holdings. Witness the rise in sovereign wealth funds. Witness the rise in the Euro. Witness the rise in Gold.

Investment Strategy Implications

The slow, steady crash in the dollar threatens to get out of hand. Heaven help us if it does. And while no one knows what level a relatively non-productive asset like Gold should trade, it is without question that Gold is benefiting from the diversification effects of major buyers of dollar denominated assets.

Conclusion: Up to a 5% position in Gold belongs in everyone’s portfolio for the foreseeable future.

*Scroll down to "Topics Discussed" links to your left to view.
**click on images to enlarge.