Have Currency Wars Begun?

Share this article

Over the last several months U.S. and Chinese government officials have volleyed back and forth criticisms of the other country’s monetary policies.  Just weeks ago the Bank of Japan formally intervened on the currency markets to weaken the yen.  Other central banks, including Brazil, Colombia, Peru, Romania, Russia, Serbia, South Korea, Switzerland and Thailand, have similarly acted to prevent their currencies from rising, not all successfully.  Australia, England and Israel are plotting strategies to push their currencies to levels that will keep their exports competitive.  Brazil’s Finance Minister Guido Mantega declared that currency wars have begun.

This is more than an arcane footnote in pages of the financial press.  History has not been kind to the equity markets of countries caught in the maelstrom of currency crises.  When countries with conflicting objectives undertake beggar-thy-neighbor monetary policies, protectionism and trade wars frequently result.  Most notably in our own country, the competitive devaluations of the 1930s, plus actions like the Smoot-Hawley Tariff Act, provoked retaliatory actions with our trading partners that contributed to a halving of U.S. trade volumes.  The subsequent consequences for the stock market during the Great Depression are legendary.

The progress of competitive currency devaluations is extremely hard to predict, even among normally friendly trading partners.  We can see among our European allies how contentious is the issue of a common rescue of overindebted nations within the European Union.  And this is among countries trying to protect a common currency.  Contentiousness can grow exponentially when far more disparate national objectives are introduced into the equation.

We have all learned to our great dismay over the past decade the extent to which excess leverage can multiply adverse effects in the equity markets.  The currency markets are far larger and are monumentally leveraged.  In a September 30 blog post, Graham Summers pointed out that the currency markets trade over $4 trillion per day on average.  At that rate, a mere nine days of currency trading would equal the market capitalizations of all the world’s stock markets combined.  At leverage rates that can magnify positions by 50 to one or 100 to one, mistakes or mere miscalculations by warring central banks could have disastrous consequences.

We cannot know how this growing currency war will conclude, but its size and leveraged nature offer myriad opportunities for untoward results.  As countries grow increasingly protective in a world of deficient consumer demand, a favorable outcome becomes increasingly unlikely.  It poses yet another big danger for the equity investor.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

|

Beware Of Unanimous Opinion

Share this article

At Wednesday night’s fall seminar, we examined the question of how investors should balance risk and reward.  Among the many topics covered, we noted how polarized bullish and bearish attitudes have become on a variety of assets.

In the period since Federal Reserve Chairman Ben Bernanke indicated the likelihood of additional quantitative easing, investor sentiment has soared for stocks and for precious metals.  Most investors find great comfort being in agreement with the majority of other investors.  Ironically, markets typically provide their poorest returns when investors share extreme bullishness.  Conversely, the strongest rallies usually begin at points of maximum pessimism.  As a result, at least at extremes, sentiment tends to be an excellent contrary indicator of coming market direction.

Since the Fed’s expressed intention of raising the rate of inflation while simultaneously depressing interest rates with direct bond purchases, the dollar has fallen precipitously.  The outlook for the dollar has become so gloomy that a mere 3% of investors expressed bullish expectations in this week’s Daily Sentiment Index (DSI).  To put that in context, as the dollar approached and reached its June peak following a six month 18% rally, 95% to 97% of investors registered bullish expectations.  As the dollar plummeted by 10% over the next two months, bullish readings fell to just 7%.  That was enough to provoke a 4% relief rally prior to the present decline that began in August.

That 7% bullish reading was identical to the DSI level marking the late 2009 low after the dollar had fallen by 16% through most of that year.  Seeing just 7% bullish at the last two meaningful lows and 95% to 97% bullish at the 2010 top should make investors leery of the current miniscule 3% bullish reading.  Investors were extremely optimistic at the top and pessimistic at the recent bottoms.  Today’s level shows even greater pessimism.

DSI readings for the Euro are almost the exact opposite of those seen for the dollar. A better than 20% rally through most of 2009 led to a 93% bullish reading at the top. All of that gain was given back over the next 7 months. The current 17% rally has rekindled an even more optimistic 97% DSI. Can the Euro hold up in the face of such bullishness?

Precious metals have exhibited similar contrary responses to extreme sentiment levels. Silver showed only 12% DSI bulls two years ago at under $8.50. Today at more than $24 everybody loves silver, with a 97% bullish DSI. Gold’s almost 100% rise over that same two years has brought the bulls up to the 98% level.

While stocks haven’t reached the same level of unanimity, they have periodically reached sentiment levels that have signaled danger. Equity mutual funds currently hold just 3.4% in cash, the lowest level in history. Active investment managers surveyed by the National Association of Active Investment Managers have recently raised their equity allocations above the 76% level that has led to negative performance over the past several years. The current Investor Intelligence poll indicates a dangerously wide spread of 22.5 between bulls and bears. Ned Davis Research’s Crowd Sentiment Poll recently reached a bearish extreme optimism level, which has produced negative investment returns for the past decade. Elliott Wave International pointed out this week that 89.4% of the S&P 500’s stocks are trading above their 50 day moving averages. The last six times this percentage has approached 90%, stocks have at least experienced multi-week declines. Approaching 2010’s peak price, however, this reading held in the 90% area for a few weeks before stocks fell 16%. And the widely watched VIX Index now under 20 shows a dangerously high level of complacency.

Extreme optimism does not necessarily sound a death knell for market rallies, but it does accurately identify market tops frequently enough that it should not be ignored. At the very least, these levels of optimism are raising some cautionary red flags. At the other extreme, the excessive pessimism being expressed for the U.S. dollar could well be building a foundation for a meaningful rally. Should the dollar begin to climb, the rallies in stocks, the Euro and precious metals could be shot-circuited, and corrections could soon follow.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

|

Interview With GoBankingRates.Com – Part 2

Share this article

Last week we posted the first part of an interview I gave to another blog site, GoBankingRates.com.  Here is a transcription of the second part of that interview.

4.  With the recent recession and market downturn, many investors have been trying to spot the “bottom” and time the market.  What are your thoughts on this strategy?  Are there advantages or disadvantages you can discuss?

The biggest disadvantage to market timing is that very few people succeed at trying to buy market bottoms.  Quite obviously, the advantage to the few who do succeed is that they buy at the best possible price.

In our investment management work we do very little of what I would characterize as “trading”.  We did, however, successfully buy four short-term bottoms between 2004 and 2008, in each instance with prices severely oversold.  We were otherwise light in equity holdings, and we succeeded in boosting returns for the year in each of those instances.  We anticipated that a similar profitable opportunity existed in March 2009, but we never identified a point at which we saw risk and potential reward properly balanced.  Clearly the potential to add to portfolio return existed, but we missed it. An integral part of our investment philosophy is that we would always rather miss an opportunity than suffer a significant loss.  While there will always be more opportunities, you will be ill-equipped to take advantage of them if you lose significant amounts of capital.

I strongly suggest that investors would spend their time far more profitably learning about the history of market valuations than trying to time market bottoms.  Learning to recognize historically attractive valuations will provide a sound foundation on which to build a successful investment strategy.

5.  Do you have any advice for investors looking to develop their own strategy?

As mentioned in the prior response, the single most valuable tool in an investor’s arsenal is an understanding of what represents good value.  One would certainly benefit from a thorough understanding of the fundamental investment principles espoused by such fathers of value investing as Benjamin Graham and David Dodd.  An essential complement to that understanding is a comprehensive knowledge on a macro level of what has represented attractive valuation levels for the overall equity market for a century or more. Those levels are measured by such ratios as price-to-earnings, dividends, book value, sales and cash flow.

Just as we practice in our own investment approach, we likewise urge all investors to remain flexible.  Invest when and where you find value, but don’t be afraid to retreat to safe cash equivalents when value is absent.

Beware of the herding instinct.  Almost all of us feel more comfortable when we believe what most others believe.  At extremes of both positive and negative sentiment, however, securities prices have a strong tendency to reverse course.  The vast majority of investors are wrong at every major market turn.  Find a data source to identify such extremes.

Benjamin Graham titled his outstanding book The Intelligent Investor.  Becoming an intelligent investor is certainly not easy.  It takes years of work.  Recognize, however, that if you try to invest without putting in that effort, you will be at a distinct disadvantage competing against those who have done the work.  The investment world has no minor leagues in which you can hone your skills against less developed competitors.

In your ongoing education, I encourage you to find sources of guidance that don’t try to justify their own investment outlook.  Attempt to gather data that both confirm and challenge your own expectations.  Find data sources that evaluate pros and cons in both the economy and the markets.

If you don’t have both the time and the interest to do a thorough job of economic and market research, hire an investment advisor who evaluates data as you want them evaluated.  Don’t simply select a manager based on past performance.  Make sure the manager’s philosophy and investment process are in synch with your risk tolerance and comfort levels.  In an environment like ours today, make sure also that the manager fully appreciates the broad spectrum of possible economic and securities market outcomes.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

|

Interview With GoBankingRates.Com

Share this article

Earlier this week I was interviewed for another blog site, Go Banking Rates.com.  A transcription of the initial portion of that interview follows.

1. You have very extensive experience in investing and finance.  Can you talk briefly about your background in asset management and financial services?

Interest in finance and investments dates back to my MBA program at the University of Santa Clara.  Upon concluding that program, I taught for a few years at the college level before gravitating to the securities brokerage industry in the late-1960s.  From that initial exposure, investment consulting and asset management particularly captured my attention.

Having worked extensively with religious, charitable and other not-for-profit organizations in those early years, in 1978 I decided to establish Thomas J. Feeney & Co., an investment consulting firm, to serve that not-for-profit clientele.  At the urging of several consulting clients, in December 1985 we began the asset management function and founded Marathon Asset Management Co.  The two companies were based in La Jolla, California.

In 1994 my wife Carmen Bermúdez founded Mission Management & Trust Co., a full service trust company, in Tucson, Arizona.  After three years of commuting weekly from Tucson to La Jolla, I opted to relocate Marathon to Tucson.  Mission’s initial chief investment officer retired in 1997, and I assumed that role.  Since that time I have served as chief investment officer for both Mission and Marathon, and we run the firms side by side in the same offices.

2. When it comes to investing, what is the strategy that you generally favor for your clients?  What factors do you consider when determining the right investment strategy?

I have long disagreed with the investment industry’s two-part prescription for investment success: 1) Set an appropriate asset allocation mix and regularly rebalance to it; and 2) Buy and hold stocks and bonds for the long run.  Instead our investment staff and I work daily to identify securities that represent real value.  We rely on quantitative processes that evaluate current securities data and relate those data to valuation ranges that have prevailed over most of the past century.  Unless precluded by client inability to withstand the risk of concentration, we are willing to invest large percentages of our portfolios in either stocks or bonds, when they present compelling value.  At the other extreme, we are equally willing to shun stocks and bonds and hold portfolios largely in cash equivalents, when compelling valuations are absent.  I strongly agree with Warren Buffett’s comparison of investing to a baseball player taking batting practice: You can’t be called out on strikes; you can let as many pitches go by as you wish; you can wait just for pitches that are particularly attractive.

We also differ from the common wisdom of our industry by not benchmarking to any market index.  We pursue absolute, not relative returns.  That approach has been especially valuable over the past dozen years or so.  We have not felt compelled to hold large allocations of common stock in an era of historically high valuation measures.  That stance was extremely helpful through the destructive stock market decline from 2007 to 2009.  Our Controlled-Risk Flexible Allocation investment approach, which most of our clients employ, has earned positive returns in 23 of our first 24 years.  We barely missed a clean slate by suffering a minimal loss of a fraction of one percent in 2008, when the S&P 500 lost over 37%.

3. For investors who saw half their portfolios disappear during the recession, putting their money back in the market again can be very scary.  This is especially true if they’re nearing retirement.  How do you recommend investors cope with that fear of the market?  Is that fear justified?

Fear is as justified today as it has ever been.  While government and monetary authorities rescued our financial system from imminent implosion less than two years ago, a great many domestic and international risks remain.  Subsequent to the massive rescue efforts applied to our domestic economy, dangers of default have been recognized in Dubai, Portugal, Italy, Ireland, Greece, Spain and Hungary.  In our own country numerous states and municipalities are in precarious financial shape.  At the individual level foreclosures and unemployment are at or near modern historic highs.  The average household balance sheet has been badly damaged in recent years and portends little resilience should the economy not recover soon.  Notwithstanding the myriad dangers which legitimately justify concern, investment markets could still do well.  The government and the Federal Reserve Board may succeed in rescuing and stimulating the economy, and investors may rediscover lost confidence and push securities prices higher.  Much depends on whether or not confidence can be rekindled.  Investment markets have advanced nicely over the past year and a half on the back of inventory rebuilding and capital expenditures.  That advance will grind to a halt, however, if we consumers don’t start to spend regularly.  Because consumer balance sheets are still well below where they were three years ago, it is an open question as to whether a new-found frugality will constrain such spending.

There is no easy answer for investors, especially those in or near retirement.  While they can ill afford to lose more capital, they need income in an atmosphere in which safe income is hard to come by.  Almost anything an investor or saver does in this environment has the potential to be very wrong.  Assets invested in equities could do well if the government and Fed rescue efforts succeed and especially if printing massive amounts of new money should float financial asset prices far higher.  On the other hand, if QE2 or another round of stimulus efforts should fail to raise consumer and investor confidence, stock prices could retreat significantly from current levels.

Investors and savers will be rewarded for taking the more conservative path in highly secure bonds or cash equivalents if the economy continues to slow and especially if collapsing debt and deleveraging lead to deflation.  Those same investors and savers, however, could be seriously damaged if the flood of new rescue money should lead to runaway inflation.  Which scenario might unfold will be determined by many future actions of governments, regulators and private citizens.  Many of those actions are simply unforecastable.

Although hardly satisfying to investors seeking guidance, I offered my strongest recommendation in the August 13 post titled, “Keep Your Job,” on Thomas J. Feeney’s Measure of Value at www.ThomasJFeeney.com.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

|

Searching For Safe Yield

Share this article

Again this week, the Federal Reserve Board repeated its intention to keep interest rates near all-time lows for an extended period of time. Clearly, the Fed is concerned about the economic recovery’s fragility, despite the greatest amount of stimulus in U.S. history. Accordingly, it will continue to be difficult to earn any significant safe yield on fixed income securities.

We have already taken steps to improve–at least slightly–the yield on completely liquid, short-term securities. The FDIC has restricted the yield banks can offer on certificates of deposit. With worldwide financial volatility as high as it is, we believe that these restricted rates–beyond one, two or three months–are insufficient to justify tying up funds for longer periods of time. We are particularly unwilling to tie up money for multiple years for yields of just a few percent. The inflationary picture and interest rates could change dramatically within a year or more.

Through a newly-initiated program, we will boost portfolio yield by putting portions of client portfolios into multi-year CDs at yields currently around 2%. We will avoid tying the funds up for years, however, because in the few selected banks we are able to redeem those CDs early with only minor penalties. If we hold the CDs beyond four months, we will earn more, even after penalties, than if we were to keep the money in short-term securities.

While we do not anticipate that interest rates will remain at current low levels for more than a year, they could if the economy remains weak and the Fed remains in rescue mode. If no more attractive alternatives appear in the meanwhile, we retain the option to leave the money in the CDs and continue to earn the stated yield.

In an environment in which even countries are in increasing danger of default, there are great risks in all financial areas. Even holding short-term cash equivalents could prove destructive, should the dollar’s value decline precipitously or if Fed loose-money policies lead to runaway inflation.

We have no way of knowing what sequence of events will strongly affect markets in the months ahead. We do know, however, that events could unfold rapidly and unexpectedly. That puts a premium on remaining highly liquid in order to take advantage of opportunities that could present themselves quickly should markets overshoot realistic levels.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

|

Welcome To The Casino

Share this article

Stock market volume has been declining consistently since the May lows. It seems ironic to imply that risks are rising when fewer investors are buying and selling. In fact, the declining volume is directly raising the risk level. Because high frequency trading, a substantially recent phenomenon, now accounts for far more than half of daily trading volume, the retreat of traditional investors is dramatically understated.

For longer-term investment purposes, volume is smaller still when we recognize the changed profile of current market participants. Fundamental analysis is being overtaken by technical analysis, which typically has a far shorter time horizon. More and more transactions are placed by traders rather than investors. The “Flash Crash” on May 6, which saw the Dow Jones Industrials drop by 1000 points intraday, was striking evidence of the dangers of overwhelming volume on one side of a trade from which true investors have retreated.

Wall Street and the financial media that cater to it clearly reflect the changed orientation. Current comments debate “risk on” or “risk off” rather than valuation fundamentals, for example. When one watches financial television, we hear corporate earnings and revenue figures compared only with street expectations, which are absolutely irrelevant to long-term investors. They matter only to traders. We no longer hear year-over-year comparisons, which do provide helpful fundamental information. Financial TV would provide such data if investors were to demand it; but the producers are playing to their audience’s interests, which are far shorter-term.

There is nothing nefarious about the investment arena turning into a casino. It is important, however, for individual and institutional investors to recognize that this is no longer the traditional environment that has prevailed for decades. The players are motivated and influenced by many different factors from those that have been the prime influences on stock prices in the past. The investor’s traditional “buy and hold” approach, with which we have long disagreed, is a far riskier approach today than in decades past.

On a fundamental level, we have argued in many past writings and conferences that the current long weak cycle differs in both degree and specifics from most past cycles. The excesses built up in the 1980s and 1990s have yet to be purged. Rescue efforts to date have largely been an effort to prevent imminent catastrophe. Those efforts have been partially successful, but at what long-term cost? From an investor’s perspective, it is still unknown whether we can escape this cycle without solving the many problems that led to the financial crisis. The situation becomes more perilous by the long-term investor’s retreat , leaving the scene to traders whose approach is to flee from danger rather than hold stock through it. It is easy to see how almost everyone can quickly line up again on one side of a trade in an environment in which terrorism or physical or economic calamity could shake the world. More “Flash Crashes” are certainly possible.

We continue to encourage all investors to abandon traditional buy and hold, fixed asset allocation approaches and to adopt more flexible approaches based primarily on sound absolute, rather than relative, valuations.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

|

No, We’re Not Market Timers

Share this article

A local institution asked us this week to describe the “tactical asset allocation” approach we employ in our Controlled-Risk Flexible Allocation style.  My reply, which follows, should fill in some gaps for others who have looked into our approach and provide some history for clients who have not been with us many years.

While Mission and Marathon do alter portfolio asset allocation quite significantly over time, we are not tactical asset allocators in the sense that most people use that term.  In our view, that title implies active market timing.  With very few exceptions, we are not market timers.  We tend to modify allocations based on valuations–a very fundamental, not technical, methodology.

Our allocations through this calendar year reveal little about our approach.  Over that period we have had essentially an unchanged allocation: low single digits in stocks, nothing in bonds and most of the portfolio in cash equivalents.  Equity valuations remain high, and economic and market danger levels are substantial.  In such a volatile environment, we believe that conditions could change dramatically and very quickly.  With an essentially liquid portfolio, we are highly defensive, yet ready to take advantage of opportunities in domestic stocks, bonds, gold or foreign securities, which could arise very rapidly.  So far this year, our portfolios are up with the S&P 500 down.  Our careful, valuation-based approach has produced positive returns in 23 of our 24 years.  In 2008, our worst year, our portfolios declined by just under one percent.

A longer-term view is far more illustrative of our approach.  Over nearly 25 years, equities have ranged from a high of 74% of our Controlled-Risk Flexible Allocation portfolios to low single digits, where they are today.  Bond holdings have fluctuated from slightly more than half of portfolio assets down to zero.  Cash equivalent holdings have varied from negligible up to almost 100% of portfolio assets.

Over the very long term there exists a clear priority in our holdings: stocks first, then bonds, then cash equivalents.  We recognize, however, that each asset class can go into positive or negative cycles that last for many years.

A long strong cycle in stocks began in the early 1980s and continued through the end of the century.  Stocks reached levels of extreme overvaluation in the last few years of the 1990s.  In 1998 and 1999, our equity allocation dropped from just over 50% of portfolio assets down to 32%, as individual stocks hit their sale points and fewer replacements met our valuation-based selection criteria.

A major weak cycle, which we forecasted in the late-1990s, began in 2000.  We found fewer and fewer stocks meeting our selection criteria as the new century progressed, and our equity holdings declined from 32% of total assets to today’s 4%.  In a period in which stock prices declined, our freedom to restrict purchases solely to stocks that met all of our valuation criteria resulted in those stocks providing a strong return.  If we had had to buy a larger number of stocks to meet an allocation minimum, it would have been unlikely that our portfolios would have done as well.

Between 2004 and 2008, volatile markets intermittently created some very oversold conditions.  In five instances, we strategically added between 10% to 25% to our existing small base of equity holdings by purchasing an exchange-traded fund for the S&P 500.  Four of the five instances proved profitable, which also added to long-term portfolio profitability.  Those purchases were the closest we have ever come to market timing.

From the late-1980s into the mid-1990s, our portfolios held as much as 50% in long term U.S. Treasury bonds as interest rates were declining from double digits to the 5% level.  In the years since then, we have been strategic holders intermittently.  While those holdings have been consistently profitable, we would have done even better had we not moved away from bonds before Federal Reserve policies brought interest rates down near all-time lows.  Our present caution is born of the knowledge that bonds underperformed risk-free cash equivalents for more than four consecutive decades from 1941 to 1981 in the last rising interest rate cycle.  We do not profess to know when the next rising rate cycle will begin, but there will be great destruction to bond portfolios when it does.  At current rate levels, careful attention is mandatory.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

|

Investors Have Not Yet Abandoned Stocks

Share this article

The cover story in yesterday’s USA Today Money section speculated that investors’ reduction in their common stock holdings could be a market malady that lasts for years.  It prompted me to re-visit a study I did for our 24th Annual Mission/Marathon Investment Conference in April 2007.

At the time, we posed the question as to which was the relevant trend: the four-year market rise from the early 2003 low or the sharp 6% decline that had just preceded the conference.  We differentiated clearly between our advice to speculators and to investors.  Acknowledging that we had just added 20% to our still low equity holdings–an addition that was strategic, not long-term in our view–we anticipated that momentum was still a powerful positive.  While we believed the four-year rally was likely to climb still higher, the predominant advice was caution aimed at longer-term investors.  In today’s market, we are largely agnostic on the short-term trend.  We remain cautious, however, about the long-term picture for many of the same reasons we identified in 2007.

Over the past two centuries, stock prices have moved consistently in long cycles between strong performance and weak performance.  Such cycles have averaged about a decade and a half apiece, with significant variation.  Long strong cycles invariably end in investor euphoria and great expectations.  Conversely, long weak cycles end with investors fearful and swearing off equity ownership.  The current negative investor outlook profiled in yesterday’s USA Today article led several TV talking heads to counter that those absent investors will likely miss out on great returns in the years ahead.  I would argue that a more comprehensive review of past long weak cycles indicates that cautious investors may well be rewarded rather than penalized over the next few years, although they will undoubtedly stay cautious far too long.

In 2007 we examined the three long weak cycles of the twentieth century, not simply as a history lesson. Our intent was to evaluate whether there were some characteristics we could employ to determine whether the current long weak cycle was likely to continue.  The analysis of three years ago is still relevant today.

Each of the following graphs shows a simplified progression of stock prices from the beginning of each cycle to the end.  While the precise patterns unfolded differently in each cycle, there were some common characteristics.

Slide1Slide2

Slide3

In two of three profiled cycles, stock prices rose above the cycle’s starting point after the initial decline.  In all three instances, the final low was below the starting point 13 to 16 years later.

In each cycle, volume dropped significantly from the beginning of the cycles and from the intracycle highs to the sequential lows, sometimes down to small fractions of earlier volume levels.

The initial declines in each cycle failed to wipe out investor enthusiasm.  Investors’ desires to own stock were not eliminated for a significant number of years until after the second or subsequent major declines.

In every instance, the long weak cycle ended after well more than a decade with extremely cheap valuations– high dividends, very low price-to-earnings ratios and very low price-to-book values – even though those valuations had been expensive at some point within the cycle following the initial decline.  By the end of each cycle investors had largely given up and did not want to own stocks.

Another instructive example of investor behavior is seen in the following graph from Ned Davis Research, an excellent data source.

Slide4

The current weak cycle, which began in 2000, looks very similar to the cycle that began in the late-1960s, albeit with grander dimensions.  The initial price declines in each instance put huge dents in the value of individual investors’ equity holdings.  The rallies that began in 1970 and 2003 rekindled enthusiasm for stock ownership, but not to the same degree seen at the initial highs.  Behavior subsequent to those rallies differs somewhat from the 1970s to the present.

The 1973-74 declines so discouraged investors that there was tepid enthusiasm for the 1975-76 and subsequent rallies, despite prices returning essentially to former highs.  In the current cycle, even after suffering through the two biggest bear markets since the Great Depression of the 1930s, investors have quickly brought equity holdings back toward their prior peak.  The strength in equities over the two decades leading to the turn of the century built such tremendous confidence in stocks that the need to own them will not easily be extinguished.  While the anecdotal examples of investor fear cited in USA Today’s article indicate a tendency to retreat from equities, the Ned Davis graph clearly shows current equity holdings well above the historic mean.  Most investors certainly have not abandoned hope for common stocks.

Additional evidence exists as well to indicate that markets remain firmly in the grip of the long weak cycle that began near the turn of the century.  If a new long strong cycle indeed began at the March 2009 low, the weak cycle will have been much shorter than the two-century average and far shorter than any of the 20th century’s weak cycles.  That the weak cycle is finished is especially unlikely because the preceding strong cycle was the strongest in history, combining both its duration and the extent of the market’s advance.  The resulting excesses were the largest ever.

Even more convincing, never did stocks become cheap by standard measures of valuation.  Even at the depths of the declines in 2002-03 or 2008-09, at best, valuations approximated long-term norms.  They never approached the cheap valuations that ended all prior long weak cycles.

None of these factors would preclude even a substantial move higher, especially in an era of government stimulus and seemingly never-ending quantitative easing.  Intermittent rallies notwithstanding, however, the ultimate end to this long weak cycle probably lies some years in the future, with stock valuations at give-away levels and most investors not wanting to play anymore.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

|

Pros And Cons Of Seeking Increased Yield

Share this article

As interest rates continue to decline, we increasingly receive questions about how we can obtain a greater yield on portfolio assets.  As I have frequently said, we can always obtain more yield if we simply accept more risk, either in the credit quality of the assets we hold or in the maturity of those assets.

For more than a decade we have been warning about elevated risks in the economy because of excessive debt levels.  Over that same period we have warned about equity risk stemming from historically extreme valuations, excess leverage and the secular weak cycle that the markets entered just after the turn of the century.  Those that seek yield from high dividend-paying stocks bear an inordinate risk that such yields will compensate only partially for principal losses in a declining stock market environment.

Bonds have been the traditional vehicle to provide portfolio yield.  While we made some profitable forays into the Treasury market in recent years, our clients would have been better served had we simply ignored interest rate risk and held Treasuries throughout the past decade.  With the 10-year note yield now around 2.5%, profit potential has been substantially reduced, and an increase in yield could quickly produce bond market losses. Moves in corporate and municipal bonds have been far more volatile.  As the economy contracted in 2008, prices of corporates and munis fell hard with fear growing about the survival of our financial system.  The Federal Reserve’s efforts to shore up the system boosted investor confidence, however, and corporates and munis rocketed upward in price.  That rally continues today.  Willingness to accept risk was rewarded.  In fact, the more risk accepted, the greater the reward.  The riskiest of junk bonds, CCC-rated, returned over 100% in the first twelve months of their rally off the financial crisis lows.

The continuation of the bond rally becomes increasingly problematic the lower rates fall.  Economic conditions are weakening again, and the Fed has indicated its intention to hold short rates near zero for the foreseeable future.  In fact, the softness in the economy is increasing the prospect that the Fed will serve up another large dose of quantitative easing, already being referred to as QEII.  There is political opposition to further bailouts, but analysts are leaning toward the belief that the Fed will once again act by their September meeting.  They could undertake another program of purchasing more Treasury notes and bonds, despite their already very low yields.  All else equal, that would sustain the bull market in Treasury paper.  All else, however, is not always equal.  China is the largest foreign holder of our Treasury securities.  They have cut back their holdings over the past two months.  Others have stepped up to replace the Chinese, but that could change fast.  At current low yield levels, it would take only a minor rise in yields to turn a full year’s total return negative.  Should yields rise simply to where they were just over one year ago, losses would be significant.  At these yield levels, the risk from a rise in yields is substantially greater than the potential reward from a further decline in yields.

Regardless of what happens to Treasury yields, there is far more significant risk in corporate and municipal bonds.  Rising rates would hurt all bond prices.  While falling Treasury rates would benefit Treasury bond prices, the reasons for those falling rates–weak economic conditions with or without deflation–could do a great deal of damage to corporate or muni bond prices.  We do not want to take that risk.

For money not invested in stocks or bonds, we have over the years made generous use of laddered certificates of deposit to boost portfolio yield.  The Fed’s actions to reduce short rates virtually to zero removed most of the attractiveness of that alternative.  Compounding that rate reduction is the decrease in demand for borrowed funds by banks that formerly issued large volumes of CDs.  We continue to put some money in one and two-month CDs, but we have been reluctant to extend maturities beyond that at the minimal yields available.

Clients ask why we do not buy longer CDs at higher yields.  We constantly weigh that alternative.  Evaluating our expectation for possible changes in rates, we set minimum yield levels for various maturities.  Currently we would not tie money up for three months for less than 1% or for a year for less than 2%.  The full year rate is not available today and the three month rate only available in the rare instance in which a bank badly needs short-term funds.

To tie funds up for a very small return is to lose the option to use that money more productively in a stock or bond transaction which could arise very quickly in an environment of great economic and market uncertainty and volatility.  For example, just over a year ago we deployed a significant portion of client portfolios into 10-year U.S. treasury bonds when yields spiked up to 4%.  Although we took profits on that position just a month later, the boost that it gave the full year return was far more than could have been earned with the same money in a CD for the entire year.  While we can never be sure that we will find such strategic opportunities, they have occurred with sufficient frequency over the years that we are unwilling to forego such options unless we are being rewarded adequately to do it.  Right now we are clearly not being paid much to tie up funds, so we are keeping most of them liquid.

We are working doubly hard, however, to locate options to earn even small amounts of safe additional yield.  Our recently opened program bank operation is a case in point.  This program enables us to increase the yield on money that is effectively liquid and FDIC guaranteed, while earning higher returns than are available in safe money market funds.

We are also exploring the possibility of buying longer CDs from the few banks that would allow us to cash in CDs early without the typical penalty.  Such an alternative would get us somewhat better returns while enabling us to retain the needed liquidity.  Unfortunately, those opportunities are difficult to find.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

|

Inconclusive Week

Share this article

This entry will be shorter than usual, as my wife Carmen and I are celebrating our 24th anniversary today with our daughter’s family in San Diego.

The week ended with stocks showing a negative bias but no clear directional conviction. The major equity indexes closed mixed with the Dow, S & P, Wilshire 5000 and New York Stock Exchange Composite all down by a fraction of one percent for the week, with the Nasdaq and small cap indexes up by a fraction.

As might be expected, trading volume was generally light through most of the week, quite possibly because this is one of the last weeks of summer. It was somewhat noteworthy, however, that we saw a continuation of the recent pattern of volume shrinking on days of rising prices and volume rising when prices fall—indicative of sellers acting rather more aggressively than buyers.

Monday began ominously as prices opened almost 100 Dow points lower than Friday’s close. There was no follow-through selling, however, and a low volume rally brought prices back to virtually break-even at the close. Tuesday and Wednesday saw more low volume attempts to rally early each day. In each instance, sellers came in to take away much of each day’s gain in the final hour. Bad economic news pushed prices down Thursday on rising volume. A poor opening today led to new lows for the week in the middle of the day except for the Nasdaq indexes. All in all the market action was weak, but selling was not aggressive. Nasdaq’s positive divergence at today’s price lows offers some hope for the bulls.

In all likelihood the last week of August will again be slow as traders head for the beaches to enjoy summer’s end. One possible caution: a variety of market conditions and patterns are flashing warning signals. While there is no certainty that they will resolve to the downside, it appears that we are in a window that probably extends well into September in which disappointing news could lead to a very sharp decline in stock prices. Seasonally, September is the worst month of the year. We remain cautious.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

|