Asset Allocation for the Next 12 Months
(January 25, 2009)
Dear Subscribers and Readers,
Let us now begin our commentary by reviewing our 7 most recent signals in our DJIA Timing System:
1st signal entered: 50% short position on October 4, 2007 at 13,956;
2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
3rd signal entered: 50% long position on January 9, 2008 at 12,630;
4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 4,094.44 points as of Friday at the close.
7th signal entered Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 3,785.44 points as of Friday at the close.
I am going to be more wordy than usual. A front-page news story on CNN yesterday tells of a struggling family whose father had to deliver Domino's pizzas after he lost his job as a restaurant manager. With nearly $50,000 of medical debt racking up, he had no choice but to swallow his pride and take the job after several weeks of searching. Ashamed of his predicament, he admits that he fell into depression at times. Here is my 2 cents on the matter: As the US retail and restaurants industries continue to deleverage and par back the overcapacity that have developed over the last decade, look for more stories like this for the rest of 2009. Look for more social tensions, calls for government action, and calls for CEOs and executives to cut their salaries and bonuses. The latter has already started in the financial sector, and will most likely spread to other sectors/industries that are deleveraging (or that are just starting to deleverage, such as the energy sector). As for Mr. LeBlanc's situation, I see no shame in having to support one's family by delivering pizzas, or working in other odd jobs. My parents went through the same experience when we migrated to Sydney, Australia, from Hong Kong in the 1980s. You do what you can in this environment, and I applaud his family for being so supportive.
Now, I will let you in on a secret: There are no “gurus” when it comes to the financial markets. Warren Buffett – certainly one of the greatest investors and timers in the modern era – makes his own share of mistakes (and he doesn't even have to “pitch” if he doesn't want to, unlike all the hedge fund or mutual fund managers that have to keep minimal cash at all times!). So did Peter Lynch during his tenure as the “star manager” of Fidelity Magellan from the late 1970s to 1990. So does Paul Tudor Jones (who called the 1987 crash and made nearly 100% for his investors in that year), SAC's Steve Cohen, Jim Simons, and George Soros (Soros has been calling for the collapse of the modern financial system at least since the early 1980s). True, once in awhile, one gets “his day in the sun,” but in the financial markets, such recognition is fleeting. Just ask Robert Prechter, who found fame by calling the October 1987 crash, but who quickly sank into obscurity again as he remained bearish for the remainder of the 1980s and 1990s bull market. In fact, just as a financial market figure is designated a guru, it is time to do the opposite of what he says. I will leave it to your imagination to see who I'm talking about (the amusing part is that this so-called “guru” actually underperformed the S&P 500 last year even though he did make some correct predictions). Relative to him and many mutual fund and hedge fund managers, our DJIA Timing System actually did rather well last year, with an outperformance of more than 11% over the Dow Jones Industrial Average.
Before we shift gears and discuss our asset allocation for the rest of 2009, I want to devote some comments to crude oil. In our January 11, 2008 commentary (“Tapping into the Brewery Market”), we discussed our ongoing lack of bullishness on oil prices and oil demand – in light of changing consumer habits (especially in China as the government retains its goal of reducing energy intensity by 20% over the next few years), the slowing global economy, and further investments in alternative energy technologies. One long-time subscriber was skeptical. Among other things, he cited the lack of further “fuel switching” opportunities (from crude oil to other fuels such as coal and natural gas) in the US electric power sector, as well as the lack of new oil discoveries and lack of investments stemming from the latest decline in crude oil prices. These points are well taken. So let me try to expand our thoughts on this topic. First of all, as discussed in this recent Reuters article, the IEA has ratcheted down its oil demand growth forecast for China in the upcoming year – predicting a mere 1.1% growth in crude oil demand, down from its previous forecast of 4.2%. More ominously for the oil bulls, the risk is now to the downside. Meanwhile, the EIA is now forecasting global oil demand to decline by 0.9% in 2009 – and again, the risks are to the downside as the Euro Zone remains in denial about its crashing economy and the crashing economies of their Central and Eastern European trading partners.
At the same time – while some companies are now cutting back on exploration and drilling – countries such as Saudi Arabia and Brazil have committed to increasing its production capacity over the next few years. More specifically, Saudi Arabia plans to increase its production capacity from its current 10.5 to 11.0 million barrels/day capacity to as much as 12.5 million barrels/day by the end of this year. The Brazilian government, via Petrobras, is also committing to a new $174.4 billion five-year spending plan to develop the offshore Tupi field discovery. It claims that the field will be profitable even with oil at $45 a barrel, and aims to boost oil production to about 4.63 million barrels a day by 2015, up from 1.80 million barrels in 2007.
But Henry, what about when the global economy recovers? Won't global oil demand start to spike up again?
As I mentioned in our January 11, 2008 commentary, I believe global oil demand growth will remain challenged for years to come, given the oil price spike we just experienced last summer. True, unlike the 1980s, the net supply of oil in the US will not gain from the “fuel switching” opportunities we had in the late 1970s, as the electric power sector's crude oil consumption is now less than 2% of total consumption (compared to nearly 8% in 1979), as shown in the following annual chart:
That said, the fuel switching benefits that the US received during the 1980s – while significant – were overrated, as crude oil demand from the electric power sector declined just slightly less than 1.2 million barrels/day over the last 30 years. Rather, the dramatic decline in US oil demand in the early 1980s, along with the steady growth afterwards, partly resulted from both conservation and higher fuel economy for new cars and light trucks in the 1980s. Starting in 1990, the combined fuel economy of light-duty vehicles actually decreased, as US consumers bought more light trucks. As documented by the EIA, while there has been little improvement in average fuel economy, this is not due to the lack of technological improvements. Quoting the EIA from its 2005 Annual Energy Outlook:
Although the relatively flat fuel economy for cars and light trucks over the past 15 years may suggest little technological improvement, this is not the case. Instead, technological advances have led to significant improvements in vehicle performance and increases in vehicle size, while generally maintaining or slightly increasing fuel economy. Based on NHTSA data, the average new car in 1990 achieved 28.0 mpg, had a curb weight of 2,906 pounds, and produced 132 horsepower. In 2002, average new car fuel economy was 3.2 percent higher at 28.9 mpg, curb weight was 8.7 percent higher at 3,159 pounds, and engine size was 30.0 percent higher at 171 horsepower. Thus, although fuel economy improvements have been minimal, the introduction of advanced technologies (including variable valve timing and lift, electronic engine and transmission controls, lock-up torque converters, and five-speed automatic transmissions) have produced significant improvement in engine and transmission efficiency, allowing substantial increases in new car size and performance. Data from the EPA show similar performance trends. For example, from 1990 to 2002, average new car horsepower per cubic inch displacement, a measure of engine efficiency, increased by 28.6 percent, from 0.83 to 1.07, as a result of implementation of advanced technologies and improved engine designs.
Similar improvements in vehicle attributes have also occurred for light trucks. In 1990, the average new light truck achieved 20.8 mpg, had a curb weight of 4,005 pounds, and produced 151 horsepower. In 2002, the average fuel economy for new light trucks was 4.8 percent higher at 21.8 mpg, curb weight was 13.5 percent higher at 4,547 pounds, and engine size was 45.7 percent higher at 220 horsepower. As in the case of cars, manufacturers have provided improved fuel economy for light trucks while increasing vehicle size and performance by implementing advanced technologies. From 1990 to 2002, light truck horsepower per cubic inch displacement increased by 37.4 percent, from 0.67 to 0.92.
In other words, the adoption of hybrid and plug-in hybrid technology notwithstanding, there are still much efficiency gains that could be “squeezed out” of the US vehicle fleet, assuming US consumers could purchase automobiles with less horsepower and that they could curb their desire to buy light trucks. Given that the vast majority of trips are for commutes of less than 40 miles, buying a Toyota Corolla or even the Camry with its in-line 4 engine is sufficient for most of our daily needs. Assuming that the Boeing 787 succeeds once it is flown commercially next year, automobile manufacturers could also adopt carbon composite technologies to reduce the curb weights of their products, increasing fuel economy by 20%, if not more. More importantly, neither the global automobile industry nor the US government is halting research and adoption of hybrid and plug-in hybrid technology (Iran won the battle with higher oil prices, but will ultimately lose the war), with last summer's spike in oil prices still fresh on everyone's minds. With the inevitable adoption of hybrid, plug-in hybrid, and solar technologies, the US automobile fleet could achieve unprecedented efficiency gains over the next decade.
Of course, the skeptics would say it would take decades for the US automobile fleet to adopt hybrid technologies. That may be true, but do not underestimate the power of new technology. As shown in the following graph (courtesy of the New York Times), the adoption of new technologies tend to follow an S-curve. Once adoption rates pierce 10% to 20%, it tends to accelerate, before finally flattening out as the technology matures.
There is a reason for this, of course. Once the mass-market penetration rate crosses 10%, product costs would've come down drastically, as manufacturers learned from their mistakes and as they achieved significant economies of scale. We've seen it time and time again – with color TVs, the computer, cell phones, today's LCD panels, not to mention the advent of the Ford Model T. We are already seeing signs of battery innovation, with many automobile manufacturers now spending significant amounts of R&D on battery technologies. Assuming Congress sticks with its higher CAFÉ standards, we could very well see the adoption of plug-in hybrid technologies accelerate over the next decade, as the cost of buying a hybrid automobile decline relative to one with a pure internal combustion engine. Moreover, given a normalized US automobile sales of 16 to 17 million vehicles per year, 50% of the US automobile fleet could be easily replaced within 10 to 15 years. As I discussed in our January 11, 2008 commentary, I am not overly bullish on global oil demand over the next decade. In terms of the crude oil price in the prompt futures month, I expect oil to trade in the $30 to $75 range over the next decade, with a possible spike to $90 to $100 a barrel should a hurricane “take out” production in the Gulf of Mexico or should a war in the Middle East occurs.
Let us now discuss our thoughts on asset allocation for the next 12 months. First of all, a disclaimer. One should only adopt an asset allocation that one is comfortable with – i.e. one that he/she could sleep with at night. This must not only be consistent with your risk tolerance, but with your time horizon and your funding needs when you are in retirement. For the pension plan sponsor or the university endowment, one would want to extend your asset duration as much as possible to match the duration of your liabilities, but with an eye towards taking advantage of the current dislocation in the financial markets.
In general, a typical individual investor aged 60 (or below) and in a reasonable state of health should overweight equities relative to bonds, given the tremendous valuations in the equity markets, even relative to corporate bonds. Within your equity portfolio, I would heavily overweight US and emerging market (non-Eastern Europe) equities, relative to international developed equities (or the MSCI EAFE). As documented in our commentaries and in our discussion forum, export-driven economies such as Germany and Japan will continue to lag the US, especially given the high Euro and the Yen. In addition, the demographics in both Western Europe and Japan are horrible. With Western European banks having lent over US$4 trillion to Central and Eastern Europe, I expect a banking crisis to emerge in Western Europe later this year. More importantly, official forecasts are still in denial with respect to the Western European economy, as the Euro Zone and Germany in particular are expected to emerge out of recession by the second half of this year. With respect to emerging markets, I continue to expect China, Brazil, and India (with the glaring exception of Russia) to outperform international developed equities over the next 3 to 5 years, as these countries continue to embrace capitalism and to make investments in their own workforce and infrastructure.
With the ongoing deleveraging in both the residential and commercial real estate markets, I would advocate a 0% allocation in REITs. As I discussed earlier, I expect mass deleveraging in the retail real estate and the lodging industry later this year, as retail and leisure spending continue to decline. At the same time, an enormous supply of retail and lodging real estate is expected to come online this year and in 2010. While underwriting standards were clearly more discipline in the commercial real estate market, this doesn't mean that cash flow forecasts were not too optimistic. As for commodities, I continue to urge subscribers to stay away – given the contango in the oil futures markets, along with a tremendous amount of natural gas potentially coming online over the next few years (in particular, from the Marcellus and the Haynesville Shale formations, which collectively hold over 300 Tcf in recoverable reserves). Within the fixed income market, I do not advocate a purchase in high yield bonds just yet, as I expect more bankruptcy filings later this year. On the other hand, I believe investment grade corporate bonds are a great buy, as well as bank debt (which are senior to the government's preferred stock holdings in the capital structure) and TIPS, as the latter is now pricing in deflation in the US for the next five to ten years.
For the typical university endowment or ultra-high net worth individual, I have compiled a sample target and recommended target asset allocation (this is taken from an actual university's target asset allocation). The “target” is the endowment's original target allocation, while the “recommended target” is my recommendation allocation for the next 12 months. In general, I am okay with the heavy exposure to hedge funds and private equity funds, assuming the endowment's investment committee has done a thorough job of evaluating their managers. Given the endowment's liability duration (which is higher than the duration of pension plan liabilities and obviously the duration of the individual investor's liabilities), it is prudent to have a substantial portion of the endowment's assets tied up in various hedge fund and private equity strategies in order to take advantage of the current “dislocations” of the financial markets and the “illiquidity premium” of private equity investments. Again, similar to our recommended asset allocation for the individual investor, I would advocate overweighting US equities and emerging equities at the expense of international developed equities (as highlighted in yellow below):
I am also happy with the endowment's 0% allocation to REITs. Assuming there are special opportunities in private real estate partnerships, a 9% allocation is quite prudent, although I would keep a close eye on it. Within the endowment's hedge fund allocation, I would recommend underweighting long-short equity hedge funds. Given the deleveraging that is still occurring within the public equity markets, it continues to be difficult to “extract alpha” using a traditional long-short equity strategy. Within the relative value strategy, however, I believe there are opportunities in convertible arbitrage strategies, given the severe undervaluation of convertible bonds (especially in Asia). Hence the overweight. As for “event driven' strategies, I also believe there are opportunities in distressed debt, as well as capital structure arbitrage. Finally, I would underweight directional strategies such as global asset allocation and global macro strategies, given the attractiveness of other opportunities over those – at least for the rest of 2009.
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 2006 to the present:
For the week ending January 23, 2008, the Dow Industrials declined 203.66 points while the Dow Transports declined 181.71 points. With the Dow Transports declining to below its November 20, 2008 bear market low last Friday, things are now looking very bad for global trade and for the export-driven economies, including Japan, Germany, and to a lesser extent, China (the Chinese government has ample room to stimulate its economy through social safety nets and other spending given its huge budget surplus). With the market waiting for a system-wide bailout of the US banking system, the stock market is now at a crossroads. Even though the Dow Industrials is still 7% above its bear market low, we could very well see another breakdown if the government does not come up with a workable solution for a system-wide bailout – something akin to the RTC-style fund to absorb toxic assets or a system-wide backstop of banks' balance sheets. With tax-loss selling and hedge fund liquidation now over, I expect a sustainable rally in the stock market to develop (and for a significant increase in bank lending) once/if any broad rescue plan is announced. That said, while there are still landmines in various emerging market countries (such as most of central and eastern Europe) and individual stock investments, I urge subscribers to take a longer-term view and to try not to time the market on a day-to-day basis, given the most compelling valuations in the US equity market in decades and the emerging innovative/Schumpeterian growth forces that will inevitably be unleashed in the next 5 to 15 years. We remain 100% long in our DJIA Timing System.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators decreased from -8.7% to -9.0% for the week ending January 23, 2008. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
With the stock market at a cross-roads, the four-week moving average of our popular sentiment indicators could sink to a more oversold level before turning back up. Again, this week's market action will be news-driven, given ongoing jitters about the global banking system (especially in the UK) and fourth quarter earnings reports. For now, we should continue to be cautious, but given the end of tax-loss selling and hedge fund liquidation, the upcoming release of the remaining $350 billion in TARP funds, the compelling global equity market valuations, the sheer amount of global investable capital sitting on the sidelines, and the easing in the money/credit markets, I still believe we are in the midst of the biggest buying opportunity of our generation. For now, we will remain 100% long in our DJIA Timing System.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
Since the most recent bottom of the 20 DMA of the ISE Sentiment Index in early to mid October, both the 20 DMA and the 50 DMA have reversed convincingly to the upside. Historically, a reversal of the ISE Sentiment index from an immensely oversold level has been the most powerful indicator for an upcoming or a continuation of a rally. That said, the 20 DMA of the ISE Sentiment Index is currently at overbought levels (relative to its readings over the last two years) – suggesting that the market could experience some short-term weakness next week, especially with the lingering concerns of the global banking sector. However, as I have mentioned before, as long as one is under the age of 60 and is in a reasonable state of health, I believe US equities are still a great buy at current levels.
Conclusion: For those who are looking to rebalance or change their asset allocations this year, I highly recommend overweighting global equities versus fixed income. Within one's global equity portfolio, I highly recommend an overweighting of US equities and emerging markets at the expense of international developed (mostly Western European and Japanese) equities. Finally, I believe investors should have no allocation to either REITs or commodities, as I believe they are still stuck in a bear market for now. Again, with the US stock and financial markets now at a crossroads, and with the UK government leading the way, I expect the Obama administration to announce a system-wide bailout solution over the next couple of weeks – starting with more concrete plans on how to spend the remaining $350 billion TARP funds, and ending with an announcement of a broader plan to bail out the US banking system. With global economic leading indicators still heading south – and with the OECD economies plunging into deflation – there is no time to lose. Given the immense amount of cash sitting on the sidelines (including the amount of cash assets on commercial banks' balance sheets), any official government “backstopping” of the US banking system would create an immediate incentive for fresh lending. Such a move would also bring a lot of risk capital back into the financial markets – starting with the corporate bond market, and moving on to the high yield and equity markets. However, subscribers should be very selective if buying individual stocks, given the ongoing deleveraging phase in the OECD economies. As I mentioned before, subscribers will also need to be very careful with buying “yesterday's winners,” as the stock market's “favorites” tend to change in a new bull market.
Assuming a system-wide bailout of the US banking system is announced, I expect a dramatic easing of global liquidation pressures, although there are still further “shoes to drop” – primarily in Central & Eastern Europe, and in the commercial real estate market. For those with a long-term timeframe, the stock market still represents the greatest buying opportunity of our generation. I am still constructive on US and Chinese equities. Unfortunately, I am no longer overweight in Japanese equities, as both the Japanese government and corporate CEOs have shown continued reluctance for structural reforms. We will stay with our 100% long position in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA