The Opportunistic Investor Portfolio
(October 18, 2009)
Note: So much for Peak Oil. According to the USGS, the Bakken Formation – located at the borders of the states of North Dakota and Montana – contains an estimated 3.0 to 4.3 billion barrels of undiscovered, technically recoverable oil. This makes it the biggest oil formation in the lower 48 states. Meanwhile, many analysts are now asserting that the Three Forks-Sanish formation – located right underneath the Bakken Formation – may actually be a separate formation and contain another 3 to 5 billion barrels of recoverable oil. As drilling technology continues to improve (note that horizontal drilling has done wonders for natural gas supply), I expect the amount of recoverable reserves to increase over the next few years. With the ongoing technological breakthroughs in solar power, cellulosic ethanol, algae-based biofuels – combined with better battery technology – I expect US oil import volumes to decline by half over the next five to ten years.
Dear Subscribers and Readers,
Let us begin our commentary by reviewing our 9 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 2,176.09 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 1,867.09 points as of Friday at the close.
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;
9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points.
In our “ad hoc” commentary on Wednesday evening, we stated that we would strive to provide more value to you by providing more tradable ideas in our future newsletters. We now intend to map out our plan.
We created MarketThoughts.com with the mission of providing the highest level of service and investment education to our clients. Our service was created in 2004 to help our readers navigate what we believed was a unique investment and economic environment – an environment characterized by historically high asset valuations, relative complacency, but which also promised great changes/upheavals ahead as we move forward into the 21st century. At the time, we believed equity P/E ratios will continue to shrink – and that with modern globalization and the proliferation of cheap information via the internet – many whole industries will be transformed or even destroyed (e.g. the destruction of the domestic auto industry was a foregone conclusion). Trends that we tracked included the aging of the baby boomers, the rise of China and India, and the aging of our domestic energy infrastructure (which we correctly believed would result in higher crude oil prices).
Our twice-a-week commentaries were designed to educate subscribers about the stock market, the broader financial markets, and the global economy beyond the headlines. Our DJIA Timing System was incepted on August 18, 2004 and was designed to outperform its benchmark, the Dow Jones Industrial Average, over a typical market cycle on both an absolute and risk-adjusted basis. While we have received very positive feedback about our global macroeconomic and other education commentaries, we feel like we could provide greater value to subscribers through more targeted commentaries about certain investment ideas (and developing a mechanism for tracking these ideas). Over the next month or so, we will modify our website to include a dedicated session on these ideas. We have named this section “The Opportunistic Portfolio.”
The Opportunistic Portfolio
As mentioned, The Opportunistic Portfolio is designed to provide greater value to our subscribers through the creation of more targeted, original, and timely investment ideas. It will also act as mechanism to track our investment ideas and to make us more accountable. But just as important, The Opportunist Portfolio is an inevitable offshoot of my passion for tactical asset allocation, global macroeconomics, and opportunistic investing, as well as my belief that there is more value-added through opportunistic investing/tactical asset allocation (at least in the current environment) rather than active investing through traditional long-only stock-picking or private equity strategies. This applies to retail and institutional (i.e. public pension fund, endowment, and foundation) investors alike.
As the stock market became more efficient in the 1990s, low-cost passive indexing and/or quantitative enhanced indexing strategies became much more viable strategies for both retail and institutional investors (e.g. I know pension funds that are only paying one basis point (yes, 0.01%) in fees to index to the S&P 500). Folks such as David Swensen of the Yale Investments Office, meanwhile, chose to focus their resources (and investment fees) on more inefficient areas of investable asset classes, such as private equity (preferably in management teams that could add operational value), distressed debt, and private real estate. With the exception of last year, this strategy has paid off very well for David Swensen and for other institutions such as Harvard, CalPERS, etc.
Alas, all good things must come to an end. With many endowments and foundations now trying to emulate the “Yale Model,” a significant portion of inefficiencies in the private equity market has been arbitraged away. Even within the middle market private equity asset class, auction markets are now cropping up – this “exchange market” for private equity has attracted more bidders and aided in the price discovery process – thus allowing business owners to sell their private businesses at higher prices than before. Aside from riskier investments in the Middle East & Africa, or in other asset classes such as fine art, fine wine, and antiques, there are really no comparable asset class today to what private equity was in the early 2000s – and if one is managing a $40 billion pension plan, investments in these markets are certainly not worth the effort given their inherent lack of liquidity.
As I asserted, however, one field is still relatively fertile for those retail and institutional investors who want to obtain better risk-adjusted returns in their portfolios. This field is what I would term “opportunistic investing.” In the broader sense, this generally encompass ideas that only occur once or twice a year, covering things such as distressed investing, liquidations, and various global macro/sector themes when the opportunity arises. Many endowments and public pension funds now have an opportunistic investing “bucket” (which is generally 5% to 10% of the total portfolio) – so that when the opportunity comes, capital can be deployed very quickly and efficiently. There are three reasons why I believe opportunistic investing provides an intellectually sound framework to achieve outsized returns:
- In general, institutional investors (including hedge funds and traditional long-only mutual funds) are not looking to beat their peers through opportunistic investing. Success in this area typically involves a broad global macroeconomic background and the capacity to “sniff out” contrarian investment ideas – which many investment professionals are not trained or qualified to do. The relative lack of capital pursuing these opportunities suggests that the market for opportunistic investing is “inefficient.”
- With global policy makers now actively intervening in the financial markets, and with the unprecedented change occurring in many sectors of the global economy, there would be more opportunities for investors who are nimble and have a better grasp of geopolitics and global macroeconomics.
- Global macro/opportunistic investing is truly an area I am passionate in – as my writings have so far attest to. While I cannot claim an advantage in valuing individual securities or understanding a company's business process, I tend to think I have a better framework of figuring out how the global financial market and economy works – and how this would affect global tradable assets. With the “new era” of global government/central bank intervention now upon us, I have also decided to pursue a Master of Public Policy degree at UCLA (with a concentration in international policy) – which would help me better understand how global policies are shaped and implemented and how this would affect the financial markets.
Over the last 12 months – aside from our explicit signals in our DJIA Timing System – we have only proposed two investment ideas in detail and that subscribers could easily act on. In our November 13, 2008 (“Charting Best Buy (BBY)”) and January 15, 2009 (“Cruisin' Into the Sunset”) commentaries, we laid out our case why these large cap stocks in the consumer discretionary sector were a “buy.” In addition to the market's overall pessimism on consumer discretionary stocks, there were also legitimate company-specific reasons for us liking these two stocks at the time.
Since we have not articulated an exit strategy for these two stocks, we will thus monitor them in our Opportunistic Portfolio. Note that since we are catering to both retail and institutional investors, the practice of buying large cap stocks is probably the most “micro specific” we would get (small cap stocks just do not have the liquidity that institutional investors need) – and even then, would probably be few and far between. Going forward, our recommendations in the stock market would most likely be country, sector or industry-specific. Our investment philosophy in this portfolio would allow us to invest in any tradable, liquid asset class, anywhere in the world. Following is an update of our Opportunistic Portfolio as of last Friday:
|The Opportunistic Portfolio
(As of October 18, 2009)
||Best Buy Common Stock
||Carnival Common Stock
Over the next month or two, we will design a specific section for our Opportunistic Portfolio. Subscribers who are interested in opportunistic investing and who want us to explore certain ideas (note that we will publish these ideas, although our subscriber base is too small to impact the markets) should email them to us.
As I mentioned in our last few commentaries, a couple of ideas so far would include going long the US Dollar Index and shorting UNG, the natural gas ETF. We will illustrate these two potential trades as new developments, ideas, and thoughts come along.
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 January 2007 to the present:
For the week ending October 16, 2009, the Dow Industrials rose to another new high, closing 130.97 points higher. Meanwhile, the Dow Transports also to a new high, closing 147.43 points higher. Both the Dow Industrials and the Dow Transports made rally highs last week – negating the Dow Theory non-confirmation by the Dow Transports a week earlier. Per the Dow Theory, the upside trend remains intact. However, given overbought condition in the stock market, and given the vulnerability of the European banking system and US commercial real estate market (at the very least, these two sectors still need to raise a substantial portion of capital from the equity markets), I continue to expect the US stock market to be mired in a consolidation phase for the rest of this year. Should the Federal Reserve withhold liquidity creation to try to prop up the US Dollar, I expect the market to correct over the next few weeks. For now, since the intermediate trend remains up, we will maintain our 100% long position 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 increased from a reading of 8.6% to 9.6% for the week ending October 16, 2009. 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:
Note that the four-week moving average just hit a 15-month high as of last Friday. While this reading is still far from a historic overbought level, its relentless rise from early March to the present suggests that individual investors have gotten too bullish, too quickly. That is, while there is still enough “fuel” for a longer-term rally, probability suggests that the stock market will need to consolidate before we can embark on a further rally. Moreover, while the “Bernanke Put” is still alive, the Federal Reserve has already indicated it will end its “credit easing” policy at the end of 1Q 2010 – thus constraining liquidity creation and support for the financial markets. For now, we will remain 100% long in our DJIA Timing System, but as we mentioned last week, we would not hesitate shifting to a more defensive position should the Dow Industrials rally to above the 10,500 level on relatively weak breadth and volume.
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:
For the week ending October 16th, the 20 DMA increased from 127.1 to 131.5, while the 50 DMA increased from 123.7 to 125.5. Note that the 20 DMA is now at its highest level since June, suggesting that retail investors are again leaning towards the bullish side (and confirming our other sentiment indicators). With the 20 DMA above the 50 DMA, probability suggests that sentiment will get more bullish as we head into Thanksgiving – suggesting that the stock market rally has further to go. That said, with many of our technical and sentiment indicators in very overbought conditions, the most likely scenario would be for the market to enter into a long period of consolidation over the next few months, especially given the liquidity troubles in the European banking system and US commercial real estate market. For now, we will remain 100% long in our DJIA Timing System.
Conclusion: As the global economy and financial markets continue to evolve – and as global policy makers take a more active stance – the “alpha” opportunities for investment professionals who have a better grasp of global macroeconomics and international policy would be much more fertile than those who are solely engaged in bottom-up investing or “traditional” asset allocation. In order to deliver more value to our subscribers, we have instituted the “Opportunistic Portfolio” – which would act as a portal tracking and monitoring our global macroeconomic investment ideas. I am very excited about this service and looking forward to conversing with our subscribers about your best ideas going forward.
As for the stock market – with the S&P 500 trading at a P/B ratio of 2.2 – and with other valuation metrics (such as Morningstar's proprietary valuation indicator based on its universe coverage of over 2,000 stocks) at near “fair value” levels – stock valuations are simply not “telling us much.” While the compelling valuations in early March 2009 are long gone (it makes more sense to buy blue chip/defensive names at this point), we remain bullish on the intermediate uptrend given the strong upside breadth and volume we've witnessed in the stock market since early March. In the short-run (as mentioned in last weekend's commentary), we may turn defensive in our DJIA Timing System should the market continue its rally (up to DJIA 10,500 or higher) on relatively weak breadth AND volume. One indicator that may provide such a sell signal is the NYSE Common Stock Only A/D line – however, at this point, this indicator is still giving us the “all clear.” Even should this scenario pan out, we will only be looking for a correction scenario – not the beginning of a major bear market. For us to turn very bearish on the market again (i.e. for us to enter into a short position in our DJIA Timing System just like we did in October 2007), many other things would need to line up, including a potential fiscal policy mistake (i.e. higher taxes), economic policy mistake (i.e. major protectionist threats), or a monetary policy mistake (such as the failure of the ECB to assist the Euro Zone's banking system in raising capital). Moreover, while we no longer believe European banks pose a global systemic risk, there is no denying that European banks still need to raise $200 to $300 billion of capital in order to resume its “normal state” of lending going forward. As a result – while this is relatively bullish for the global economy (since this would jump start lending again) – this would be very dilutive for current equity holders – and thus I look for both European and US bank shares to underperform over the next 12 months. In addition, the ongoing decline in US commercial real estate prices continues to pose a global systemic risk, and is something that we will continue to track for the foreseeable future. For now, our short-term belief is that the US stock market will be mired in a consolidation phase for the rest of this year. Subscribers please stay tuned.
Henry To, CFA