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How is This Recovery Different?

(Guest Commentary by Rick Konrad – January 14, 2010)

Dear Subscribers and Readers,

Before we begin Rick's guest commentary, I want to update our DJIA Timing System's performance to December 31, 2009.  Note that subscribers who want to independently calculate our historical performance could do so by tallying up all our signals going back to the inception (August 18, 2004) of our system (we have sent our subscribers real-time emails whenever there is a new signal).  Without further ado, following is a table showing annualized returns (price only, i.e. excluding dividends), annualized volatility, and the Sharpe Ratios for our DJIA Timing System vs. the Dow Industrials from inception to December 31, 2009:

DJIA Timing System vs. the Dow Industrials from inception to December 31, 2009

To recap, our DJIA Timing System was created as a tool to communicate our position (and thoughts) on the stock market in a concise and effective way.  We had chosen the Dow Industrials as the benchmark (even though all institutional investors today use the S&P 500 or the Russell 1000), since most of the American public and citizens around the world have historically recognized the DJIA as “the benchmark” for the American stock market.  In addition, the Dow Industrials has a rich history going back to 1896, while the S&P 500 was created in 1957 (although it has been retroactively constructed back to 1926).

Looking at our performance since inception, it is clear that most of our outperformance was due to our positioning in 2007 and the first half of 2008 – when we chose to go neutral (from our 100% long position) in our DJIA Timing System on May 8, 2007, and when we decided to shift to a 50% short position on October 4, 2007 at a DJIA print of 13,956 (which we subsequently closed out on January 9, 2008).  While we have stayed on the long side for the most part since mid January 2008, we also made a couple of timely tactical moves during the May to June 2008 period – which gave our DJIA Timing System nearly 5% in outperformance during that timeframe.  Looking at the last 12 months, our 25% additional long position that we bought on February 24, 2009 (and which we exited on June 8th) provided over 4% in outperformance, although that resulted in slightly higher volatility (since we were 125% long).

Subscribers should keep in mind that our goal is to beat the Dow Industrials by a significant margin over a market cycle with lower volatility.  While we are not totally happy with our performance over the last two years, subscribers should note that we are still ahead of the Dow Industrials by over 9% on an annualized basis over the last two years, or since the beginning of the credit crisis.  In addition, on a cumulative basis, we are ahead of the Dow Industrials by more than 16% since the inception of our DJIA Timing System on August 18, 2004, returning 19.66% vs. 3.42% for the Dow Industrials (on a price-only basis).  Our goal is to beat the stock market with less risk over the long run, and so far, we have done that.  Today, we remain 100% long in our DJIA Timing System. 

Subscribers should remember that:

  1. It is the major movements that count.  Active trading – for the most part – only enrich your brokers and is generally a waste of time – time that could otherwise be spent researching individual stocks or industries (note that our two stock picks, Best Buy and Carnival Cruises have beaten the S&P 500 by a very wide margin since they were recommended);

  2. Capital preservation during times of excesses is the key to outperforming the stock market over the long run.  That being said, selling all your equity holdings or shorting the stock market isn't something I would advocate very often, given the tremendous amount of global economic growth that will inevitably come back in the next innovation cycle.  I am not going to change my mind on this unless: 1) the Fed or the ECB makes a major policy mistake, 2) an inflationary spiral emerges, 3) the Obama administration makes a major policy mistake, such as protectionist policies or higher taxes, 4) extreme overvaluations in the U.S. stock market, or 5) a major regional war becomes a possibility, especially in the Middle East.  At this point, I do not see much threat to the stock market on any of these five counts (versus late 2008, when valuations were overly high and when the Fed was reluctant to cut rates), although Iran remains on our watch list.

Also note that our (annualized daily) volatility levels continue to be lower than the market's, given our tendency to sit in cash during sustained periods of time of market excesses, resulting in relatively good Sharpe Ratio readings across all time periods.  For now, we believe that the stock market made a solid bottom in early March 2009, and thus we will likely remain 100% long in our DJIA Timing System for the time being (unless the Dow Industrials experiences a rip-roaring rally this quarter – in which case, we will shift to a more defensive position).We will again update the performance of our DJIA Timing System at June 30, 2010.

Let's now roll onto Rick Konrad's guest commentary!  For those who had want learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick has been a regular guest commentator for a few years now and is offers his unique insights to us every first and third Wednesday of the month.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick compares the current economic recovery to those of the past, and believes that capital spending and exports will pick up the “slack” in the U.S. economy as consumption growth remains rather muted.  Rick ends with a discussion of the general market and a fundamental breakdown of the ten economic sectors.  Again, this is a must-read.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see "The Great Depression in Listings" for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


Happy New Year!

What a contrast 2010's inception infers as compared to the beginning of 2009. Most of us are elated and surprised to have seen the returns that last year provided. Yet, following the washout of 2008 and the tsunami of fear that swept most investors into cash, capital markets were coiled into a powerful vault that superseded our wildest hopes. What will the New Year bring?

Remember how much doubt was expressed about the sustainability of this recovery. Observers concocted “L” shapes, “W” shapes, and “square root” shapes to describe the trajectory. Every recovery is different, the leaders and laggards of the recovery switch their velocities with every cycle and certainly this also affects which groups assume market leadership.

Anecdotally, I remain encouraged by most of what I see. The Conference Board's Measure of CEO Confidence edged up one point to 64 in the most recent quarter, indicating continued optimism about economic growth. It was its fourth consecutive gain, albeit the smallest, to its highest level since Q2 2004.  Three-quarters of respondents noted better economic conditions. The Beige Book data indicates an uptick in manufacturing in about half the districts.

Consumer spending over the holiday season was higher than a year ago, but still much weaker than in 2007.  Consumers remained cautious, focusing on bargain items and necessities.

Most economic commentary that I hear suggests that the current recovery (for which we have but one quarter of data but which most believe started in Q3) is tepid.  Utilizing some JP Morgan and Bureau of Economic Analysis data, here is a look at the most recent recovery versus prior recoveries and compared to the last 50 years.

 

Last 50 Years

“Share”

Last 7 Recoveries

“Share”

Most Recent Recovery

“Share”

Overall GDP Growth

3.2%

100.0%

5.0%

100.0%

0.9%

100.0%

Less Cyclical Components

2.6%

82.6%

2.0%

40.1%

0.2%

24.1%

Consumption ex-Autos

2.1%

66.8%

2.4%

47.9%

0.3%

35.0%

Commercial Construction

0.1%

2.4%

-0.1%

-2.3%

-0.1%

-8.2%

Net Exports

-0.1%

-0.1%

-0.6%

-12.7%

-0.1%

-15.7%

Government

0.5%

14.9%

0.4%

7.2%

0.1%

13.0%

More Cyclical Components

0.6%

17.4%

3.0%

59.9%

0.7%

75.9%

Auto Consumption

0.1%

3.0%

0.4%

7.7%

0.3%

31.7%

Residential Construction

0.1%

2.1%

0.7%

14.5%

0.1%

16.2%

Equipment

0.4%

12.3%

0.5%

9.1%

0.0%

2.2%

Change in Inventories

0.0%

0.1%

1.4%

28.6%

0.2%

25.8%

The past 7 recoveries are measured over a four quarter period, so perhaps it is somewhat unfair to compare this against the one quarter of data that “most recent recovery” represents.

The character of most recoveries following a recession is a heavy dependence on the recovery of the more cyclical elements of the economy, even though over 50 years of economy, these most cyclical elements provide only about 17.4% of the economic recovery. Post recession recoveries ordinarily command about 60% of the growth from this cyclical element. In the third quarter, the more cyclical components provided about 76% of the “ammo” for the recovery. The sub-components of the “more cyclical” economy were quite different than in the past. The cash for clunkers was very successful, providing about 31.7% of the push in the third quarter as compared to normal conditions where auto consumption is a mere 3% of the economy. In prior recoveries, autos are an early cyclical as well but provide only about 7.7% of the charge. Housing performed surprisingly well, in line with prior recoveries probably due to the housing credit. Corporate capex on equipment contributed almost nothing as of yet, a modest 2.2% of the fuel as compared to a more normal 9.1% in prior recoveries, and well below “normal” levels. The focus on cost control and the emphasis on maintenance of free cash flow in a credit-deprived environment have certainly slowed the pace of the recovery. Inventory changes contributed about 26% of the fuel in the third quarter, roughly in line with most recoveries. However, corporate investment in inventories is well below historical levels as working capital improvements have been prevalent.

When the less cyclical components of GDP growth are examined, the current recovery demonstrates a fairly muted response compared to the past. Though under “normal” circumstances of the past 50 years, these segments provide some 83% of the economic fuel, particularly consumption, this recovery has seen only about one quarter of its fuel from this segment, due to the very high reliance on what have been government –backed programs in housing and autos. Commercial construction subtracts as it usually does at this stage, but represents an 8% “retardant” on growth as compared to about 2% in prior recoveries. Net exports, despite the dollar weakness have not helped either, and largely due to the high correlation of the recession globally, are worse than most recoveries. Despite the tumult and accusations of irresponsible government spending, the push from “G” has been less than normal times at 13.0% versus 14.9%, a rather surprising result. However, given the muted nature of the recovery and the rather weak confidence in most segments, government spending is significantly higher than what has been needed in the last 7 recoveries.

What conclusions should we draw about the economic recovery? Yes it is different and has been influenced considerably by government policy. Government spending has been an important propellant but stands out largely because of the weak private market response. In fact, relative to 50 years of history, government spending, much as we don't want to believe this, is not becoming an inordinately high contributor to the economy, rather its influence and suasion on the private sector has been the major driver. The corporate sector, which unlike the consumer sector is quite comfortably capitalized and liquid, has not held up its usual role in the recovery. My belief is that corporate capex will begin to pick up through the rest of this year and will become a much more significant driver of growth. Net exports too have yet to ignite, but I believe that as the global economy starts to build, US companies will be a beneficiary.

Optimism is not excessive at present. Despite the huge run the market has enjoyed, there remains a cloud of doubt and disbelief rather than a surge in optimism as Henry's work continues to show. Short term, we are quite overbought, but the long term mutual fund picture is quite instructive:

Fund Flows per Investment Company Institute)-To November 2009 in $billions

Year Domestic Equity International Equity Taxable Bond Tax-Exempt Bond Money Market
YTD 2009 -30 26 285 64 -535
2008 -151 -82 19 8 637
2007 -48 139 98 11 654
2006 11 148 45 15 245
2005 31 105 26 5 64
2004 111 67 3 -14 -157
2003 130 23 39 -7 -258
2002 -25 -3 124 16 -46
2001 54 -22 76 12 375
2000 260 50 -36 -14 159
1999 176 11 8 -12 194
Current Assets Under Management $3,580 $1,245 $1,736 $450 $3,318

Note that this data does not include ETFs which have absorbed a significant amount of investors' appetite for pooled product. The global ETF industry (as compared to the above data which is US only) had 1,939 ETFs with 3,775 listings, and assets of US$1,032 Billion from 109 providers on 40 exchanges around the world at the end of December 2009 according to BlackRock.

Like Rodney Dangerfield, domestic equity funds in the US get no respect with outflows over the last three years and very modest inflows prior to that. Most of the capital flows last year was out of money market where zero interest rates provided plenty of incentive to do just about anything else. Bond funds absorbed most of these flows, hopefully into high yield funds rather than Treasury based funds.

Let's look at performance and valuations by sector:

Financials  
2009 Performance  17.2%
Since Oct 07 Peak -57.1%
Since Mar 09 Low 134.4%
Forward PE 14.9 times
Trailing 20 Year PE 15.8 times

 

Technology  
2009 Performance 61.7%
Since Oct 07 Peak -10.6%
Since Mar 09 Low 87.2%
Forward PE 16.8 times
Trailing 20 Year PE 27.0 times

 

Health care  
2009 Performance 19.7%
Since Oct 07 Peak -9.8%
Since Mar 09 Low 45.4%
Forward PE 12.2 times
Trailing 20 Year PE Trail24.9 times

 

Industrials  
2009 Performance 20.9%
Since Oct 07 Peak -32.1%
Since Mar 09 Low 86.6%
Forward PE 16.7 times
Trailing 20 Year PE 20.1 times

 

Energy  
2009 Performance 13.8%
Since Oct 07 Peak -23.2%
Since Mar 09 Low 40.7%
Forward PE 13.8 times
Trailing 20 Year PE 19.2 times

 

Consumer Discretionary  
2009 Performance 41.3%
Since Oct 07 Peak -18.1%
Since Mar 09 Low 89.6%
Forward PE 16.3 times
Trailing 20 Year PE 19.8 times

 

Consumer Staples  
2009 Performance 14.9%
Since Oct 07 Peak 0.7%
Since Mar 09 Low 41.2%
Forward PE 14.2 times
Trailing 20 Year PE 21.6 times

 

Telecom  
2009 Performance 8.9%
Since Oct 07 Peak -28.7%
Since Mar 09 Low 36.2%
Forward PE 13.6 times
Trailing 20 Year PE 18.5 times

 

Utilities  
2009 Performance 11.9%
Since Oct 07 Peak -17.7%
Since Mar 09 Low 44.0%
Forward PE 12.8 times
Trailing 20 Year PE 14.3 times

 

Materials  
2009 Performance 48.6%
Since Oct 07 Peak -21.6%
Since Mar 09 Low 86.7%
Forward PE 17.4 times
Trailing 20 Year PE 19.3 times

 

S&P 500  
2009 Performance 26.5%
Since Oct 07 Peak -24.9%
Since Mar 09 Low 67.8%
Forward PE 14.8 times
Trailing 20 Year PE 19.8 times

 

As you can see, despite the significant appreciation by the aggregate index, there were many sectors that have had significant under-performance. A “Gimme Shelter” portfolio of utilities, telephone utilities and consumer staples provided fairly modest relative performance for the year. Stock and sector picking was of paramount importance through last year.

We will be reviewing our favorite sectors with you in our next Marketthoughts post as well as some stock picks. As we look forward to a much less exciting year, we believe that stock selection will be of far greater importance than the sector selection. Admittedly, within some sectors, the pickings are getting slim and good performance will require some above consensus earnings performance. We are beginning to see such opportunities in the defense stocks but strangely, we are sensing this in some of the auto parts companies. We will have more to say about this next time.

Wishing all a prosperous year!

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