Why the Latest ISM Data isn't Anything to Worry About

The latest manufacturing data from the Institute for Supply Management, or ISM, certainly spooked the market into a sell-off, but was it justified? In other words, Is the weak ISM Purchasing Managers Index, or PMI, data the first indicator of a slowdown in the manufacturing sector, or is it merely a weather related phenomenon? 

Read the full article linked here

Trends in the Industrial Economy

One way to check the pulse of the industrial sector is to analyze the outlook statements from the industrial gas suppliers like Praxair  $PX  and its rival Air Products  $APD . They always give great color on short term trends in global industrial markets, and there a very few companies with more overall exposure to the manufacturing sector.

Read the full article linked here

Analysing the Fed Model

What happened to the so-called Fed model? Although it was never actually endorsed by the Federal Reserve, the idea of comparing the 10-year Treasury yield and the earnings yield (earnings divided by price) on the S&P 500 (SNPINDEX: ^GSPC  ) has become a standard valuation tool for many investors. Moreover, for investors in SPDR S&P 500 (NYSEMKT: SPY  ) or the iShares Core S&P 500 (NYSEMKT: IVV  ) , a view on the value and future direction of the indexes is a critical part of investing. So how useful is the model, and what can investors learn from it?

Introducing the Fed model
As usual with valuation methodologies, there is no end of disagreement over which input factors to use. For reference, the earnings used in the following charts is as-reported, rather than adjusted. All of the raw data used comes from Noble prize winning economist Robert Shiller's website at Yale. 

The basic theoretical idea behind the model is simple. An investor faced with buying bonds or equities might choose between a 10-year U.S. Treasury yielding, say 5%, or buying an equity with an earnings yield (earnings/price) of 5%. Roughly speaking, when the Treasury yield is below that of equities then it makes sense to buy equities, and vice versa.

The following chart compares the long-term performance of these two variables. As a rough guide, when the earnings yield (in red) is above the 10-year Treasury yield (in blue) then equity markets are seen to be cheap and vice versa.

Source: Robert Shiller Home Page.

Yes, you are reading the chart correctly! The model is implying that the S&P 500 is a screaming buy right now. So does that mean that equity investors should just pile into index ETFs and enjoy the ride upward?

The answer depends on how much you trust the model.

A false friend
The model became popular in the '80s and '90s because it appeared to provide a very useful way to judge the future direction of the S&P 500. In fact, plotting the 10-year yield (x-axis) against the S&P 500 P/E ratio (y-axis) and performing a regression analysis on the data produces a remarkable result.

The best-fit trendline in the chart generates an equation with a coefficient of determination, or R^2, of 0.83; a result which indicates a very strong relationship. In plain English, the equation (rounded up) of y=0.98x-1.5 means that for a 10-year yield of, say 5%, the S&P 500 earnings yield should be equal to 0.98*5-0.015=4.9%. Since the earnings yield is the inverse of the P/E ratio, this implies a P/E ratio of around 20 times.

Source: Robert Shiller, author's analysis.

It's not hard to see why this metric became popular, because from 1980-2000 it appears to offer a failsafe way of investing in bonds or equities!

However, Foolish readers will note from the first chart that the relationship seems to break down after the year 2000. In fact, from 2003-2013 there is only one period where equities where not "cheap." That's 2009 when earnings (and therefore the earnings yield) collapsed during the recession.

Three explanations
There are many ways to interpret the relative cheapness of equities to bonds right now, or rather to interpret what the market is interpreting on the issue.

One approach suggests that bond yields are being artificially held down by massive injections of liquidity by the Federal Reserve. Therefore, equity investors may be saying that they don't really believe that equities are relatively cheap, because either interest rates will inevitably go up in a few years or earnings will fall in the future. Alternatively, both events could happen concurrently. For example, a collapse of confidence in lending to the U.S. could lead to Treasury yields rising, with damaging effects on corporate growth. However, if equity investors think that interest rates will go up, then why not just short bonds via something like the iPath US Treasury 10-year Bear ETN (NYSEMKT: DTYS  )

Another explanation is that investors are afraid of a cataclysmic event in the future, and don't wish to hold equities. Indeed, every recent global recession seems to have been deeper than the last. Moreover, the U.S. public debt situation is such that the U.S. (and the global economy) could face a severe and lasting depression if another recession takes place in the next few years.

US Projected Government Debt data by YCharts

The third explanation is that asset classes' valuations tend to be the product of a combination of fundamentals and waves of enthusiasm that come in to the sector. It was equities in the late '90s, then property in the early 2000s, then oil and commodities, then it was gold, and now it's emerging market bonds.

The bottom line
Unfortunately, the Fed model doesn't provide a catch-all solution to asset class allocation.  Any valuation method needs to be put into the context of the overall investment environment, and while it's easy to argue that the Fed model works under "steady state" conditions (such as between 1980-2000) it's a lot harder to predict when those conditions will come about again. Investing just isn't that simple.

Protectionism on the Rise

Since the recession of 2008 the main debating point of the investment community has been over the possibility of a sustainable recovery in the global economy. However, this focus could lead many investors to be blindsided by the fact that increased protectionism has caused world trade to grow slower than global GDP. The repercussions have been directly seen in transportation plays like shipping company DryShips (NASDAQ: DRYS  ) and FedEx (NYSE: FDX  ) . Moreover, an increased climate of protectionism, led by countries such as India, also threatens prospects for companies as diverse as Cisco (NASDAQ: CSCO  ) and Pfizer (NYSE: PFE  ) .

Global trade growing slower than GDP
Over the last few months, three highly regarded institutions have highlighted the increasing growth of protectionism in the global economy. First, in an interview with CNBC television, World Trade Organization Director-General Roberto Azevedo outlined that the WTO would downgrade world trade growth estimates for 2013 from 3% to 2.5%. In addition, 2014 estimates would be cut from 5% to 4.5%. These would be done because of protectionism.

Second, the EU produced a report that highlighted a "worrying increase in the adoption of certain highly trade-disruptive measures." Interestingly, the emerging markets appear to be the worst culprits with Brazil, Argentina, and India cited in the report's conclusions.

Third, the International Air Transport Association argued that almost 500 protectionist measures were taken in 2012 alone.   Furthermore, data from the IATA clearly demonstrates that airplanes' cargo revenue and passenger revenue have diverged since the recovery took place. Cargo revenue is particularly susceptible to protectionism.

Source: IATA.

Transportation companies FedEx and DryShips affected
The immediate consequences can be seen in air cargo and transportation companies. For example, FedEx has undergone a remarkable transformation in profitability in recent years.

Source: Company presentations.

In recent years, FedEx has had to retire planes in its express segment because international express and cargo revenues have been less than hoped for.   The company still has good long-term growth prospects from e-commerce demand and its internal productivity improvement program. However, if a trade war escalates, then FedEx is likely to be a loser.

Moreover, the impact isn't restricted to air cargo. Shipping has also struggled, and a historically accurate predictor of the global economy, the Baltic dry index, has diminished in importance. The index is a measure of the shipping costs of moving raw materials. For example, here is a chart of the share price of Dry Ships vs. the Baltic dry index.

DRYS data by YCharts

Spot the correlation!

Shipping companies will be inordinately hit by a trade war, because they rely on future cash flows to at least offset the depreciation in the value of their shipping fleet.

Technology, pharmaceuticals, and consumer goods
A full-on trade war will obviously hurt the global economy, so most companies will be affected. However, smaller protectionist measures will hurt some companies more than others.

The U.S. is a major exporter of technology solutions, and Cisco is one of its leading players. Cisco just reported a very weak quarter for its emerging markets, and it's not clear if it was at least partly due to protectionist measures.

It would not be surprising if tit-for-tat measures were being taken by certain governments. In 2012, a U.S. House of Representatives report argued that Cisco's Chinese rivals Huawei and ZTE "could undermine core U.S. national-security interests," and went on to recommend that Huawei and ZTE be excluded for government work. While the U.S. may be completely justified in its actions, the potential repercussions should be considered by tech investors hoping for emerging market growth.

The pharmaceutical industry is another area of huge concern. Last year, Pfizer's chief intellectual property counsel, Roy Waldron, delivered a damning congressional testimony on the "rapid deterioration of the business environment in India." Waldron argued that India "demonstrates a flagrant disregard of patent rights." The revoking (twice) of its patents for cancer drug Sutent (while an Indian generic manufacturer launched its product on the market), and the denial of a patent to Pfizer's anticancer therapy Gleevec, were of particular concern. India stands accused of discriminating against U.S. companies in favor of supporting its own generic manufacturers, while its companies benefit from open markets in the U.S.

The bottom line
The rise in protectionism is a worrying trend in the global economy because everybody will suffer if it escalates. However, some industries will suffer more than most and long-term investors in the types of companies discussed above will need to keep an eye out for developments. In particular, countries such as India need focus more on halting their own creeping protectionism, rather than pointing fingers at others.

Equity Markets Set For a Strong 2014?

It's a new year, and Foolish investors' thoughts will naturally turn to the outlook for the S&P 500 (SNPINDEX: ^GSPC  ) and Dow Jones Industrial Average in 2014. One useful predictor of future market conditions is U.S. household net worth, because history suggests that so long as it's growing, then investors should feel optimistic about equity markets. However, when it stagnates, it's time to consider some downside protection.

The roaring 1980s
When it comes to U.S. household net worth, the warning indicator is two consecutive quarters in which the metric grows less than 1%. My earlier article goes through the basics of household net worth and outlines the evidence of its usefulness from 1960 to 1980. The graph below shows the relation between household net worth (numbers on the left-hand side) and the level of the S&P 500 (on the right-hand side).

Source: Federal Reserve, Yahoo! Finance, author's analysis.

The 1980s were notable because not once did net household worth growth less than 1% for two consecutive quarters. While this may seem unremarkable, take a close look at what happens at the end of 1987. The market experienced the famous Black Monday crash, when the Dow Jones fell more than 22% in one day in October. However, U.S. household assets weren't significantly affected, and the fact that there was no warning sign would have encouraged investors to stay in the market despite the trauma of Black Monday.

The 1990s
This graph picks up where the last one left off, marking three instances in the '90s when household net worth grew less than 1% for two consecutive quarters. These instances are marked along the blue line representing household net worth; the numbers above each instance indicate how many quarters each lasted.

Source: Federal Reserve, Yahoo! Finance, author's analysis.

The decade was a favorable environment for long investors, and although there were a few warning indicators, they weren't particularly strong, and investors' fortunes wouldn't have been significantly altered if they followed them. The important thing is to avoid significant downside.

From 2000 to 2013This is where it gets really interesting:

Source: Federal Reserve, Yahoo! Finance, author's analysis.

While there were only a couple of minor warnings from 2000 to 2003, the market dropped significantly in that period. Clearly, market valuations matter, too, and merely following household net worth isn't enough. Meanwhile, the indicator in Q4 2007 presaged six quarters of negative growth in net household worth and would have proved a useful signal to avoid the worst of the 2008-2009 crash.

Right now, however, the current situation looks favorable, as household net worth has risen nicely over the past couple of years.

Is this indicator valid?
In conclusion, the evidence is that following movements in US household wealth is a useful way to gauge the future direction of the market. However, the 2000-2003 period demonstrates that the indicator can't be looked at in isolation. Investors will need to feel comfortable with market valuations, as well as the underlying trends in the economy.

Foolish investors will also need to consider that each recession appears to be getting more and more severe, so this kind of warning system is well worth following, because if the trend continues, then the next recession could be quite nasty.

In addition, there have been plenty of periods where the indicator didn't signal a protracted decline. However, in these cases investors would not have missed out on much upside, either. It's not a perfect science, but it's a useful metric for investors to follow, and right now, it's indicating further gains for the markets in 2014.

Household Net Worth and The S & P 500

There is no such thing as a magic indicator that will tell you when to buy and sell the S&P 500 (SNPINDEX: ^GSPC  ) , and we Fools do not recommend timing the market. However, Foolish investors can use the following indicator to decide whether to be fearful of a sustained market fall or not. It can also help keep you from panicking in the event of a market dip.

Moreover, being cautious doesn't always have to involve selling out of the market. For example, you could always buy some downside protection for your portfolio with a short ETF like the Short S&P Pro-Shares (NYSEMKT: SH  ) ETF or get some protection from volatility with the ProShares Ultra VIX Short-Term ETF (NYSEMKT: UVXY  ) . You could even increase your bond holdings (which can outperform in a recession) with Vanguard's Total Bond Market ETF (NYSEMKT: BND  ) .

Household net worth and the S&P 500
The idea is simple. Most economic trends will usually manifest themselves in a change in U.S. household net worth. In turn, how U.S. households feel about their finances will affect consumption, real-estate markets, business investment, and a whole host of factors that influence the stock market. In other words, follow U.S. household net-worth trends, and you are following a sentiment indicator for the S&P 500.

The Federal Reserve publishes this data on its website. The data comes out a quarter after the period in question, but no matter -- this analysis is for strategic considerations, not for market timing.

In the graphs I use to illustrate this indicator, the correlation between household net worth and stock market performance shows when sequential growth in U.S. household net worth is below 1% for at least two running quarters.

The 1960s
There were two instances in which this correlation showed during the 1960s. The first was in Q1 of 1962, and it's a short trend only lasting two quarters. Moreover, Foolish investors should note that the S&P 500 fell 16.8% in Q2, and this surely had a negative influence on net worth. However, this impact didn't last.. In fact, net household worth then increased by 1.8% in Q3 of 1962 and by 4.8% in Q4.

Those who waited for a good quarter or two to confirm that net household wealth was rebounding were probably optimistic again when the S&P 500 reached about 66 points. In a sense, the indicator tells you not to worry too much about a stock market fall, because it isn't really caused by, or even creating, any significant drop in wealth.

The numbers on the left-hand side refer to household net worth, and the numbers on the right-hand side show the level of the S&P 500. The numbers in the middle of the graph show how many consecutive quarters saw household net worth grow by less than 1%.

]Source: Federal Reserve, Yahoo Finance, author's analysis.

The second slowdown in household-net-worth growth lasted for six quarters, during which the S&P dipped at least 20% before it went up again.

1970s
While the 1970s began in a negative fashion, it only took three quarters before U.S. household net worth starting growing sequentially by more than 1%, with 3.4% growth recorded in Q3 1970. As the data is reported in Q4, the S&P 500 is likely to have stood around 95. The S&P 500 index then rose nicely until household-net-worth growth slowed to 0.5% in Q1 of 1973 and 0.8% in Q2.

While it's true that household-net-worth growth of 3.8% in Q3 1973 was something of a false friend -- it would have encouraged you to be optimistic around the 96-point level -- note that the cautionary indicator gave another signal in the next quarter at about 90. Furthermore, the index falls to the low 70s in the quarters afterward.

When data was released that demonstrated U.S. household net worth trending positive again, the index bounced back to about 87. Again, you would have missed some upside with the bounce-back, but you also missed the pain of the violent drop in the markets beforehand..

Source: Federal Reserve, Yahoo Finance, author's analysis.

Perhaps the most important point is that net worth increases nicely from the mid 1970s onwards, thus encouraging long-term investors to stay in the market and buy on the dips. While the increase in net worth in the 1970s is somewhat illusory in real terms (because of inflation), stock prices should go up with inflation, too.

The bottom line
In conclusion, there is scant evidence from the 1960-1980 period to suggest that this indicator is useful for market timing, but it does appear to be a useful primer for thinking about some downside insurance in the form of the ETFs mentioned earlier. Insurance can be bought by hedging your portfolio with some short ETFS as mentioned above. Alternatively, if you are worried about a sudden and violent drop, then buying a volatility ETF may benefit you. If you are worried about a protracted slowdown, then bonds could outperform, so a bond ETF might fit the bill.

For long-term investors, the indicator simply provides a good read on the underlying strength of the economy, particularly in periods where the index is indicating weakness. In other words, it will encourage you to stay in the market when short-term noise suggests otherwise. 

In the next article, I will cover the 1980-2013 period, revealing an amazing fact about the 1987 stock market crash, demonstrating how this indicator would have helped you in 2008, and ultimately arguing why investors should stay bullish right now.

Don't Give Up on US Housing Just Yet

It's not often that a company beats estimates and raises guidance only for the stock to be promptly sold-off by investors. Clearly, in the case of Home Depot (NYSE: HD  ) , the market is pricing in some future macroeconomic uncertainty.

The company's recent earnings were excellent, and gave no cause for the sell-off. The most likely explanation is that investors are starting to fear the future impact of rising rates on the housing market. So is this a buying opportunity in the stock, or is the market right to be concerned?

Home Depot hits a home run

In the second quarter, Home Depot recorded its first double-digit sales increase in over 13 years, and raised full-year earnings and revenue guidance. Indeed, the latter event is becoming a pretty good benchmark for improving conditions within the US housing market.

source: company reports

Clearly the US housing market is doing well this year, but recent rate rises and a fall in new home sales data for July has highlighted the potential dangers in housing. Conditions may well be fine now, but if this turns out to be the peak then buying into home-improvement stores could prove to be a mistake.

Moreover, the valuations on Home Depot and Lowe's (NYSE: LOW  ) suggest that both companies need an ongoing housing recovery in order to move higher from here.

Home Depot P/E Ratio trailing-12 months data by YCharts

If you put these arguments together, it is easy to start beginning the case that Home Depot's prospects have peaked and the stock could fall from here.  Is it really that simple?

Why it's not time to panic

There are four main reasons why investors shouldn't give up just yet.

Firstly, while rising rates will affect housing affordability, according to historical data, buying a house via a mortgage is still affordable. For example, here is the NAHB and Wells Fargo (NYSE: WFC  ) housing-opportunity index.

Source: national association of home builders

It is an index that Wells Fargo investors should follow closely, since the bank runs over 20% of the US mortgage market. The index may well have peaked, but continued job gains and increases in average household wealth will help to mitigate the effects of rising rates on the index.

Indeed, Wells Fargo needs an improvement in new mortgage origination because higher rates are slowing refinancing activity. In response, the bank is taking measures to boost lending, but the ultimate guide to its fortunes will be how the housing market fares in future.

Secondly, homeowner vacancy rates remain low and close to historical norms.

Source: united states census of the bureau

This is a pretty good indication that the housing recovery has legs, because it implies that there isn't an oversupply of properties on the market. The figures are nowhere near the kind of vacancy rates reached from 2006 through 2011.

The third reason is that the economy doesn't just turn on a dime. The US economy is growing (albeit moderately), and investment in housing isn't just a function of interest rates. In fact, rates tend to rise when the economy is getting better, and banks tend to start loosening credit standards when the economy improves. Moreover, job gains will add new potential home buyers to the marketplace; all of which are good for the housing market.

The final reason is that the Federal Reserve is watching! For all the talk of tapering quantitative easing, the truth is that Ben Bernanke always outlines that tapering is contingent upon the economy improving. Since housing is a key part of the economy, it is reasonable to expect that the Federal Reserve will do what it takes to keep mortgage rates low.

The bottom line

The market is right to fear some affect from interest rate rises, but the housing market has too much momentum behind it to fall away anytime soon. Investors in Home Depot and Lowe's should look forward to ongoing improvements in end- market demand.

While Home-Depot is more of a pure-play on housing, Lowe's also has upside from its internal restructuring. The latter is trying to reset its sales lines with a view to increasing inventory turnover. Lowe's is executing well on its plans, but its usually easier to do such things when end-markets remain favorable. In other words, both companies are still likely to see their prospects dictated by the housing market.

With the market seemingly determined (in the short term) to price in some future weakness in Home Depot, it looks like a good opportunity to pick up some stock.

It's Time to Worry About China

There are two ways of looking at developments on the macro-economic front.

The first is to take a top down approach and analyze as much economic data as you can get your hands on. The second is to build up a macro view by aggregating knowledge from looking at a large number of micro sources such as company earnings.

In this article I want to do the latter and look at what a few companies have been saying about current conditions in China. The issue is highly significant because the global economy is reliant on China to generate growth this year.

Government changing or is it a deeper issue?

The key question about current conditions in China is whether the slowdown is a temporary one brought about by the change in Government (as businesses/consumers wait to see the policy changes) or whether it is a deeper problem relating to structural problems in the economy. It is true that the Government has the resources to ‘buy’ its way to GDP growth closer to 8% but will it do so? Moreover will it chase 7.5%-8% growth even if it involves pumping investment into corrupt or non-competitive channels? Even at the expense of inflating a bubble in housing?

The big fear with China’s real estate market is that it is being inflated by liquidity being pumped into the economy (partly from its foreign currency reserves) which has few other mature investment vehicles with which to attract investors. This puts the government in a difficult situation. Should it buy growth at the expense of inflating a property bubble or stand and watch as the economy possibly gets weaker?

What the companies are saying

The most interesting thing about Oracle’s (NASDAQ: ORCL) recent results was the diversity in its geographic results. Its Americas results were pretty much in line with expectations while EMEA was actually slightly above its expectations'. Oracle came in with new license growth at 4% and 5% respectively in these regions.

The big surprise geographically speaking was that the Asia region was down 7% in terms of new licenses. China was cited as being weaker and, interestingly, Australia was particularly weak too. Moreover Brazil was stated as having pulled down growth in the Americas. These two countries are significant because they are commodity-heavy economies which rely on exports to China in order to grow. Since Oracle spoke to continuing ‘to see pressure in China’, I think it is more than a short term issue. The good news from Oracle's perspective is that China is not a huge part of its current sales.

Turning away from technology, I thought industrial filtration company Pall Corp (NYSE: PLL) had some interesting things to say in its recent results. I have looked at them in more depth here. Again, its big weakness in the quarter was from-you guessed it-China. It described many of the markets that it had historically sold into as being ‘down year-over-year’. Indeed its Asian sales were down 11% with China being particularly weak.

Pall’s challenges relate perfectly to the changing nature of growth in the regime. The Chinese stimulus packages will not be about pumping money into heavy industrial and infrastructural projects designed to develop its export laden manufacturing facilities and more about stimulating internal demand. Ultimately this means disruption to companies like Pall who got used to selling to the exporters.

On a broader perspective I think FedEx Corp (NYSE: FDX) gave some fascinating color on the changes in the global economy. Just a few years ago it used to generate the bulk of its profits from its express services but now the big income generator is its ground services.

Going back to 2997, its express services generated nearly 61% of operating income but that fell to around 22% in the last year. Meanwhile its ground services contributed 25% of income in 2007 but it has now risen to 70% now. This perfectly represents the changes in the global economy whereby slow growth has led customers to shift to lower priced (and slower) ground services in the face of a world with $100 oil prices.

In addition, management never fails to point out that global trade growth has been lower than global growth over the last few years. This reflects the structural changes in consumer demand from the Western consumer world which ultimately will lead to slower export growth in China.

Such issues have created operational issues at FedEx as it was geared up for international growth in its international express services. It was a growth that never came and over the last couple of years it has been restructuring and taking impairment charges as it retires unnecessary aircraft and routes. Indeed its big upside opportunity is to generate cost savings in express going forward.

The bottom line

Putting these results and commentary together paints a picture of some short term weakness plus some structural issues in China. Investing in the types of heavy industrial plays on China that worked so well in the past isn’t going to be the best option anymore and there are question marks over the viability of China’s plans to shift to a more consumer orientated economy.

It’s time to be a little cautious over China.

To QE or not to QE

tread carefully in writing this article because whenever anyone discusses the pseudo-religious issue of investing fundamentals and/or why markets move, he is usually met with a gale of fundamentalist abuse. In this case I’m talking about the recent falls in various asset classes, which were caused by Ben Bernanke’s recent statement . I want to look at why the market reacted the way that it did. What does this say about how readers might evaluate investing? In which stocks can we see the repercussions of these changes?

To QE or not to QE, that is the question

In short, the Federal Reserve is expected to reduce bond buying this year because the economy is in better shape. It also expects to end it in 2014, but these expectations are entirely contingent upon the economy getting better. Furthermore Bernanke stressed that he was willing to add whatever support was necessary if the economy didn’t improve. The optimistic among us would conclude that this is actually good news because it confirms that the Federal Reserve believes the economy is getting better. So why did the market sell off so aggressively?

I think the answer is that a new generation of investors is now conditioned to think that asset classes move in tandem with liquidity provision by central banks. ‘Oh look the Federal Reserve is doing more quantitative easing! buy, buy, buy!’ or ‘the latest PMI numbers were crumby but hang on, that means the Federal Reserve will be forced to do more QE!! Buy!’

And lest anyone think this is only a national game, consider the European Central Bank (ECB): ‘What’s that? The Europeans are now writing off hundreds of billions of debt from countries like Greece and also buying their debt in order to keep them solvent? Sounds like QE to me! Buy, Buy, buy!’

How it started and why it has gone on

In truth this all started in 2008 when we all realized (bar some Austrian School enthusiasts) that the global economy would have been toast without massive injections of liquidity from central banks. In a sense we have all lost a certain amount of confidence in the global economy and are more focused on the immediacy of QE as a catalyst for positive equity market returns.

The pattern has been set, and the die has been cast. I guarantee you that after the speech made by Bernanke (and the market falls) the only topic of discussion among young ‘hot-shot’ investors will be over liquidity injections in the marketplace because that is what has guided the returns that they are judged on.

Will it always be like this?

The tricky bit now will be to ascertain whether investors can rid themselves of the notion that markets only move based on QE injections.  If so then good old fashion notions like evaluations and maybe even the equity risk premium could make a comeback. You may say Warren Buffett is a discounted cash flow dreamer, but he’s not the only one. Frankly I have no idea if this will be the case or not but I observe that this type of investment conditioning can go on a lot longer than people think.

What are the stocks to look for?

The key thing in the short to mid-term is to look at the sector/company results for those that are the key markers of the effects of QE.  Within housing, the idea is that as QE is scaled back, the stimulus behind the housing recovery will be reduced.  A key beneficiary of housing would be something like Home Depot (NYSE: HD).

It recently said that it was seeing a broad based recovery in the housing market and since last summer has noted that its growth prospects were diverging from correlation with GDP. The key thing to look for here is whether Home Depot starts to report any deterioration in its market conditions. My view is that it will not because scaling back QE is unlikely to have an immediate effect on housing sentiment.

Another key area will be banking, namely Wells Fargo (NYSE: WFC) and Capital One
Financial (NYSE: COF). The interesting thing about Wells Fargo is that its net interest margin has been falling partly thanks to low interest rates.

So surely rising rates would potentially be a good thing? The answer lies in whether you think the economy is improving and whether loan demand will improve or not. If so then Wells Fargo should be able to make more money anyway. This line of argument highlights the fact that the quality of its loan book and its future prospects are tied to the direction of the economy. If Bernanke is right then Wells Fargo will see increased loan demand. Again it’s something to look out for.

It’s a similar situation with Capital One. It is regarded as a more conservative type of lender and, so far, it has not reported strong loan growth. Indeed, it expects $12 billion of run-off in 2013 and a further $8.5 billion in 2014, and despite a decent automotive market in the U.S. it recently reported a $500 million drop in auto loan origination. As Capital tends to be more conservative, it is useful to follow its commentary closely because it is unlikely to adjust its lending criteria in order to chase business.

Another area worth following closely is the utilities sector, which could be represented by an ETF like the Utilities Select Spider (NYSEMKT: XLU). I think this ETF will be a very useful gauge of interest rate sentiment and/or whether the economy is going to slow down or not. Utilities do tend to be interest rate sensitive (thanks to their tendency to carry debt and pay high dividend yields), and the sector has sold off sharply in recent weeks as the market anticipated Bernanke’s statement.

^TNX data by YCharts

Again it is worth watching this ETF’s movement in order to see what sentiment is over interest rates.

The bottom line

In conclusion, I think the investing fixation with QE will continue for a while yet, and we can expect the Federal Reserve to carry on doing exactly what it has been doing before. If the economy gets weaker (and you will see it in the stocks discussed above) then the rhetoric will turn back into more liquidity provision but, if the economy continues to do well then, and only then, will the QE fixation abate. However we might be headed for some more volatility as this QE obsession continues.

Recent Data Weak But The Economy is Still On Track

The markets have been concerned over the state of the economy recently. The double whammy of a set of weaker Institute for Supply Management (ISM) reports and disappointing payrolls numbers have had the the bears coming out. Although the direction of the market is not really my concern – I’m market neutral -- the direction of the economy is of great interest. There is more reason to be bullish than bearish on the economy. If you are one of those investors that thinks stocks go up with the economy, then now is not the time to lose your nerve.

Now payrolls?

It doesn’t take much to get television journalists shouting, and the last decade has given them more than their fair share of things to worry about. The fact that this fragile psyche also exists in the corporate world shouldn’t really surprise anyone. Discerning investors need to adopt a calmer perspective.

I’m going to start with non-farm payrolls. The key point to understand is just how volatile these numbers are. Moreover, they are subject to significant revisions. In fact, it is rather bizarre that the most followed dataset in the US economy is also one of the most unreliable. I blame Alan Greenspan because he would always refer to it as being the best indicator. This article expresses some of the general underlying issues. The truth is that the payrolls data is usually unreliable from point to point. It is much more useful to take a longer term view.

For example, here are three month averages for the total non-farm payrolls taken from the Bureau of Labor Studies.

There is nothing really unusual about mini troughs and peaks, but overall job growth is still strong. It hasn’t been strong enough to fully gain back the jobs lost in 2008-2009, but that is another matter. We are discussing the direction of the economy.

Furthermore, a quick look at the American Staffing Association Index shows that the index is currently stronger than it has been for over five years.

On a micro level, Robert Half International (NYSE: RHI) always gives good color on conditions. In the company's latest set of earnings, Europe was declared as remaining weak, but its US staffing branches were reported as seeing good demand, particularly in technology and accounting. However, it also stated that the share of temporary jobs (as opposed to permanent) in this cycle was double that of previous recoveries. This may be great news for Robert Half, but it also goes a long way to explaining the sense of ease that is reported over employment conditions in the US.

ISM-ism

The tendency is to look at the ISM data on a monthly basis and then put it out of context. The recent numbers were superficially disappointing, but I think they represented more of a natural correction than any kind of trend change.

Here is the manufacturing data from the Institute of Supply Management for new orders, employment and the headline PMI data.

Note how periods of political uncertainty cause a temporary slowing of orders, which then snaps back as the pipeline build-up gets cleared, following which there is a natural mini correction. I would argue that we are in a period like that now (which has been exacerbated by the sequester), but history suggests that the economy will keep growing -- albeit at the slow pace it has been in recent years.

Investors also need to appreciate that any number above 50 for the index indicates growth. Furthermore, the employment index (it is much harder to turn off employment plans than it is to go slow on new orders or inventory) is still rising well in 2013.

On the micro level, the short-term weakness in the ISM data in December was picked up in the reporting of something like MSC Industrial Direct (NYSE: MSM). Its end demand lacks visibility and is subject to sudden short term changes. Indeed, it reported that its markets were in near ‘paralysis’ in December, and this mirrors the temporary weakness in the ISM data. Furthermore its commentary in its recent results revealed a bifurcation within the metalworking sector. Aerospace and autos are doing fine but general industrial engineering is still soft, with customers delaying activity. Nevertheless if the stock sells off aggressively I think it could be worth a look. Its sales are subject to short lead teams, and if you think the ISM data will improve then this will eventually feed through into MSC's numbers.

Moreover, if we look at General Electric’s (NYSE: GE) recent set of earnings, the surprise was on the upside. Of course, its revenues are a lot more internationally focused than MSC’s will be and its strength in the quarter is an indication that the temporary weakness was really about the US and political considerations, rather than any kind of global drop off in manufacturing. The interesting thing about GE is that--although we know there is pressure on global public spending--it is exposed to areas of government spending (emerging market health care, utilities, transportation etc) that are still being invested in. If the recent results confirm this then the stock is worth a look.

The bottom line

I don’t think the recent data is any cause for significant concern unless it is confirmed by another few months weakness. Short term thinking never did anyone any favors in investing, and the underlying trends for the US economy remain positive. Looking out for stocks that might get beat up with undue short term pessimism seems a good approach to me.

Investing in the Spending Trends of the Wealthy

I have a quick trivia question. What share of US net worth does the bottom 60% of the US hold? Stop for a second and think about the answer. The correct answer is just 4.2% while the top 5% of the US owns nearly 62%.  Now consider an average superstore in an average mall (such a thing doesn’t actually exist but assume it does) and accept that spending correlates strongly with net worth (it does) this would mean that just 5 out of a 100 shoppers is doing the bulk of spending. Meanwhile 6 out of the 10 are doing just 4% of the buying. Now hold that thought.

A Realistic Way to Think About Spending

The reason I am engaging the reader in this kind of thought framing is because it is the reality whereas it is so easy for us to fall into the delusion of misattributing spending trends thanks to the language we use. Analysts and commentators use words like ‘mass’ and ‘luxury’ to describe the retail market. They are useful concepts and I am not in any way arguing that the top 5% only buys luxury goods! However the point is that we should think about retail trends in terms of who is doing the spending rather than just assuming that the conditions of the majority (80% of the US only holds 15.1% of net worth) dictate overall spending.

In order to graphically demonstrate income distribution I’ve broken out the numbers graphically below. All numbers in this article come from research carried about Edward Wolff.

 

I’ve put the bottom 40% but even then it is hard to see! The top 5% is broken out and as you can see comprises almost 62% by 2007.

 

A Bifurcated America?

Indeed the trends appear to be slowly getting worse and I’m sure the economy of recent years has accelerated them. For a host of reasons –most of which I can’t go into here- I think that this will continue. My central point is that there appears to be a growing bifurcation in America and it is just not about money. Lifestyles are also bifurcating and at the heart of the reasons for it lie two ideas which I think are mistaken but widely accepted as truth by the constituent groups that holds them. On the one hand one group seem to think that the US lives in a pure meritocracy and taxes and government expenditure are a disdainful burden on them that is intended to punish their success. On the other, another group seems to believe that all men are born with equal attributes and abilities and the purpose of Government policy is to rectify any ‘unnatural’ imbalances via redistribution of resources. This is part of the reason why the US has such large public debt. You can’t reduce a debt by paying less and spend more, yet that is the ‘happy’ consensus that US has been living in for years.

The result of this mess is that the wealthy are getting distrustful of the merits of the public sector while the poorer segments are developing a dependency culture. Moreover the cultural ties that bind America are splitting.

What Does This Mean For Stocks?

Of course many of these observations have been made by Citigroup in its investment research on plutonomy stocks, however the stocks I want to discuss are subtly different. Whilst those stocks were primarily about luxury stocks, I want to focus on stocks that are emblematic of the cultural shifts and that are dependent upon them continuing. For example the wealthy bought Louis Vuitton bags in the 60’s and they do so today but, what about other differentiating trends in wealthy peoples spending habits?

Let’s focus on lifestyle. Take Lululemon Athletica (Nasdaq: LULU) and Whole Foods Market (Nasdaq: WFM). The former appears to be a business without any significant moat and therefore susceptible to margin erosion as rivals threaten to introduce cooler yoga gear. Indeed a quick look at the figures from Yahoo finance indicates that there is a 27% short interest in the stock. While I sympathize with such an approach and find some of the company’s pronouncements over the cultural importance of its yoga pants to be comedic, I would caution against being too negative. It is not pitching itself into the mass market but rather at the kind of wealthy health conscious lady with significant spending power. Her spending priorities are not governed by the same kind of economics as the rest of the athletics gear market.

As for WFM a relatively small number of its customers make up a huge amount (around 20/80) of its revenues. Moreover as long as the trend towards healthy living and differentiation from the eating habits of the rest of the nation continues then I think WFM can convert shoppers to its offering. WFM doesn’t just offer a healthy option, it offers a tangible differentiated lifestyle choice and wealthy people in the US appear willing to pay for this in itself.

Similarly take something like the Boston Beer Co (NYSE: SAM). Beer is as far from a ‘luxury’ stock as you will ever get but SAM does offer premium craft beers and this market is growing significantly in excess of the mass market beers. All it requires is a notable shift in purchasing behavior from the top 10% of the US and there will be a notable marginal shift in demand. Given that SAM has such a small market share it is not hard to see the company continuing to generate double digit revenue growth.

Another area in which we can expect the wealthy to continue to spend is in personalized health care and cosmetic surgery. Stocks like Myriad Genetics (Nasdaq: MYGN) and Allergan (NYSE: AGN) are worth a look. The former develops diagnostic tests for people who want to assess the risk of developing certain diseases (typically hereditary). Admittedly it needs to develop revenues outside of its Bracanaysis (breast and ovarian cancer) test but if the trend towards the wealthy spending money on personalized and pre-emptive medicine then its chances will improve. As for Allergan, as long as the trend towards cosmetic surgery increases among the wealthy then it can expect good sales of its market leading Botox product.

How to Be a Better Investor

It’s Christmas shopping time: No doubt us obsessive investors will be thinking about gifts and contemplating buying the latest book designed to convince us that a certain investor or other has the panacea to investment or management problems. Whether it is a book on ‘master investors,’ the latest Buffett biography, ‘Business Secrets of the Pharaohs,’  ‘Why Mayan Civilization Collapsed: A Technical Analysis’ or other such nonsense, you can be sure they will be out in book shops near you. Well, in the spirit of Christmas, it’s time to throw my opinions over for free.

Fooled by Topiary

Any discourse on this subject can’t avoid a reference to Nassim Taleb. In truth, most investors owe a debt to him for his popularization of the idea that most of these tomes are merely selling observations of ‘certainty’ on events which are in fact random in nature. I’m greatly sympathetic to this view. For example, if you want to analyze what makes great investors do you only analyze the traits of ‘the greats’ or do you analyze a huge cross sample and see which traits appear to lead to some of them being great?

Let me put it this way. Assume Buffett, Soros and Chanos love doing topiary on the weekends. Conclusion: doing topiary makes you a great investor! However, you can analyze 1,000 investors (including plenty of losing investors) and discover that doing topiary on the weekends actually causes negative overall performance.

In other words, I don’t think a narrow analysis of a few great investors’ traits is a legitimate pursuit.  It’s a bit like looking at say Exxon Mobil or Chevron and the huge run up they both had from 2003 to 2008 and then concluding that the management was fantastic because they may have all favored topiary when in fact it was largely due to the price of oil. If you buy these stocks, you are de facto taking a position in oil.

And don’t get me started on hindsight or survivorship bias!

Stop Analyzing the Pro’s

The other problem that private investors (and authors for that matter) have is that most of the track record is in the professional arena.  This is an issue because professional investors are necessarily solely focused on generating risk adjusted returns.  I’ll explain.

Private investors can take no solace in the track record of professionals.  Essentially the investment industry works on a couple of working principles which it has learned empirically over the years. It took the work of behavioral psychologists Kahneman & Tversky to rationally express these principles or heuristics, but the investment industry has always lived by them.

• A loss is psychologically weighted double that of a gain
• Investors overweight near term performance

The first point plays out because asset managers are terrified to deviate from industry benchmarks on the downside because they will lose their blessed assets under management (AUM), and there is little benefit to be gained in trying to beat their peers because upside is not as strongly rewarded.

The second point is that investors tend to overweight short term performance, and the industry knows this so there is nothing wrong (for the industry) in chasing myriad risky strategies which produce short term outperformance but then blow up when conditions change. After all, the important thing is to get AUM and tie it up.  This is why asset managers tend to have a stable of different types of funds. When one is hot they market it more and then investors duly reward them with AUM. Of course the problem is that that manager may have taken on excess risk to get the numbers. But who cares? Asset managers make money by managing assets after all.

In this sense it is exactly the same principle with what went wrong with the financials. Risk went out the window in many cases and if it wasn’t for the largess of the Government and taxpayers money, the likes of Goldman Sachs (NYSE: GS), JP Morgan (NYSE: JPM) and AIG (NYSE: AIG) wouldn’t be around today. It’s tough to blame them for the whole crisis because so few saw it coming, but then again if conditions collapse for a topiary supply company then they go bust.  Who ever heard of a bank going, errr, bankrupt?  My point here is that these organizations don’t appear to be run with a cognizance that they might fail, therefore the only game in town is (still) to go for profits irrespective of the risk.

I would urge great caution in following professional investors too closely unless they have demonstrable track records of making money over the long term. I would also suggest investors avoid tomes in technical analysis which in fact turn out to be capturing some facet of market conditions that worked for a while only to then fall apart as they changed.

So What to Do?

My only suggestion if you want to be a better investor is to look at your internal thought processes. You will find no end of information, views and data on stocks. In my humble opinion what makes a good investor is the ability to disseminate this mass of information into something coherent and then pick out the salient drivers that are going to guide the stock price. In the end all you want is the stock price to go up while not taking on too much risk. The latter stipulation usually requires a level of humility (diversifying to accept that fact that you might be wrong) that is often missing in professional investors touting for AUM.

No matter, it shouldn’t detract private investors from trying to define clearly what they think is the key driver of the stock price and then analyzing whether they are good at doing this or not over the long term.

As for the Christmas book shopping, I would advise Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay. Any lingering doubt that investing requires humility and the need to avoid selective reasoning should be eradicated after reading that marvelous book.

Who Told Celebrities They Could Do Science?

One of the most disturbing trends of modern times is the inexorable rise of the tendency for large swathes of the population to substitute proper scientific research in favor of “celebrity science.” Well I apologize, but I prefer to get my medical advice on things like GM foods from the FDA and not from, say, a guest on a chat show or a former swing dancer cum yogic flyer who self publishes books and now thinks he is the world’s authority on the issue.  I’m not sure if my approach is the one taken by the majority anymore.

I’m going to discuss a couple of examples here. It’s time to stand up for the scientists. The real ones, not the idiots.

It’s so much easier for people to listen to a celebrity when they are articulating their expertise on medical matters. Indeed, Time magazine has cited research that claims that 24% of parents place “some trust” in medical information given by celebrities.

The MMR Vaccine and Autism, What the Scientists Said

The most infamous case in modern times is the claim that there was a link between the MMR vaccine (measles, mumps and rubella) and autism. Indeed, anti-MMR litigation was directed at companies that manufacture the vaccine. Current manufactures include GlaxoSmithKline (NYSE: GSK), Sanofi (NYSE: SNY) and Merck (NYSE: MRK). Who speaks up for these companies when they are subject to this sort of nonsense in the media?

The original report on which much of the MMR/Autism claim is made was published in the The Lancet in 1998 by Andrew Wakefield. The report has subsequently been denounced as a fraud by the British Medical Journal and has received widespread condemnation in the scientific community.

In case anyone is in any lingering doubt as to the validity of the claim, the following bodies have found no link between the MMR vaccine and autism.

• Centers for Disease Control and Prevention
• The National Health Service in the UK
• Institute of Medicine (IOM)
• World Health Organization
• New Scientist Magazine

In addition the FDA reported on the subject  and discussed the final report of the IOM’s Immunization Safety Review Committee in 2004

“ body of evidence favors rejection of a causal relationship between thimerosal-containing vaccines and autism, and that hypotheses generated to date concerning a biological mechanism for such causality are theoretical only…  …the benefits of vaccination are proven… … widespread rejection of vaccines would lead to increases in incidences of serious infectious diseases”

So this is what the scientists said but they don’t always get listened too, according to a report  until relatively recently “one in four Americans” still thinks that vaccines cause autism.  Why?

What the Celebrities Said

There is no higher profile celebrity expert on autism than Jenny McCarthy and indeed her status on the issue has been raised by appearances on chat shows like Oprah Winfrey and Larry King where she has been on record as believing that vaccines caused her son’s autism. She is not alone as other television and radio presenters have also reiterated these claims.

Indeed media coverage of the Wakefield research caused widespread fear and declining rates of vaccinations with the inevitable disease outbreaks occurring afterwards. Of course the overwhelming scientific evidence (or rather the lack of scientific evidence) is presented to these people, but nothing works. Everything seems to be subservient to homespun anecdotal evidence which is given widespread credibility for no other reason than they saw it on television spoken from the mouth of a celebrity. As another celebrity and great philosopher, Marina & The Diamonds, correctly once wrote “TV taught me how to feel, now real life has no appeal”.

It’s not just celebrities and the media that were at fault here. The Wakefield research was always highly questionable and even after it was widely discredited and evidence came to light that made the Anti-MMR litigation case in the UK untenable, the lawyers still displayed their usual tendency to make money irrespective of the situation. According to an interview with Dr. Michael Fitzpatrick, the lawyers who lead the campaign

“refused to acknowledge openly that the scientific case against the MMR-autism link was overwhelming and advise their clients to conclude the action. Instead, they continued to pursue the case, allowing it to drag on for a small number of families, acting without legal aid funding, for a further three years.”

In addition Fitzpatrick claimed that £8m of the £15m ($23m) in legal aid funding used up in this case went to the solicitors. A further £1.7m went to the barristers and expert witnesses took up £4.3m.

Shameful.

Conclusions

This sad tale of misinformation which was promulgated by self-appointed celebrity experts, fraudsters, self-interested parties and lawyers would be an interesting footnote in history if it was an isolated case. Unfortunately there seems to no end this hogwash. The latest media friendly scare stories-backed up by flimsy “science”- seem to surround genetically modified crops and companies like Monsanto and Syngenta.

I’m certainly not arguing that these companies shouldn’t be subject to scrutiny, but what I am saying is that any criticism of them should be based on the body of scientific evidence rather than listening to chat show ‘experts’, celebrities whose usual response to the overwhelming evidence against their case is simply to find another chat show.

If I want to know about scientific facts I listen to a scientist.

Private Investors Outperforming Professionals?

At some point in his/her investing life, every private investor is faced with the same question: Does he actually add value by investing himself or not?  I suspect the most common response is to ignore the question safe in the notion that it’s just a bit of fun on the sideline. Another is to avoid the complication of benchmarking performance and just be happy that the account is positive. However, for full time investors, the issue simply cannot be avoided.

Discerning readers will note that I specifically reference private investors here. The reason is that professional investors are not that as exposed in how they earn money (fees, etc.) to the vagaries of performance. Private investors lose money when performance is negative. Do money managers refund fees?



Why Professionals Aren’t Trying to Outperform

It gets worse: The investment industry has learned a fundamental truth of behavioral finance and constantly applies it. I’m talking about the tendency of investors to psychologically weight a loss double that of a gain.

Asset managers understand this because they realize that investors will overweight a losing performance versus a winning one. In other words, if an asset manager underperforms for a client his downside risk (losing assets under management) is far greater than the upside from outperforming. Now you know why the investment industry produces such ‘samey’ benchmark-hugging performance. It’s in their interests to do so.

If there was a difference between what, say, T Rowe Price (NASDAQ: TROW) and Ameriprise Financial (NYSE: AMP) did, surely it would show up in marked differences in share price performance?

AMP data by YCharts



And investors in these companies should understand that they are just making a highly correlated bet on the markets by buying them.



A Waste of Talent

I'm not saying there aren’t a lot of talented people in the investment industry. There are, and in their ‘defense’ I should point out that it is hard to outperform when you are not really trying to do so! While this may be disheartening for the young investment professional anxious to prove himself by generating performance, he is soon overwhelmed by the pressure to conform to the industry game of focusing on getting assets under management (AUM) and not particularly bothering about performance.

Remember folks, given the same performance fee, an asset manager generating 5% with $1 billion AUM earns more than a guy generating 12% with $400 million. Who would you rather be? Also consider that during a down year the whole industry will suffer. As none of the major firms with AUM will deviate from each other’s performance they will all make the same excuses and try and hang onto AUM as best they can.

Some of these clowns even try to sell you their services without a track record. If I want my car window replacement, I go to someone who does it every day and is tried and tested at doing it. Alternatively, if I want my money invested, should I go and give it someone who won’t even tell me how good he is at what I am paying him to do?



Confidence is the Key

Turning back to the challenge for private investors confidence only really resonates with someone if it is accompanied by extensive experience. It is something hard won but easily lost. I’ve outperformed the market for years and across different market conditions. No matter. When I have a couple of months of underperformance, I start to stress. I’m the worst investor ever, this is all a waste of time, I am losing money. My hard earned money.

The usual ‘confidence boosting’ supporting arguments kick in. Historically, you lose money 4/12 months a year so it’s just random that two are next to each other. Look at the long term chart, you had blips before. You outperformed for over 10 years so what is two months in the scheme of things? It’s all good stuff but the truth of it only rings true when you get back to a profitable month. It is a stressful game.



Private Investors Edge

So, when under this stress, why exactly should private investors feel they can outperform? Why should they feel they can add value when all the empirical evidence suggests that fund managers don’t do so?

The answer lies in the fact that private investors are actually trying to outperform rather than mimic a benchmark. They don’t have to diversify away returns by constant adherence to sector weightings in the benchmark indices. In addition they are not obliged to be in the market just because they are trying to generate a buck in management fees. Private investors have far more flexibility.

For example take a stock like General Electric (NYSE: GE), which is going to see its prospects correlated with global GDP growth. Here is how the market priced it in 2000:

GE PE Ratio TTM data by YCharts



The good news is private investors don’t have to pay 50x earnings, while professional investors have to hold it. Another example is Google (NASDAQ: GOOG), of which we can see revenue growth here.

GOOG Revenue Quarterly YoY Growth data by YCharts



It is in a nice uptrend since the recessionary dip, and even with the transition to mobile and tablet Internet usage, Google still has a dominant position in search. However, every fund manager this year was forced to listen to the hoopla and hype surrounding Facebook (NASDAQ: FB) just because one part of the investment industry wanted to sell something to another part of the industry. However, amidst all this, very few people actually pointed out that Facebook had no articulated plan for mobile at the time of the IPO. No matter institutional investors were obliged to pick some up due to benchmark weighting issues. Private investors could avoid it altogether. Meanwhile Google goes on churning out revenue growth.



The Bottom Line

In conclusion, I think there are a whole bunch of reasons why hard working private investors can outperform professionals. It’s a stressful process, but then again it is a whole lot more stressful to look back on 10 years of miserable returns for you and then add up what your investment advisor has made out of this process. Despite the puff that the investment industry churns out, private investors are better placed to generate alpha. The real issue is having the confidence to keep doing it. Hopefully reading and participating in this sort of online forum will help!

How to Diversify Your Portfolio

Very few professional investors would advocate a portfolio of equities without insisting diversification. It is certainly a worthy aim, but what is puzzling is that so few seem to understand it or at least make the effort to think in non-conventional terms about. In my humble opinion the conventional and consensus opinion on the subject is plain wrong and investors with even a rudimentary understanding of the underlying issues can better generate diversified portfolios.

In this article I will briefly focus on two ideas.  The first is the concept of beta (derived from the modern portfolio theory beloved of unintentional index hugging fund managers) and the second relates to mechanical based investment systems. In turn, I’ll share a few thoughts on what investors might do to better achieve diversification.


Beta in Investing

The concept of beta is wonderful in principle. Theoretically all an investor has to do is put together a portfolio of stocks whose average beta works out to one and he/she has a portfolio thaqt approximates market risk.  Bingo he is diversified! Furthermore, when he wants more risk, he just buys more stocks with a beta more than one. When he wants less, he just buys stocks with the opposite property.

Unfortunately, it is not that easy. Beta is- by definition- based on historical data. It tells you what was a high or low beta across previous market conditions. I’m not saying that this isn’t useful. It is. If market conditions are the same going forward then the concept of beta is highly applicable. Alas, markets are not that compliant.

In the last 20 years or so, we have been through a technology boom, a housing market boom, a banking boom, a commodities boom, a banking bust, a housing market bust, a boom in emerging market bonds, boom in Gold, a China housing boom and so it goes on. The fact is that market conditions constantly change and deluding yourself that you can obviate the necessity to think about how macro-conditions are evolving by just relying on some backward looking data like beta, is a recipe for trouble.

Consider, a stock like Intel (NASDAQ: INTC) and then look at Caterpillar (NYSE: CAT). Yes, during the dotcom boom the former was likely to have been a high beta stock as the market priced in every ‘Blade Runner’ technological fantasy whilst Caterpillar would have been a lot less beta. After all, they just provide machinery to the boring housing, mining and construction industries. Fast forward a few years into the dotcom bust/low interest rate era and suddenly housing, mining and anything China are (literally) hot property and no one wants tech. Guess who is high beta now?

This sort of example illustrates that beta changes with market conditions and cannot be relied upon. In a brief aside, I will also note that fans of Soros’ reflexivity would also point out that self reinforcing feedback loops also create investment bubbles (i.e. high beta stocks or sectors) and they can come from origins such as sheer sentiment or regulatory changes. How anyone can think that these factors will be expressed in the historical beta of a stock is beyond me.

Ultimately, if the beta moves around with conditions then structuring a portfolio based on this approach will not lead to diversification because the portfolio will do the same.



Mechanical Based Strategies Lead to Unintentional Style or Sector Biases

Another instrument of self-delusion is the seductive idea that investors can achieve diversification by investing based on a set of mechanical metrics which attempt to capture some sort of attribute or other. Again, I am not completely decrying this idea because I use such metrics to quantify stocks and I think they are useful. What I am saying is that if they are applied without consideration of the macro-conditions or overall portfolio direction they will lead to an unintentional style or sector bias.

In plain English –I can use it in occasion, I promise- if a portfolio is constructed purely using a metric such as , say dividend yield or PE ratio or Price/Assets etc, it will end up manifesting an unintentional market view. To give you an example, consider that in 2008 the highest yielding stocks tended to be banks, insurance companies and house builders. Guess what happened next?  The dividend did not exactly provide a floor to the share price, especially when it had a tendency to disappear as earnings collapsed. Investors can look at the stocks like Citigroup (NYSE: C) as a classic example of this trap.

Another example of a pitfall with this approach can be seen if investors focus on only investing in say an earnings or cash-flow basis. This sort of approach has a tendency to immediately disqualify certain sectors like biotech or oil & gas exploration. No one invests in Vertex Pharmaceuticals (NASDAQ: VRTX) or other such stocks because their growth prospects are all about future cash flows and earnings. If you wait for them, you will be too late to capture the upside.

Putting these two examples together begs a key question. How can a portfolio be truly diversified if it overweights one sector and/or it ignores whole swathes of the market?



An Alternative Approach to Risk Management

I’m going to conclude this article by suggesting another approach. Namely, to try and actively diversify the profit drivers in a portfolio and/or select stocks that have upside drivers which are relatively non-correlated with the macro economy. An example of the former approach would be to say balance an oil services company (which you think is undervalued) with say a company that has a high proportion of its fixed costs in oil or energy. Another example would be to buy a fertilizer company and balance it out with a food producer.

In other words, what you are trying to do is pseudo-hedge away macro risks and create a diversified portfolio that isn’t over exposed to anyone sector of the economy. Of course such an approach requires a lot of forethought into stock selection, but hey, no one said investing is easy!

As for the non-aligned approach, I think special situations investors tend to cross over a lot into this camp. It is all about finding stocks with almost hidden upside potential.  I think an example of this now is Johnson & Johnson (NYSE: JNJ). It isn’t the sexiest stock out there but its growth prospects are mainly about execution. If it sorts out its production difficulties within consumer products, integrates the Synthes acquisition and successfully develops sales of its new drug products then the stock price can appreciate irrespective of the economy.

Investing is more of an art than a science and there is no reason for fund managers to try and bamboozle private investors with the idea that they have the secret formula for diversification. They don’t. In truth it is much more about understanding why stocks move in the way they do and trying to balance the overlying risk. There is no reason why private investors can’t do this just as well as institutional investors.

Spanish Housing Market

Spain Housing Market in Crisis

Some economic statistics on Spain displayed here, which suggest that it is still in crisis. Worrying times ahead, but great if you want to buy a property in Spain.

Spain Housing Market Statistics

The funny thing about Spain (and Ireland) was that before the 2008 recession their deficit situation was quite good. Of course, this was the consequence of a housing boom which boosted GDP growth and finances, yet, stored up a whole load of problems now. As ever, it’s worth reminding ourselves that irrespective of the efforts of the Government to capitalize the banks, if their underlying assets are falling in value then more capital will be needed.

The key is the Spanish housing market and, things don’t look good.

Spain House Price Index

Firstly, the latest quarterly numbers (general index) for the Spanish house price index is out from the Instituto Nacional de Estadistica

(%)	Q1 2010	Q2 2010	Q3 2010	Q4 2010	Q1 2010	Q2 2010	Q3 2010	Q4 2010
New Housing	-4.2	-1.7	-2.6	-2.1	-1.9	-5.2	-5.0	-8.5
Existing Housing	-1.4	0.0	-1.8	-1.6	-6.3	-8.3	-9.6	-13.7
General Index	-2.9	0.9	-2.2	-1.9	-4.1	-6.8	-7.4	-11.2

These are annualized numbers which suggest that Spain’s housing market is getting worse.

Furthermore, despite the fall in bond yields since the ECB’s LTRO operations, the banks in Spain are tightening lending conditions.

Spanish Bank Lending

Here is a summary of the Banco de Espana Bank Lending Survey

Index	Q1 2011	Q2 2011	Q3 2011	Q4 2011
Housing	11.1	11.1	11.1	22.2

This number is just the share of banks tightening vs. easing. It’s a similar type of survey to the one that the Federal Reserve does for Bank Lending.

And, nor is it likely to get better any time soon! 

Spanish Bank Bad Debts

Let’s go back to the Banco de Espana for a breakdown of lending and deposits of credit institutions and, then compare this with how many are classified as doubtful

Eur (bn)	2005	2006	2007	Q2 08	Q3 08	Q4 08	Q1 09	Q2 09	Q3 09	Q4 09	Q1 10	Q2 10	Q3 10	Q4 10	Q1 11	Q2 11	Q3 11	Q4 11
Total	1202	1508	1760	1838	1853	1870	1862	1861	1846	1837	1827	1847	1837	1844	1824	1818	1788	1783
Bad	9.6	11	16	31	49	63	79	86	90	93	98	99	101	107	112	122	128	136
%	.8	.7	.9	1.7	2.6	3.4	4.3	4.6	4.9	5.1	5.3	5.4	5.5	5.8	6.1	6.7	7.2	7.6

The rise in the doubtful rate is worrying.

The crisis isn’t over for Spain.

Source:

House Price Index
Banco de Espana Bank Lending Survey
Banco de Espana Credit Data