The Right Track

120 Second Summary

Will Rogers

“Even if you are on the right track, you’ll get run over if you just sit there.”  – Will Rogers

This advice offered by the always witty Will Rogers reminds us that even if one’s portfolio returns best over 98% of money managers in the world, occasionally, bear markets visit the stark reality of statistical theorems upon you. Accordingly, we have adjusted a few positions in order to set up on what we believe may be the “next” right track.

Let it be said, no investment strategy was ever met with greater investor skepticism than ours to massively deploy funds into treasuries, strips and treasury market funds over the past 18 to 24 months.  Perhaps someday, researchers will derive theorems highlighting how controversial strategies lead to future profit as the potential upside identified by our work was, largely, realized. We were on the “right track.”

Though we still believe this approach will continue to garner fruits of profit, one must pause to remark upon the breathtaking speed at which hostilities concluded in Iraq plus [what appears to be] an upcoming $350 billion federal stimulus to the U.S. economy.  This combined stimulus may represent additional profit potential for investors and we have considered increasing asset backed income securities and selecting diversification abroad though we still avoid a number of U.S. blue chips whose sales continue to descend faster than their stock prices. It will be at another time and place, where the question will be answered: ‘How will the United States Treasury rebound from significant tax cuts sans coincidental spending cuts?’ [1]

Burke offers considerable data to assist in beginning to address this rather complex and unique question (tax cuts sans spending cuts). He submits two possible paths for the market to travel in order for stocks to re-visit attractive valuations relative to fundamental data. His research leans on evidence from the “nowhere” trading range of 1968­1982 and the plummet of 1929-1934. [2]

The biggest dilemma we face is: discovering which of these two paths best matches that which the market will travel in the coming years.  At this time, the data produces statistically insignificant results – viz. you cannot prove returns may outweigh risks. Therefore, we move with caution and construct investment strategies to (1) avoid the perils of EITHER of these two scenarios while (2) striving to outperform market indexes in the process.  In a word, we will determine if we are on the right track.  If we are not, we may find the ‘new’ right track may be our old favorite track. Recall, the trend is your friend until it isn’t.

Let the Data Do the Talking

In April 2003, the S&P 500 posted gains not seen since 1982 and the index posted an impressive increase for the quarter amidst the bear market.  Consequently our relative preference for capital preservation led to our relative quarterly performance slipping vis-à-vis the lofty spread posted in the first quarter. Notwithstanding, we are pleased to report we have maintained relative out-performance in most managed account portfolios over the entire period since we began measuring individual portfolio quarterly performance.

Conservative guidance protected a significant amount of capital vis-à-vis the major market averages for quite some time.  Then, on March 12, 2003, our model registered a signal commensurate with the signal registered on the short-term market bottoms seen in July 2002 and October 2002. We began to redeploy some assets over the quarter.  However, as the signals in July and October 2002 begat rallies which later fizzled coupled with other red flags still waving in the market winds (e.g. over-levered consumers), we opted to measure, not over-allocate, our exposure to market risk as projected market return scenarios remain fraught with significant macroeconomic challenges; some not seen in seventy years (e.g. a geo­synchronous economic downturn).

We are inclined to believe the legal woes permeating the mutual fund industry coupled with the inability of many high net worth investors to diversify, at the best, prevent significant market upside and, at the worst, represent future investor casualties.  A change in these phenomena would be cause for re-evaluation of investment strategies.

More specifically with regard to diversification, an autopsy is performed to address the question: Just how did the median stock market investor lose so much money since 2000?  We think clues were in the data.  Consider:

(a) Individuals hold a disproportionate amount of their retirement plans in the company stock of their employer.[3]

(b) Investors are prone to investing in familiar stocks and ignore portfolio diversification. [4]

The mean U.S. household holds only 4.3 stocks: [valued at $47,334]

The median U.S. household holds only 2.61 stocks: [valued at $16,210]3

[It is commonly accepted that market risk cannot be reduced without at least 10 – 12 stocks.]

Nearly 50% of High-Net Worth Investors cannot diversify into the stock market.  Note, private equity capital was worth more than public equity in the United States as late as 1995 [notice?] and is still of the same order of magnitude today [5]. In addition, “over 45 percent of the net worth of investors with private businesses consists of private equity.  Of this more than 70 percent is concentrated in a single firm.” [6]

Why you may ask is the private business owner important to the public equity markets? Answer: Investors in private businesses hold over 12 percent of the total public equity in the United States.[7]

As fundamental recovery fails to materialize and over $3 trillion in investor assets have been lost while in the custody of mutual funds, the fuel for a new secular bull market remains unidentified. Like an aging magician who cannot perform tricks of old, the Federal Reserve’s 13 attempts at monetary stimulus have come up dry.  Thus, all eyes direct their attention on fiscal stimulus (as noted above).  Maybe $350 Billion can pull the rabbit out of the hat. 

The Jeweler’s Eye

What often occurs is exactly the opposite of what everyone is awaiting or outright expecting. Our work persuades us to believe the battle lines are becoming more pronounced while both “sides” are growing impatient – the bulls grow more bullish and the bears more bearish. For instance, a recent study implies bullishness by correlating bullish days on the market with sunny weather. [9] Using corporate insider activity and sentiment as variables, the editor of Investor’s Intelligence called for a falling market with lows in ‘May or July’ of this year. As most focus on the battle in the U.S. between the bulls and the bears, we scan the horizon for investment opportunities.

We watch the trend of increasing layoffs of high salaried Americans af the first world [10] is the Asianaztion of the first, second and third worlds.

and they are going to the University.

Given the geo-political climate in Asia at the moment, fear rules the day. Nevertheless, the aforementioned charts should open investor’s minds to the potential such trends represent.

A Shortage of Geeks and Nerds on Campus

Engineering graduates are growing scarcer in U.S. Universities. 

and those that are graduating are more likely to be foreign students.

they are increasingly planning to stay in the U.S.

The shift of engineering from the U.S. to foreign countries reinforces the notion of the proliferation of the service economy in the U.S. vis-à-vis that of a manufacturing economy.

and the shift also reinforces topical interests deemed important to U.S. residents.