See author update at the conclusion of the interview.
Jeffrey A. Miller, PhD, is CEO and President of New Arc Investments. Also a fund manager at the firm, he has guided the Sector Rotation Fund throughout its exceptional history. Before beginning his financial career in October 1987, Jeff was a college professor who worked extensively with quantitative modeling of sophisticated state and local tax issues. He is the author of the A Dash of Insight blog.
Seeking Alpha's Jonathan Liss recently spoke with Miller to find out how he planned to position clients in 2011 in light of his understanding of how a range of macro-economic trends were likely to unfold in the coming year:
Seeking Alpha (SA): How do you arrive at your investment decisions? Do you have specific recommendations for our readers as we begin a new year?
Jeff Miller (JM): Thanks for inviting me to participate. My company has a variety of programs. We start with the client, not with our specific program offerings. Once we determine the client needs, we match up a blend of programs.
Some of our methods are driven by a scientific approach -- models developed by experts, models that I personally test in ways the developer could not have imagined. Other methods reflect my personal analysis of the investment horizon. The answers in this interview reflect my own analysis, stock picks, and sector picks. These have done very well over our company's history.
Meanwhile, I would like to share some current output from our Dynamic Asset Allocation model. Each day we ask the question: Which five ETFs are the best choices for the coming twelve months?
We include a carefully selected universe of 56 ETFs. We chose this fund universe to avoid a situation where our "top five" were all from the chip sector, all Latin America, or the like. We picked a top representative for each sector group, based on liquidity and a narrow bid/ask spread.
I want to be clear. We ask the question each day. We are not "buy-and-hold" so we do not hold the positions for a year. This is active management. If you ask the "one year" question every day, you get about thirty changes in the portfolio. The portfolio also includes fixed income ETFs and three inverse ETFs. We can get very conservative, and even go short if that is indicated.
As long as readers understand that our recommendations might be somewhat different in two weeks, I would like to share our current best recommendations for 2011 with a line on the logic behind them.
- KOL -- Energy demand, global economy, a cheap source.
- XME -- Metals and mining -- economic strength, the dollar.
- PXQ -- Networking -- an emerging global trend.
- XRT -- Retail -- the consumer has been stronger than expected.
- GDX -- Gold -- a store of value and a hedge against inflation.
As you will see in the rest of the discussion, my own choices differ from some of the model recommendations, but that is just fine. It is good to have the discipline of a model, and also to have programs with different philosophies.
If you look at a chart of these ETFs you will see plenty of strength. This is a winning long-term strategy that deserves respect. It may miss smaller trades, but it keeps you on the right side of major moves. An easy way to get a feel for this is to compare the stock price to the 50 and 200-day moving averages over the last year. GDX has started the year poorly, but is still among the leaders in our ETF universe.
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SA: Despite predictions of a dip in equities amid slow global growth in 2010, stocks were clearly the better choice than bonds in 2010, especially in Q4 where bonds sold off almost across the board whereas stock returns remained robust. How are you planning to position clients with a longer-term horizon in 2011 in terms of an equities/bond mix?
JM: I like the distinction about the "longer-term" horizon. Each client is different. The first question to ask is whether the client needs wealth preservation or wealth creation. Next you need to know about risk -- and I mean a very specific discussion. Even investors who enjoyed nice returns in the last two years still needed to deal with some corrections.
With that in mind, I am recommending an adjustment of at least 10% more stocks to one's normal stock/bond allocation. Many stocks and sectors are attractive in terms of earnings and earnings growth. With interest rates so low, there is a lot of risk in long-dated bonds. I am keeping bond portfolios in shorter maturities -- seven years max.
SA: Name one ETF investment that worked out particularly well in 2010 and one that was a bust.
JM: This is a little tricky for me. We have two ETF trading programs with differing time horizons. Both were profitable in 2010. As is the case with every trading system there were winners and losers.
Playing along with the question, we had one of our biggest trading losses in XLY in July. The consumer discretionary concept was not working in July, although it did well as the year wore on. We sold the position and moved on.
One of our best trades was picking up the move in GDX during September. We locked this one in for a nice gain.
In a trading system you need to consider both your batting average and the amount of the win.
SA: Are we likely to see a continued sell-off in fixed income ETFs into 2011? Where can income investors turn for safety while still getting a reasonable yield?
JM: I have written about various income opportunities in my "Quest for Yield" series. I am looking outside the ETF universe to solve this problem: building bond ladders, writing covered calls, and finding great dividend stocks with the potential for appreciation. There are some ETFs that attempt these same goals, but I expect to continue better performance with my own picks.
SA: Which bond sector are you angling towards – Treasurys, Corporates (and if so Investment Grade or Junk?), Munis, Sovereign Debt?
JM: My bond program emphasizes investment grade corporates. Some investors are reaching for yield in risky places. My bond program is very conservative. For those who need more yield we use strong dividend stocks and covered writes.
SA: In which sectors do you expect strength in 2011 and beyond? Where do you expect particular weakness?
JM: The economic recovery has been sluggish so far, but there are many signs of improvement in the data. The Goldman Sachs economic team just upped their forecast for 2011, citing the start of a "real recovery."
This is bullish for cyclical stocks, the technology sector, and financials.
SA: Any specific ETFs or stocks (beyond XRT) you’ll be recommending clients add to the equity portion of their portfolios?
JM: Caterpillar (CAT) benefits from worldwide earnings growth. Apple (AAPL) is still cheap on an earnings or cash flow basis. Many investors get stuck on the absolute price of the stock instead of thinking in terms of earnings. XLK picks up the technology theme for those who do not want to analyze specific stocks.
I have re-established some energy positions, after avoiding the BP-related problems last year.
Health care has lagged. Eventually the market will quote focusing on the political debate and see the demographic forces. XLV is one way to play this.
SA: What are your expectations for commodities, the dollar and precious metals in 2011 and beyond? Will we finally start to see some real inflation in the coming year?
JM: As long as we have a current account deficit (let's call it a negative trade balance for the average reader) there will be pressure on the dollar. It seems like a lot of that has already been felt, but no one really knows. We need a change in China's exchange rate policy, but that has been true for years.
The emergence of real inflation in an era of high unemployment is very unlikely. This interview is not the place for detailed arguments, so I'll merely note that past times of stagflation share little with current times.
To summarize, I like stocks better than commodities for the coming year, although my long-term model has GDX in the top five.
SA: But no actual commodities exposure? GDX is made up of gold miner stocks.
JM: That is right. We invest in gold via the miners. We do not have direct commodity holdings.
SA: Let's move on to some specific issues that will affect equity returns in 2011 and beyond. In November the Fed implemented another round of QE. Will we get a third round of fiscal stimulus in 2011?
JM: No one knows whether there will be another round of QE, including the Fed! This entire discussion has been a sideshow -- fun to debate, but missing the message for investors. I'll state that message quite simply: The Fed is going to maintain low interest rates and QE until there is greater confidence of economic recovery, including some improvement in employment. If the economy recovers as briskly as the Goldman team believes, there will be no more QE. It will not be needed.
SA: How does the incoming Republican House majority affect the economic outlook for the next two years? Is gridlock ultimately good or bad for equity returns?
JM: I do not expect gridlock. There will be action on issues requiring it.
The GOP success will change the nature of compromise. The deals will lead to more moderate policies. We have already seen this in the lame duck session, even before the new members were seated. Those deals would not have been achieved without a recognition of the new reality.
There is a perception that gridlock is good, but I do not think it is very relevant for the market at this juncture. The key economic policies are already in place.
SA: How about the situation in the EU. Have you lightened up on European stock/bond exposure in client portfolios as a result of continuing contagion there? Are there any bright spots you'd focus on in terms of European equity allocation?
JM: Like everyone else, I carefully monitor developments in the EU. So far the policies seem to have been reasonably effective. The EU and the IMF stand ready to do more.
Unlike those who merely point and worry, I like to monitor actual data. My weekly update features the St. Louis Fed's Financial Stress Index. I recommend monitoring this compilation of eighteen financial indicators (including many interest rates and spreads). This lets you enjoy market gains when stress is low, and reconsider if things actually get worse.
SA: Do your clients currently have any Europe exposure? In stocks, bonds, both?
JM: Europe does not figure in my own themes right now, and it is not near the top of our model lists. It is an important story, and I am more optimistic than most about a solution, but it is important enough already without taking on direct exposure.
SA: Same question but for U.S. states like California and Illinois. Will a government bailout ultimately
be necessary to backstop state debt as defaults pile up? Are muni bond funds something you're avoiding going into 2011, or do their significant tax benefits still outweigh the possible downside of one or more states defaulting?
JM: I do not expect state defaults. The defaults will come in specific sub-municipal bond programs. I also do not expect a magical solution, and certainly no federal bailout. Each state will need to find a combination of tax increases and spending cuts. It is not easy.
I follow this closely as an investment manager. I am also a former professor who taught public finance and a member of a financial advisory board for one of the largest school districts in Illinois. I have a front-row seat on this one.
This is a problem that defied solution during an election campaign and a deep recession. We will now take a closer look at the alternatives.
And by the way, there is once again a choice for investors. You can get obsessive about the anecdotes, or you can follow a real market indicator, the credit default swaps on state debt. The numbers have been rising, but they are nowhere close to panic level.
I do not currently hold any muni funds, but I find current yields much more attractive. Like Bill Gross, I see the risk/reward as pretty good for clients who benefit from the tax break.
SA: Are you likely to recommend munis to appropriate clients in the near term?
JM: Yes. The muni yields are very attractive for clients who want the tax advantage. Some care is required in making these choices, of course.
SA: The U.S. housing market seems to be in the midst of another prolonged leg down. How are you playing this via ETFs? Is the commercial real estate market a better bet going forward? How much weight are you giving to REIT funds in client portfolios?
JM: I do not know if we are in the midst of another prolonged leg down in housing. Many sources indicate that we may have a bottom in 2011, at least in some areas. I currently have no long-term position in these markets or in REITs, but I would not be surprised at a change. Our short-term model has signaled a buy on homebuilders in recent weeks.
SA: If you decide to go that route, are you more likely to play homebuilders with individual names, or via ETFs like XHB or ITB?
JM: This is another sector where it seems early to call a turn. Typically we play via the ETFs. If housing starts to look interesting, I will take a closer look at individual names.
SA: Finally, one of the great economic stories of our time is the emergence of China and to a lesser extent, India as global economic powerhouses. How much weight do you recommend for emerging market ETFs in both stock and bond ETF allocations?
I would expand the question to include Russia and Latin America. It is wise to take a step back and see the broad global trends.
All of my investment programs reflect global demand. In my stock selection I make sure to include companies with significant revenue from abroad. Think Caterpillar (CAT). Our ETF programs are model driven, but have frequently participated in the emerging market rally. I have often written about this in my periodic ETF Updates.
Having said this, I think that the foreign ETFs and commodities had a very good run, while the US market lagged. I expect to see some "mean reversion" here this year, as the relationships return to normal.
SA: How do you plan on getting most of your U.S. equity exposure? Any broad funds, or do you generally prefer sector and single stock exposure?
JM: We have never advocated a buy-and-hold approach. Many broad funds are closet indexers, so you are just buying the market. We find investment themes, and then choose ETFs and stocks to fit. While we do not beat the market every year, we do over time. We did not have a “lost decade.”
There are many companies that are developing new technology, introducing new products, and breaking into new markets. Productivity is better. The opportunities are there, and the prices are quite reasonable.
Disclosure: I own CAT, AAPL, JPM and GS personally and in client accounts, as well as the ETF names as model choices.
Author update as of 1/24/11:
Each year I write two or three pieces that are published first at a different source and later republished here. Since the original interview ran there have been two important changes in the model output. Readers should note that I warned that the recommendations might be different in two weeks!
Our DAA model asks about the best ETFs for the next twelve months, but we ask the question every day! This means that we can adapt to changing circumstances. The DAA is great for situations like 2008, where the model shifted to bonds, gold, and eventually to inverse ETFs.
For those reading the article today it is only fair to update the forecast to the most current recommendations. Once again readers should understand that the actual positions change many times during the year. With that in mind, GDX and KOL have dropped from the list, replaced by IYR and XLY.