This is the 10th piece in our Positioning for 2012 series. Readers can find the entire Positioning For 2012 series here.
Gary A. Gordon, MS, CFP® is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. He has more than 22 years of experience as a personal coach in 'money matters,' including portfolio management, risk assessment, and small business development. Gary writes regular commentary at ETF Expert. He currently hosts the ETF Expert Show.
Seeking Alpha's Jonathan Liss recently spoke with Gary to find out how he planned to position clients in 2012 in light of his understanding of how a range of macro-economic and geopolitical trends were likely to unfold in the coming year.
Seeking Alpha (SA): How would you generally describe your investing style/philosophy?
Gary Gordon (GG): Successful investing is not about picking the next Apple (AAPL). It’s about what you can control. And the truth is, you don’t have a lot of control over the things (e.g., oil, interest rates, politics, corporate earnings, debt crises, etc.) that affect your investments.
Fortunately, one does have the power to determine every investment outcome. There are only 4: (a) big gain, (b) small gain, (c) small loss and (d) big loss. We primarily select ETFs for diversification, transparency and low cost, then employ a wide range of risk management tools (e.g., "stops," "hedges," "trend analysis," etc.) to minimize the possibility of the only thing that kills investors... the big loss.
SA: How many ETFs do you generally hold in a typical client portfolio? Do you use ETFs exclusively, or do you occasionally buy individual stocks, mutual funds, bonds or other investment vehicles? How do you measure portfolio risk?
GG: There are exceptions to every rule but we typically hold 14-16 positions in $500,000+ portfolios. When you consider the universe of potential non-correlating assets for optimal diversification, U.S. stocks and U.S. treasuries alone may not provide a desirable long-term result. We consider high yield bonds, convertibles, preferreds, REITs, MLPs, commodities and currencies – both foreign and domestic.
Our preferred vehicle is the exchange-traded fund, with its advantages in cost structure, transparency and 'trade-ability.' Yet diversifying one’s assets for non-correlation also requires diversification of “market access.” Individual issues correlate less with broader indexes than other indexes. The same tends to happened with actively managed mutual funds as opposed to using passively managed index funds exclusively. In other words, we will use all 3 types.
GG: Across the risk spectrum, there are a variety of asset types providing remarkable yields relative to the ‘risk-free’ alternative of U.S. treasuries. It follows that I am not just underweight treasuries, I have no developed world treasuries whatsoever. The sovereign debt exposure that makes sense is emerging market debt, hedged via PowerShares Emerging Markets Sovereign Debt Portfolio ETF (PCY) and unhedged via WisdomTree Asia Local Debt ETF (ALD). There is no concern that the represented countries would have any trouble paying back debt - many are lowering interest rates which will push prices higher - and the relatively attractive yield of 5% is quite worthwhile in the fixed income space.
Looking forward in 2012, there may be a great deal of uncertainty for so-called "risk assets." Still, I don't see, the 10-year yield going from 2% down to 1%. It follows that I am focusing on yield-oriented ETFs/ETNs with historically attractive spreads across the risk spectrum. I am overweight diversified high-yield corporate debt via iShares iBoxx $ High Yield Corporate Bond ETF (HYG), master limited pipeline partnerships via JPMorgan Alerian MLP Index ETN (AMJ) and dividend equities via iShares High Dividend Equity ETF (HDV) and Vanguard High Dividend Yield ETF (VYM).
SA: Name one investment that exceeded your expectations in 2011, and one you had high hopes for that didn't pan out. Do you see any particular investment surprising investors over the next year?
GG: Since its 2011 inception, PowerShares S&P 500 Low Volatility (SPLV) was attractive to me. Significantly lower beta with yield 2x that of comparable 10-year U.S. Treaury bonds - how could one resist? In the ‘risk-off’ environment that has characterized the last 3 quarters, however, it's hard to believe that SPLV could still be testing 52-week highs.
Disappointing in 2011? I had to cut back on one of my largest client positions from 2009 and 2010: iShares MSCI Malaysia Fund (EWM). Not only is EWM less volatile than the U.S S&P 500, but the country is one of the world's finest ‘emergers’ on dozens of measures. Unfortunately, the European debt crisis and China's slowdown have taken a toll.
SA: Did you sell some of your position in EWM as a result of ‘technical’ triggers, or as a result of a changing view of the risk/reward analysis for Malaysia?
GG: We sold EWM for many of the more moderate and conservative accounts on stop-losses and moving averages. Fundamentally, Malaysia (EWM) remains one of my favorite 'Asian neighbors' as a huge exporter of goods and services to both China and Japan. Its economic growth is in the 'sweet spot' - humming but not overheating. Inflation is in check, unemployment is low, EWM valuations are reasonable and it's less volatile than the S&P 500. What’s not to like if China continues to ease monetary and fiscal policy?
SA: 2010-11 saw a notable rush for the exits from equities and equity vehicles. Is this a cyclical, or secular shift? What would it take to bring them back?
GG: I am not a big fan of the words "cyclical" and "secular" when it comes to describing a bearish environment for equities. I think they mislead investors on the best way to invest for their futures. Yet, if we accept the notion that secular bear markets include cyclical bull markets within them, and if we recognize the epic nature of the risk-off movement of capital, ‘secular’ is a more accurate descriptor (than ‘cyclical’).
When Germany capitulates on how far it is willing to go to bail out its neighbors -- when there's a credible TARP-like plan for European banks as well as a stabilization of LIBOR rates -- equities will rocket skyward. There's little doubt that corporations themselves are in remarkable shape. And China is embarking on stimulative monetary/fiscal policy.
SA: Do you believe gold is a genuine hedge in uncertain markets? If so, how much exposure to it or other precious metals do you have? If not, where are you turning for potential downside diversification?
GG: Probably not, since the nature of uncertainty itself can change. The surge of the dollar and the need for hedge funds to lock in gold profits have demonstrated that gold isn't necessarily the perfect antidote to uncertainty itself. Moreover, gold has a .82 3-year correlation to the S&P 500.
On the other hand, gold is most certainly a hedge against the electronic creation of currency, as Gold ETFs have soared on every whiff of QE moves by the Fed. I've picked up SPDR Gold Trust (GLD) on every significant pullback since the yellow metal was at $700 per ounce and that has been a genuinely powerful selection.
SA: Are you not concerned that gold could be re-entering a secular bear market of its own, similar to its performance from 1981-2004 when it lost nearly 70% of its value? Are there fundamentally sound reasons gold will continue to bounce back from pullbacks, especially once the global financial system get its house in order?
GG: I am not concerned about a secular bear for gold, though I am concerned with the amount of speculation that is capable of moving prices. In truth, it may take quite a bit of time for the global financial system to get its house back in order… years. And even when it does, you then face the prospect of potential hyperinflation.
Gold may at times be volatile, and hit bearish numbers. Yet the demand from emergers like India and China in good times will outstrip supply, and in money printing times, we already know that global investors believe gold to be an admirable hedge. Until and unless gold passes the psychological milestone of $2000 per ounce or the inflation-adjusted milestones $2400ish, buying gold dips does not worry me. And besides, I will still use stop-losses long before I’d let a $1600 investment see the likes of $400.
SA: Will Eurozone contagion continue to drive the market’s direction, and how are you protecting client assets from potential fallout there?
GG: Absolutely, Eurozone fears are the be-all and end-all for markets these days. And they will continue to overshadow just about everything (else) as we head into 2012.
With rare exception, my clients have no stocks or bonds from developed or emerging Europe. That's the easy part. Deciding to exit emerging equities in Asia or U.S. stocks depends entirely on how the Eurozone drama plays out. Since it is not something that can be known, we use stop-loss limit orders on most of our holdings. If contagion spreads, and if a major crash occurs, I expect to have a substantial cash position prior to the event.
SA: How much exposure to emerging markets do you have both in terms of stocks and bonds? Are China, India or other major EMs better positioned to withstand a serious global economic downturn than the U.S.?
GG: Overall, most of my clients have no more than a 10% allocation to emerging markets. Some have 5%. I believe strongly that ETFs like SPDR China (GXC) will have a great 2012 when all is said and done with Europe.
The bottom line is pretty simple, actually. China has the money to stimulate its economy - it has already started to do so - and it has already witnessed an inflationary bear that caused -40% returns. Nearly every China ETF has a P/E below 10 (~9.7). On the few occasions over the last quarter century that China had sub-10 P/Es, the gains going forward were remarkably powerful.
SA: Where do you see Treasury yields in 12 months? Are Treasuries worth buying at current (low) yields? For clients requiring income, where have you been turning in this low yield environment?
GG: I believe the Eurozone drama, even if it gets worse before it gets better, will have a definitive moment in the early part of 2012. Year-end 2012 for U.S. treasuries should depend far more upon the fundamental backdrop of the U.S economy, and not merely on its role as a safe haven from foreign sovereign debt.
With the 10-year yield hovering at the 2% level today, I would be surprised if post-election it wasn't back to a historically subdued 3.%.
Even with a significant move higher in treasuries, the Fed’s commitment to keep intermediate yields down means that you can still clip a fantastic coupon in high-yield corporates like HYG and JNK. Individual preferreds not tied to financials are also attractive, like Constellation Energy (CEG-A). And MLPs have yield and modest capital appreciation potential via AMJ.
SA: Have you changed your allocation to muni bonds in client accounts? Do you view them as riskier than they have been in the past given state and local budget challenges?
GG: I live in California, and you couldn't pay me to buy California munis. However, as an asset class, as long as you are diversified nationally, they are a bargain for yield-hunters. PowerShares National Muni (PZA) and iShares National Muni (MUB) both provide taxable-equivalent yields near 7% for those in the 35% tax bracket. Individuals should be willing to forgo state tax-free returns, and merely concentrate of federal tax-free benefits.
SA: Generally speaking, how much of an emphasis do you put on tax management vs. overall performance in client accounts? When these two things come into conflict with each other (your momentum analysis says to sell but selling means registering a large short-term gain), which takes precedence?
GG: Without question, when it comes to investing, the investment decision to protect capital always takes precedence. Always. I’ve seen people lose half, two-thirds, three-quarters of a significant position -- or even on the entire portfolio – just because they were concerned about paying taxes. Ask anyone who bought Cisco (CSCO) at $40, watched it go to $80, if they might have better off selling with a capital gain in the $60-$70 range earlier in the 21st century.
Taxes are very important, particularly near the end of the year. We may even use hedges to avoid selling or we may sell something at a loss and buy a similar (but not equal) investment to tax-loss harvest. Still, at the end of the day, protecting capital is always going to take precedence.
Disclosure: Clients of Pacific Park Financial, Inc. currently own one or more of the following: PCY, ALD, AAPL, AMJ, HYG, JNK, HDV, VYM, SPLV, EWM, GLD, GXC, CEG-A, PZA, MUB.
Disclaimer: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.