This is the 21st piece in our Positioning for 2012 series. Readers can find the entire Positioning For 2012 series here.
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 Jeff 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): Jeff, how would you generally describe your investing style/philosophy?
Jeff Miller (JM): Hi Jonathan. Thanks for inviting me to participate again this year. The Seeking Alpha year-end program brings out a nice range of expert opinion. You have sharp questions and a good format. I enjoy reading the interviews, and I am sure that many others do as well.
Our investment style emphasizes active management, a focus on risk, and attention to each client. That has been especially challenging over the past year. Many people do not want to worry about 350-point swings in the Dow. They need yield with less volatility. The Fed policy has taken away those choices, so we need to be a little more creative.
Rather than emphasizing a specific investment style, I interview each potential client and then create a blend of our five programs – something that meets the risk/reward needs of each.
With that background in mind, I would say that I am focused on data and objective indicators. I am resistant to hype and headlines. I am contrarian – finding opportunity where others see none. On a long-term basis I am optimistic about the US, the economy, and stocks. On a short-term basis I am cautious.
SA: Within equities, are there any particular sectors or themes you are currently overweight or underweight? If so, why?
JM: I am overweight technology and cyclical stocks. The economic indicators that have passed my stringent tests are more optimistic than the general sentiment. Many media commentaries still highlight people who “called 2008” no matter how early. At some point these pundits will be “one hit wonders” in the same way traders view Elaine Garzarelli and her forecast of the 1987 crash. Meanwhile, many of these sources have been dour and wrong since 2008.
Economic growth has been modest, but it has been just fine for the profitability of the major industrial firms. The trend is favorable. I like Caterpillar (CAT) and Illinois Tool Works (ITW) among others.
The technology play is excellent with economic expansion, but still works if economic growth proves to be more moderate. Many technology names are at historic low valuations on a P/E basis. Why? The story has not worked recently, and investors are like jilted lovers. Microsoft (MSFT) is an obvious example, but I also like Intel (INTC), Oracle (ORCL), and Apple (AAPL).
SA: Do you ever buy funds to gain access to asset classes or themes, or do you stick to single stocks exclusively? What are the advantages of your approach?
JM: We do not use mutual funds, but we are very active in ETFs. Two of our five programs trade via ETFs, and we have a free weekly newsletter with ETF ratings. The trading method asks the following question: What ETF will be best over the next three weeks? We have two “experts” on this subject – Oscar and Felix. You can guess their risk/reward outlook!
We also have a Dynamic Asset Allocation approach (DAA). For this model we ask: What ETF will be the best over the next year?
Please note that we do not have a holding period of three weeks in the first case nor 12 months in the second. Nonetheless, we ask these questions every day.
This gives us 20 or so trades in DAA every year and many more for Felix and Oscar.
Right now, the DAA approach is very conservative. By the nature of the method it will be slow in capturing a rebound. Essentially, it reduces volatility and gets you on the right side of big moves.
Felix and Oscar were fully invested for the year-end rally. (This could easily change by the time of publication).
To summarize, ETFs are a very important part of our trading and we have major positions for clients. It all depends on which of our programs is right for them.
SA: Speaking of ETFs, which asset classes are you overweight? Which are you underweight? Why?
JM: We have to start with the definition of an “asset class.” There is a dangerous pitch out there, reflected in current advertising. The idea is that all of the traditional asset classes – stocks, bonds, and real estate – are over-valued. The refuge first was gold. Now I see ads encouraging people to speculate in foreign exchange. Encouraging people to do active trading based upon their “market feel” is a prescription for disaster.
My scientific, model-driven approaches sometimes recommend oil and gold, but I do not have a good method to evaluate these choices on the fundamentals. The average investor should not confuse trading with investing.
SA: Can you elaborate on what you mean by “scientific, model-driven approaches” to allow readers a better understanding of what we’re talking about here exactly?
JM: Good question! I engage several model developers with different approaches. I test these carefully. You might think of it as my own version of a “stress test.”
The DAA model follows principles that have been accepted in the finance literature for decades. It is a yearly momentum model, but including some helpful tweaks. When it is applied to our universe we minimize the chance of excessive correlation. This method gets you on the right side of long-term trends. In 2008, for example, the DAA approach would have led you first to gold and bonds and later to the inverse index ETFs. This cushioned the downside, but it would have been very slow in capturing the rebound.
Felix combines momentum, a sense of the cycle, and the element of uncertainty. Felix does not call tops and bottoms, but he does get on the right side of fresh moves. If there is a big trend, Felix will participate. If the market is declining, Felix will get into the inverse ETFs --- essentially going short.
No system is perfect, and our methods do not call tops and bottoms. There is always a delay for recognition of a new trend. It depends on the time frame.
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?
JM: Our biggest winners were Apple and some of the energy and healthcare names. We are very good at forecasting economic and earnings fundamentals, but we do not try to time market sentiment.
That was the wild card. Beginning with the Japanese earthquake, then moving to the silly debate over the debt limit, and finally fixating on the European saga, there has been a continuing reason to ignore data about what is actually taking place. This meant that the most important story of the year – fantastic earnings growth – has been given short shrift.
While we had some nice winners, we expect much better next year.
The negative side included two groups:
- Anything in the financial sector was bad. Even though we were underweight and sticking to the top names, there was no correct time to buy. I still like JP Morgan (JPM), the best of the breed (U.S. major financial). The market seems to think they have European exposure, despite explanations to the contrary. It is a favorite scare ploy to use nominal derivative totals instead of net. In the case of JPM, they also do not define “net” using different institutions. It is a “pure” version of determining net exposure. It is a favorite stock for a rebound this year.
- The other negative was the medical device makers. I really got this one wrong. (Our health insurance holdings did fine). We have chosen two device stocks (ResMed (RMD) and Stryker (SYK)) that actually save money by reducing related costs. The earnings growth has been solid. Despite this, the stocks moved lower. The political uncertainty over ObamaCare has had a big impact.
SA: Some describe the current era as “The Great Deleveraging.” Do you agree/disagree, and does this macro consideration affect your investment planning process?
JM: One of the worst things that happened in 2011 was the excessive focus on debt. The argument is seductive for most. We all try to equate government problems with our personal family experience. When the economy is bad, deficits rise. There is a “debate” about this in a highly-charged political environment.
I have simple advice for the average investor:
- First, ignore the politics unless you are in the voting booth!
- Second, understand that every macro-economic model sees short-term stimulus as favorable. Put aside your ideology. It is market-friendly.
- Third, every leader of whatever party has supported stimulus when they are in office.
If we get better economic performance, deficits will be lower. There will still be a structural deficit. But it will be more manageable.
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?
JM: The individual investor will return to equities far too late – long after most of the obvious problems have been solved. That would be when the Dow is at 20K, possibly overvalued, and risk is high. The story has been repeated many times.
Understanding this recurring phenomenon offers both the biggest reward and the biggest challenge for the average investor. I have tried to meet this challenge by providing a blend of programs that provides participation in the upside while limiting risk. It is not easy.
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?
JM: Gold has a strange character. There is no way to determine a fundamental value. It is a safe haven in a time of disaster (deflation, depression, riots….) and it will have value if there is hyperinflation.
Our programs have invested in gold and gold miners during the past year, and probably will do so again next year. We have been out of gold for a month or so for all accounts.
Since I expect neither disaster nor hyperinflation next year, I do not recommend gold for long-term individual investors. It has been approved as a 5% (or so) holding for many years – but not right now.
SA: Global Macro considerations dominated the headlines in 2011. Do you see 2012 unfolding differently? If so, how?
JM: This is definitely the key question. The selection of individual sectors and stocks has been secondary for three years. I expect the European story to be resolved in a few months. Meanwhile, if the US economy improves enough, that will also change the focus.
SA: Will Eurozone contagion continue to drive the market’s direction, and how are you protecting client assets from potential fallout there?
JM: I’ll go out on a limb. I think that by mid-year in 2012 we will no longer have the Europe fixation. I have a series of articles explaining my reasoning.
I think that the market reflects a high degree of pessimism. You can protect assets by reducing position sizes, which I have done. Buying puts is too expensive. You could do some more complicated put strategies, but something like a “put diagonal” is not suitable for most investors.
SA: Do you buy into the argument that European equities are actually undervalued right now?
JM: One of my pet peeves is people who answer questions when they basically do not know. I have an honest answer. While I study the European situation carefully, I am not considering specific stocks there. There are many US companies that are undervalued because of Europe. I can get plenty of octane with much less risk buying JPM and CAT.
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.?
JM: Most people are surprised to learn that the US has actually fared better in recent years. It is possible to get a solid amount of foreign exposure via big US firms like CAT, MSFT, and ORCL (a recent disappointment, but still a great growth story).
SA: Let's move on to another potential event on investor minds: The Iran nuke situation and a potential Israeli, U.S. or global attack. How serious would such an event be to oil prices and subsequently, the global economy/exchanges? Is this something you're positioning for and if so, how?
JM: Great question! This is one of the big wild cards for 2012. Most people are bearish on energy because it fits the pessimistic view of the world. Many energy companies are extremely cheap on a P/E or cash flow basis. Owning some energy stocks will help if oil prices spike. I like Noble Energy (NE) among the drillers and Chevron (CVX) among the large integrated plays. There are many good choices in this sector.
SA: We are coming up on an election year. Will this be good or bad for markets? Are you positioning for different potential outcomes?
JM: Elections, political events, and the impact on stocks really hit my sweet spot. As a former public policy professor at a top university, I have studied the political side for decades. Since 1987, I have been a player on the financial side. It is so tempting!
I would love to make a prediction, but it is too soon. My team is working on a generic Obama portfolio as well as a generic GOP portfolio. I will expand on this as soon as we learn more.
This is a typical area where people try to stake out positions too soon, with little information.
SA: Is the U.S. housing market still an issue, or not so much anymore? Will prices continue to fall? Do you have exposure to either REITs or residential real estate in client portfolios?
JM: I have no position at the moment, although our short-term models have been indicating good trades (three-week horizon) in these sectors. When the time comes, this will be one of our major profit sources. I am willing to miss the first part of the rebound in favor of more certainty.
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?
JM: This has been a great success story, but the end is near. I have two approaches for yield.
First, for clients that only need to preserve wealth (Congratulations!), I construct bond ladders. These include only investment grade bonds with a limit of seven years on maturity. If rates rise, we’ll be able to take advantage. If you have already achieved what you need, keep risk at a minimum!
For most clients I am using enhanced yield – a good dividend stock plus the sale of a call option. I do this with Abbot Labs (ABT), Johnson and Johnson (JNJ), as well as solid tech stocks like Intel (INTC) and Microsoft (MSFT). The combination of yield plus call premium is almost 10% per year after fees. This is working because of low stock prices and high volatility. It might not work in another year, but for the moment, let us take what the market is giving us!
This is a great method as long as you pick stocks that will hold value and monitor them carefully.
SA: What is the ideal asset allocation for someone with a long-term horizon (greater than a decade) and no need to touch their investments? Can investors continue to rely on stocks after the 'lost decade' we just experienced?
JM: I appreciate your desire to quantify this, but I am struggling since it is so far from my individual approach.
Let me try it a different way.
The single biggest mistake of the individual investor – right now – is underweighting stocks. This happens for several reasons:
Fear sells – in politics, advertising, and page views.
Individual investors always react to highly-publicized events because they do not understand how to determine what is already “in the market.”
It is a mistake to be “all-in” or “all-out.” This is not poker. Most people will never attain their investment goals if they do not have a rational strategy for when and how to buy stocks.
People underestimate the upside. We have just experienced a year with tremendous earnings growth and no movement in stock prices. The price/earnings ratio is back where it was at the market lows of 2009. If and when some of the worries are relieved, stocks can move to a more normal P/E multiple.
If the European concerns are addressed, people must understand the stocks could move much, much higher.
My advice? Based upon what I see in many interviews, most people should be nudging stock exposure a bit higher. It is possible to participate in the upside potential while keeping a rein on risk.
Disclosure Statement: NewArc’s five different programs are currently invested in all of the stocks and ETFs mentioned. The specific characteristics vary according to the investor.
Here is a good illustration. New investors do not go all-in on the first day – we look for good entry points. An investor in Great Stocks would own Apple tomorrow, since I think it is massively under-valued. An investor in the enhanced yield program would never own Apple.
To summarize, every stock mentioned is right for one of our programs. The individual investor must be cautious when reviewing market commentary like this. Everyone is different!