Seeking Alpha
Portfolio strategy, long/short equity, contrarian, registered investment advisor
Profile| Send Message|
( followers)  

How many people enjoy telling you how they are wrong about something? Furthermore, how many investment advisors are willing to admit they ever made a bad call or one that was either premature or too late? Very few, if any would ever do that. Most investment advisors do anything they can to spin the positives out of what can be very dismal results. Sadly, most investment advisors are salesmen first and portfolio managers second. The reality of managing money and wealth, however, is that you must be prepared to be wrong every so often. Ideally, over time, you just need to be wrong less often than right.

We endured a poor overall return over the past few months relative to what the overall markets have done. Keep in mind, however, that no client we help is 100% stocks nor should they be. Our goal is not to match the market, otherwise we would just dump it all into an index fund and be done with it. Furthermore, we've been fairly defensive since early November and at that time actually sidestepped a sharp market correction. Equity markets sold off around 8% in a short span and then as we all know finished off the year to end flat overall. Most broadly diversified portfolios actually may have seen negative returns in 2011 due to international exposure. Advisors typically allocate a decent percentage toward International equities and that asset class was down over 14% in 2011. Taking that piece of the pie one step further, international small caps were down over 20% for the year. Domestic small caps also were a drag on overall equity returns by being down just over 4%.

So, with all that said, nothing seemed to matter since the markets shrugged off some pretty heavy headlines and began 2012 in a stair-step fashion. Before yesterday, March 6th, we saw 44 straight days without a correction of 1% or more. The longer that type of pattern persists the more severe the pullback could be. As I've written before, market corrections are actually healthy in an upward trending and recovering, albeit slow, economy. Corrections are also far more frequent and common than most investors would like to think. Now that we've seen an almost 9% start to the year is it time to admit that the train has left the station and I've really made a horrible call? No. The more wrong or premature I've been, the more right I feel. At the risk of being stubborn or fulfilling the "broken clock is right twice a day" idiom, I simply see a market that doesn't pass my "smell test."

What Do You Think?

Put aside what my tea leaves have been telling me for just a minute and ask yourself if this looks, smells, walks, talks and feels like a good market? Does it pass your own smell test? I bring this up only because the stock market is supposed to be a leading indicator of how the economy is doing. It typically begins to decline as the economy declines and conversely it generally improves when the economy recovers. Does this "leading indicator" always paint a correct picture? Does anyone remember what the market was doing in October of 2007? How did that forecast what the economy had in store for us? Not very well, and for whatever reason most people that got clobbered in the months that followed and wanted to sell at the lows of the market in March of 2009 are the same ones wanting to buy Apple (AAPL) stock now or chase this bull market.

For a reference point, and anyone who may have checked out the past five years, the Dow Jones was pushing 14,000 in October of 2007 and by early March of 2009 it was cut in half to around 7,000. The big "surprise" and catalyst was the news of Lehman Brothers filing for bankruptcy on September 15, 2008. Hardly anyone that's being honest about that fiasco will say they saw it coming. It's not every day that an investment bank and financial icon that dated back to before the Civil War vanishes into thin air. Ironically with the correction that is brewing now. It is my belief that there will be many that said they saw it coming. Some prefer to focus on the positives and have enjoyed this wonderful start to 2012. They want to believe that the Greece story has been baked into the pie and that things are also on the mend here. I don't intend to rehash too much doom and gloom but once again I can't ignore what I'm seeing. There are several major shocks that are lurking and any number of them could truly trigger a fairly massive sell-off. At the very least, it's my opinion that several factors will continue to pressure us in the near-term. Here are some very brief summaries of what I'm concerned about:

Europe: This story is far from over. This isn't just about Greece and what looks like a possible disorderly default. How will all this spread and affect the rest of the eurozone? Several neighboring and larger countries are in rough shape too but all eyes are still on Greece. France has quite a bit of exposure to Greek debt. I'm betting that several U.S. banks have derivatives exposure although it would take a CSI episode/team to uncover it. By the way, watch headlines as more countries deal with their debt issues. An example of this was last week as Portugal and its rising sovereign bond yields, which all but guarantee their second bail-out. In two weeks Greece will likely default on its first round of scheduled debt payments. Any hiccups to these arrangements and the entire world economy will pay. Right now that number is estimated to be about $1.3 trillion. Enough headlines on "Greek hope." I've been pounding the table that eventually the clock runs out and it won't be pretty.

Technicals: I've written about the charts before and for quite some time they look more and more frothy to me. My Portfolio Guide, LLC relies on a few specific technical analysis tools but even to some broader market technicians, this recent market run is showing more cause for concern. Specifically there is a growing worry with regard to the Dow Jones Transportation Average. Typically there is a connection between how the transportation industry (mainly railroads and trucking) performs with what lies in store for the overall economy. Transports are already down but with oil prices on the rise this could amplify the matter.

Oil prices: From just a local and "Main Street" perspective, it's impossible to not notice how higher prices at the pump are effecting business. In my neck of the woods, here in Southern California, we just ended a 27-day streak of increasing gas prices. In Los Angeles County prices rose 57.2 cents a gallon over that 27-day period which is the highest amount since July 25, 2008. What will $5 a gallon do to the economy? With regard to oil prices and what effect that has on the stock market, that discussion could be sliced and diced a number of ways. Rising oil is not necessarily a bad thing just as long as markets have ample time to prepare for it. What we're seeing now is also being amplified by some very real concerns in Iran, more demand in Europe from rather severe cold temperatures, and even Germany's stance on stepping away from nuclear power. I'm just not a buyer of rising gasoline prices being an indicator that our economy is truly on the mend, at least not at the pace they've increased.

Election: Here's another topic that is getting daily press. I'm banging away on this keyboard the day after Super Tuesday and realistically Mr. Market won't take direct orders from those results. One can't really make a meaningful connection to election statistics. I recently read that in the past 21 election years (going back to 1928) there has only been four that were down. I might add, however, that two of those have been since 2000. I'll spare everyone further details on which party or what year in the election cycle favors or hampers the stock market. What is hardly debatable though, is the fact that the market does not like uncertainty or change. Elections simply make markets and investors nervous.

China: The U.S. would love an annual growth rate of 7.5% but when China lowers its largely symbolic 8% level down to that it sends ripples of fear across other markets. I've discussed and written about China's potential hard or soft landing as its economy has simply defied odds and been on a tear for over 20 years. What others should begin to think about aside from an economic slow down is how a massive real estate bubble bursting there could impact this juggernaut. Chinese real estate debt is harder to gauge than it is here. While individuals may not be underwater, as we've seen here, nobody truly knows what the real government debt looks like. It is becoming more and more apparent that Chinese real estate developers are quite leveraged and increasingly looking elsewhere for better financing. It's my opinion that this unknown is a looming factor and therefore another potential global risk.

Insider selling and trading volume: What's the big and "smart" money doing after a strong start to 2012? Do they think this rally still has legs? One of the key indicators on corporate insider selling that I follow has not seen rates of selling this high since July of 2011. It's not to say that insiders always get it right and keep in mind there are many reasons for them to sell. This past summer, however, the market got crushed and those in the know seemingly took proactive measures. Several firms that track corporate insider selling have reported that there were five times as many sellers in January than there were buyers. With February wrapped up that same ratio increased dramatically to 15 times.

With regard to much lower than normal trading volumes, one can make a bullish or bearish case. Bulls will say that there is still a ton of cash on the sidelines and once that comes back in we're off to new highs. Bears will simply say all those interested are already in and nobody wants to take on further risk or trust tomorrow. Stock, bond and commodity markets are trading at 16% lower volumes this year. We'll see how this trend plays out but I see lower volume as another sign that enthusiasm and full trust in this market is lacking. When a market rises on lower and decreasing trading volumes it can often indicate a very suspect and weak rally.

Iran: There is always some sort of "risk" that something unknown simply crushes a market. I see and suspect more of them are in this environment and therefore I'm bracing clients for them accordingly. There continues to be a huge political tug of war brewing between the U.S. and EU (European Union) versus Iran and its nuclear program. The West recently attempted to impose trade-related sanctions on Iran (who is the second largest oil producer in OPEC). Iran, however, is holding firm and now has limited supply to the West. Adding to this is China's unwillingness to partake in such sanctions and is still Iran's largest consumer. I won't speculate on how far along Iran is with regard to their nuclear programs. Could we go to war with them in the near future? Is this saber rattling during an election year? Would they attack Israel if they had nuclear capabilities? Again, who knows, but in my opinion the risks of any number of events are mounting rapidly and worthy of defensively positioning your portfolio.

Employment: Unemployment is reportedly at 8.3% right now. It's hard to make heads or tails out of all the data we are fed. Real world data is often quite messy and can be parceled many ways so perhaps this is one of those times for investors to open our eyes and look around. Are your colleagues, friends, neighbors and family prospering due to an improving jobs market? I hope so but I'm not seeing it and again it doesn't pass my "smell test" either. There are so many sources on this data but this chart tells me enough to say that we have a ways to go:

Civilian Employment-Population Ratio (EMRATIO)

Next steps: Over the next few weeks we'll be updating the blog with a "shopping list" of different investments we will be considering. Some will be new positions we've added to our radar and others we'll potentially add to coming off any meaningful correction.

In the meantime, I've been asking my clients and even my own normally optimistic investor mindset to be patient. It's difficult being "wrong" or premature in any portfolio positioning, but two months doesn't make a year. Everything I'm seeing points to a fairly sizable correction on the horizon and it would be foolish to chase a rally. Once people look back, they then realize that missing 5% to 10% upside doesn't hurt as much as losing 20%. Investors remember pain and loss far more than they do glory and gain.

The sad part about this is that once this movie is done playing, you will see people who said they "saw it coming." Those same people apparently saw several of the last few bubbles but somehow not everyone has learned how they ended nor how they disguised themselves. Yesterday's sizable sell-off should warn you that the market can punish quickly. This was the first tremor of what should be a very pivotal month.

Source: Market Outlook: I Couldn't Be More Wrong About Being Right