My Best Investment Ideas

We have been watching the markets closely to see if the recent pull back is just a bull market correction (to buy) or if its got more downside (to sell). We believe it is the later, and could be either a 15% correction (about half more still to come) or the beginning of a new cyclical bear market that would be more like a 30% fall. For now we are just expecting the market to drop something like 12% that would effectively constitute a severe bull market correction that are custom after a strong “V” market recovery (2008-2009). Our opinion is based also on the fact that the markets are correcting because the world’s growth engine, China, is putting the breaks on its economy. While this is a good thing longer-term, it will be painful for investors near-term as growth slows. Another note is that the China market has followed a very similar pattern that the Saudi Arabian market followed when it experienced a bubble. Both markets are closed to foreign investors, and benefited from amply liquidity. If the pattern holds, the Chinese market’s next big move is down significantly. Our gut tells us that this is likely as the world really isn’t expecting anything but good things out of China. As a result of all of this, we are recommending selling the China holding (FXI), and use the sale proceeds to go short the Chinese market with the UltraShort China ETF (FXP). And because we expect this correction to continue, we also recommend selling our domestic equity holding (DVY), and leave the proceeds in cash. The result of these trades will be that the total portfolio will be net short equity 20%. The resulting portfolio is as follows:

-20% Chinese equity (FXP)
20% US Dollar (UUP)
10% Agriculture commodities (DBA)
10% Gold (GLD)
10% Short government long bonds (TBT)
30% Cash

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We are happy to have accomplished our theme for our inaugural year: 20% from our best investment ideas. While we easily made our objective (almost doubled it), we had a lot of help from the market rally. We called the market turn correctly and participated, facts for which we are proud. 2010 is likely to be a bit more challenging.

2010 has gotten off to a good start, with the first week of trading resulting in stock and commodity market indexes up a few percentage points already. This “January Effect” is a good omen for 2010, and our conviction for a good 2010 is strengthen because of it. Our 2010 outlook is for a continuation of the strong stock and commodity trends for the early part of the year, and for new directions for bonds and currencies. Stocks and commodities should benefit from an improving economy, better than expected corporate earnings, inflation fears, and investor skepticism that slowly draws cash from the sidelines back into the market. Bonds will be under pressure from inflation fears and the need for the Government to issue bonds at higher interest rates to attract investors. While these trends are tough for bonds, they are good for our currency. We expect the US Dollar to continue to appreciate against foreign currencies as higher interest rates and an improving economy make the currency more attractive on a relative basis.

Within this positive outlook we also expect a significant correction in the market in 2010. While its difficult to know what will cause it, our best guess is it will come when investors are bullish again and markets have fully priced in all the good news. Right now, investors are still somewhat skeptical (although not as much as they were a few months ago) and good corporate earnings should surprise to the upside and move the markets.

So, for now we suggest an investment portfolio that “seizes the day” while we have the opportunity and before we back it down sometime before/when we see conditions change.

Our portfolio is performing well, and now we would like to invest the 35% cash position as follows:
Add 10% to our US Dollar position in UUP
Add 10% to a new position in Gold (GLD)
Add 10% to a new short position in long-term treasury bonds (TBT). This position effectively profits when bond prices fall and interest rates rise.

These changes will add to our current themes and the diversification of the portfolio. The resulting portfolio is as follows:

25% Large Cap domestic equity (DVY)
20% Chinese equity (FXI)
20% US Dollar (UUP)
10% Agriculture commodities (DBA)
10% Gold (GLD)
10% Short government long bonds (TBT)
5% Cash

We wish you a profitable and prosperous New Year, and look forward to another year of 20% returns from our Best Investment Ideas.

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As 2009 comes to a close, our portfolio remains productive and well positioned. The recent changes to the portfolio (see last post) have been timely, as markets have moved generally sideways and higher quality investments have become the focus over higher beta (risk) investments. This shift in positioning was confirmed in early December when the unemployment data came out with surprisingly few jobs lost in October compared to what was expected. Markets took the news to mean that the Fed may start to drain liquidity by raising interest rates sooner than originally thought. The US dollar rallied on the news, sending gold and other risky assets falling. The strong correlation of risky assets (commodities and emerging market equities) to the dollar has been one of our primary concerns and reasons for the recent portfolio shift. We believe a rally in the dollar is just beginning, and as such the “liquidity carry trade” is ending. The good news is that the transition so far has been orderly, except for the impact on gold that has declined materially. Also welcomed news is the fact that correlations amongst assets classes should start to decline and result in better diversification opportunities next year.

At this stag, we believe large cap domestic equity markets will continue to be productive during the Holiday Season, and as such recommend adding 15% to the existing iShares Dow Jones Select Dividend position (DVY). This addition brings our DVY holding to 25%, and drops our cash position from 50% to 35%. We are also recommending to sell the final 5% gold position GDX, and add the proceeds to the agriculture commodity position DBA. This trade will result in the only commodity position being a 10% position in agriculture.

Also, we wanted to bring to your attention some new links we have added to the site that we like and think you will find useful. Sabrient has a new blog that ranks the domestic sectors and Market Folly tracks what the hedge fund community is doing. The are both listed in the column to the right.

We will be back soon to outline our thoughts for 2010. Until then, happy holidays to all!

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With October coming to a close, we now have ample evidence that some of what we have been writing about is taking shape. October is usually a volatile month as investors begin to anticipate the new year and position their portfolios accordingly. Markets around the world continued higher in the early part of October, adding to their amazing eight month run. The usual fuel for the advance, a falling US dollar representing easy monetary conditions, continued and pushed domestic and international equity and commodity markets higher. Corporate earnings added to the favorable conditions, as popular companies such as Apple Computer posted significantly higher earnings. But just as the Dow Jones Industrial Average topped 10,000 for the first time in years, the good news became a chance to take profits. And that is exactly what the second half of October witnessed. Domestic stock markets fell 5% to 7% in the last 10 days of the month, and international equity markets doubled that loss as investors looked forward into 2010 and didn’t see much to get excited about. After a 50%+ move from the lows in March, it was easy to sell first and ask questions later.

As we have said, we continue to believe we are in a cyclical bull market within the context of a secular bear market. The cyclical bull market is a product of huge monetary stimulus, the amount of which has never before been seen. The stimulus was aimed at getting the banks liquidity health again and spur growth in the economy. While it accomplished the first goal, the second is still debatable. 3rd Quarter ‘09 GDP did come in at +3.5%, a very good sign and most definitely better than a year ago. However, 2010 growth is anticipated to be sluggish due to longer-term issues related to debt overhang.

What this all means to us is that the markets have entered the new lower risk, higher-quality phase of the cycle. We are now looking to trade-in our high risk (”high beta”) investments in emerging markets and commodities for higher quality blue chip stocks and other investments. In addition, we are very mindful that the overall upward move has matched the average return of historical cyclical bull markets (within secular bear markets) in about 3/4 of the average amount of time. What this potentially means is that the party is over for this cyclical bull because we have already gotten all the upside and now the next primary trend in the market is down. We aren’t yet ready to make this broader market call, as it is too early yet and so will be watching our indicators closely for confirmation. At the moment, our outlook is for a weak market for the next 30 days or so, followed by a seasonal rally around the Holidays and into the new year where higher quality investments work just as well as higher risk investments.

For now we recommend the following:

Sell:
20% Brazil (EWZ)
10% Energy (IEO)
5% Gold (GDX)

Buy:
10% Dow Jones Select Dividend Index (DVY)
10% US dollar currency (UUP)

Resulting Portfolio:
20% China (FXI)
10% Domestic Large Cap Equity (DVY)
10% US Dollar (UUP)
5% Gold (GDX)
5% Agriculture (DBA)
50% Cash

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Its been a little longer than usual since our last post. Part of this is because of slowness in the market during the late Summer months that has required some patience for markets to develop meaningful trends. Now that we have seen some trading action before and after Labor Day we feel its time to assess what the market is telling us. September, historically one of the worst months of the year, began very poorly; the market was down more than 2% on September 1st. What seemed like a bad omen turned out to be a one day event; the market has made this loss back and then some. Investors have obviously bought this dip rather than sold it. This trend has been in place all Summer, as investors have used pull-backs to put money to work from the sidelines.

We last stated that we were holding our ground and wanted to see what move the market would make before our next move. Now we know; markets are moving higher and don’t appear to be selling off as feared. While its still early, and the volatile October month is still ahead, we think this is significant and want to move now. We believe the recent market action is significant because it is confirmed by a weakening US Dollar. Typically the Dollar will rally this time of year AND at this stage of an economic recovery. If it followed this historical path, it meant that oil, commodities, and equities would likely go the other direction (down). The US Dollar just broke down into new low prices. Not surprising, oil has rallied along with equities and gold. Oil has a defined range of $68 to $75 a barrel. We believe that, as gold has recently broken out, oil will follow suite very soon.

To better position the portfolio for today’s market, we are selling our Europe short position (EFU) that makes up 20% of the portfolio, and adding the energy exposure in the form of oil and gas production and exploration that has been an outperforming group. We recommend putting 10% of the portfolio in the Dow Jones Oil and Gas Index ETF (IEO). We are also adding to our gold position by another 5% to result in a 10% holding. After these trades the portfolio is now as follows:

20% Brazil (EWZ)
20% China (FXI)
10% Energy (IEO)
10% Gold (GDX)
5% Agriculture (DBA)
35% cash/mmf

When you look at this portfolio the trend is obvious; exposure to hard assets is working. This theme is directly tied to another that is on the back of our minds; inflation. Given the issues facing the economy its hard to believe that we will see inflation anytime soon, but the market is telling you to get ready. The recommended portfolio is now current with the market and we will continue to update you as markets and trends develop.

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This last week was a volatile one for the markets, which witnessed the domestic equity markets down slightly overall for the week. The market was hesitant going into Wednesday’s Fed decision on monetary policy (which resulted in no change in interest rates), rallied, then gave it all back by Friday. While there is still another week or so of corporate earnings due out, there isn’t too much on the horizon in this seasonally slow period to get excited about. It seems that, with a market up 45% or so from its lows, it is easier to go on vacation at this point then to try to figure out which direction the market will take next. On the bullish side there is the incredible monetary stimulus, (slowly) improving economy, low inflation data (CPI data released today showing 0% inflation) and all the cash on the sidelines waiting for a chance to get back in the market. On the bearish side there is the fact that no historical period has seen a rally from a bear market low that was this strong in this short amount of time, the lack of a bottom in the housing market, rising unemployment and improved economic data that is largely due to inventory re-stocking and cost cutting rather than sustainable economic growth.

When investors come back after Labor Day and trading volume returns, we will see the true direction of markets. We continue to believe that equity markets will continue to climb the “wall of worry” and defy logic. However, we still believe that volatility will continue to increase, like we saw this week, as investors react and try to assign value to every new data point. We think another correction is due, and could have already begun, similar to what we saw in late June/early July. However, we would be buyers of the dip at this point as we believe sidelined cash will continue to want in, and the Fed/Administration will keep the stimulus and economic programs coming as long as it takes. With the seasonally volatile September/October period soon upon us, we are maintaining our conviction with our current holdings (see “portfolio and trades” category in the left hand column) and will wait to put more money to work until we see another correction.

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We are pleased with our portfolio’s performance, which is up just under 27% Year to date. We participated nicely in the equity market rally even though our portfolio was and remains less than 100% exposed to the equity market. We did this through being long emerging market equity, some currency and commodities, and mildly short developed market equity.

While this portfolio has served us well, we are always looking to improve upon what we own and take advantage of new opportunities. Currently, there is no “lay up” trade where a market or security is a bargain from a valuation standpoint. In fact, while this market did get cheep in some areas (financials), most of this move has been macro in nature rather than valuation in nature. As the market’s rally matures and investors become more discriminating, it will be important to be more specific with our investments.

We continue to be strong believers in commodities and the macro theme of supply constraints in certain commodities that will result in the continuation of the commodity bull market that started earlier this decade. We are interested in increasing our exposures and doing so more specifically now instead of using our emerging markets equity positions to participate generally in this theme. We believe the timing is right to start to increase our exposure to commodities via direct investments that will compliment our existing holdings and put some of our cash to work. Since commodities haven’t fully regained their leadership yet but are beginning to act better, we are recommending adding 5% of Gold and 5% of agriculture (DBA) to the portfolio now (small bet sizes). We will use the gold mining group (GDX) rather than the metal due to the operating leverage the mining companies provide. We will hopefully increase these positions or add another, potentially in the energy sector, in the future, but this is the right move for now to keep our portfolio current with market trends.

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Last week we said we had received confirmation that a medium-term downtrend was now likely in place due to declining prices and poor market breadth (significantly more declining issues than advancing issues). However, the market was very strong last week on favorable economic and corporate earnings guidance. This was a bit frustrating as we had been patiently waiting for a direction, only for it to reverse quickly on us. While market breadth continues to be weak (as has been the case for the entire rally since March), there are a few key rules of investing that always need to be followed. One of them is to always be present with the current market condition and not try to make it fit to the perspective you have. In other words, check your ego at the door and respect the market! This last week is a classic case; we were confident with our views because we made our decision rationally (data driven) and not emotionally. Now that we have new data, we need to review it and make a new, equally good decision. Whether we were right or not about the other decision is really irrelevant today. So, was last weeks strong market on better than expected fundamental data enough to change course? It was at least enough to nullify our previously bearish views, and may be indicative of a more bullish view if we get confirmation. There was minor confirmation during the week (further gains the following day after the one big up day) so we now have a bullish expectation. However, we aren’t bullish quite yet as we will wait to see what this next week of data brings (lots of corporate earnings) to see if the tide has turned in a meaningful way. So, the answer to the question is yes, there probably was a false signal last week and we are now taking the appropriate action but not over-reacting. The related trade for this action is to put back on the China exposure that was taken off last week (20% of portfolio) so as to get back to where we were before these last two weeks’ events. We will be looking to now increase exposure with confirmation of this reversal.

The net result of all of this is to stay current with the market by making minor adjustments as the market dictates so that we don’t get a portfolio that is out of line with the market, under-performing and requires a major overhaul.

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Last week we received confirmation of near-term market direction from one of our indicators. The market recently had poor ratios of stocks moving up vs. down, know as market breadth. While this is not entirely surprising in a market pull-back, extreme readings are, and their occurrence often times are indicative of trend changes. Since late May, the market has experienced at least three extremely negative breadth days. We now believe that the near-term direction of the market is down, and are reducing our portfolio exposure by eliminating our 20% long China position. We have sold China because we are concerned that surging Chinese loan demand is being directed into speculative activity rather than daily business activity that would be supportive of true economic growth. Commodity markets have weakened in this market correction, and will be important to watch to see if further weakness leads to reduced borrowing demand. Also, we are concerned that indications of economic growth here in the US are not sustainable.

After eliminating our China position, our portfolio remains very defensive and has the following positions:
20% long Brazil (EWZ)
30% short Europe (EFU)
50% cash

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As longer-term readers know I have been expecting a correction in the markets for about six weeks now. A week ago markets weakened as commodity prices dipped and the US Dollar rallied from oversold conditions. The decline amounted to all of 5% before markets rallied last week. This action is consistent with an early stage cyclical bull market, which is what we have been characterizing this market as. So, why didn’t we buy the dip last week? Because one recent day’s decline was the second very bad breadth day within 30 days. When this condition happens and continues, markets usually don’t stop declining at 5%. What we have now is conflicting market action; some pointing to bull market conditions and some pointing to bear market conditions. Lastly, many markets are trying to get through their 200 day moving averages. This last condition could be a good “tie breaker” of sorts, along with commodity and oil prices themselves (a leadership group). If prices can get and stay above their 200 day moving averages or commodities rally to new highs it would be bullish.

I expect that soon either 1) the leadership markets will make new highs or 2) the 5% correction mark will be broken to the downside. Whichever of these things happens first will tell us if this correction should be bought or sold. Stay tuned.

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