Why? Because.

Over the weekend I was reminiscing about a college professor, Dr. Hill, who actually asked the all-feared question on our philosophy final – “Why?”  Being angered at the time at the stupidity of this question I wrote “Because” and walked out of the classroom.  I later came to learn that anyone who actually attempted to answer the question got a “C” on the exam.  The answer “Why not?” earned a “B,” and my well considered “Because” earned me an “A” on the final.  I’ve been thinking about that answer lately because in the investment business, it’s important to know what investors believe in answering the question “Why?” 

In the early 20^th century, the French mathematician, Bachelier, gave us the first quantitative model for pricing options that relied on the idea that since it is impossible to figure out why prices move in a mathematical formula, it’s best to assume that price changes each day are the same as flipping a coin.  He used the mathematics of his day for price movements (Brownian motion) and for volatility (standard deviation) to derive a formula for option pricing that looks very similar to the Black Scholes option pricing model used today.  Using the mathematics of probability and statistics to make assumptions about the probability of price changes has been the rule for academics ever since.  Markowitz’s Modern Portfolio Theory relies on the same assumptions and the same math to give us the notion of efficient portfolios.  For academics, the answer to “Why?” would be to say, “Wrong question.”  Modern Portfolio Theorists assume we can’t know “why,” and so they use past data to make inferences about future returns – a process called the stochastic method in science.

For active portfolio managers and value investors of every stripe the answer to “Why?” probably falls into one of two categories.  If the answer has anything to do with interest rates, fiscal and monetary policy, earnings, currency, geopolitical news, etc, then we would consider these investors to be traditional value investors who find the answer to the question “Why?” in these and many other well known metrics of economic and financial health.  If the answer to “Why?” is determined by the study of market prices, then we would characterize these investors as technical investors.  At Pinnacle we expend enormous effort to find both traditional and technical answers to the question of why prices move.  The academic approach is misused, misunderstood, and frankly dangerous for investors who think that the answer to “Why?” can be found in past data without understanding the “because.”  I agree that actually finding the one reason that prices move is an impossible objective.  But ignoring the news and the behavior of investors can only make you money in a long-term bull market, a state of affairs that may not be in the cards for quite awhile.

Risk Management and Money Markets

I recently watched a video where a Chief Investment Officer stated that by utilizing a risk management methodology that allowed them to go to cash or money markets, “they were making the type of risk management used by large investors available to small investors.”  Let me be clear about this.  Large institutional investors will NEVER take a portfolio to a 100% cash position in order to best manage risk.  I can think of two major reasons why that is the case. 

First, institutional portfolio managers of large state, union, and corporate pension funds, endowment funds, and family offices for very large private accounts, are virtually all well-schooled in modern portfolio theory.  These MBAs, Ph.D.s, and CFAs, believe that time diversification and asset diversification are the best methods to manage risk.  Second, large institutional pension funds use an actuarial approach to managing risk by matching the maturity of their liabilities with the duration of their investment assets.  For employees retiring 25 years in the future the investment with the highest return premium and the longest duration is common stock.  For these investors, owning cash represents an unacceptable risk of mismatching assets and liabilities.  The closest institutional investors might come to “going to cash” is to allocate some small and manageable portion of the portfolio to money managers that run strategies that allow them to zero out their “long” stock positions.  Hedge funds in the market neutral and long-short space often get to 0% long exposure to stocks.  However, these allocations typically represent a small allocation in an institutional size portfolio.  In Pinnacle portfolios we call these managers “eclectic managers” and they currently represent about 10% of our total portfolio allocation.

Pinnacle Advisory Group does not go to 100% cash for reasons that having nothing to do with the views of institutional investors.  I believe the basic idea that stocks will always deliver a premium to bonds and cash over long time periods is a dangerous proposition that can’t be proved by past data.  Buying stocks at high valuations offers the virtual certainty of underperformance over long time periods.  However, the reason that we don’t go 100% to cash is for the simple reason that doing so implies that you have 100% certainty that your forecast is correct and I don’t believe investors should take that risk.  I realize that cash offers safety of principal in volatile bear markets and I also realize that certain investors will find comfort in a timing strategy that allows them to get 100% out of the stock market.  I have no problem with their definition of risk or with a money management firm that offers it to their clients.  I have often stated that active management comes in many flavors and consumers will choose managers that they believe in.   But I do take issue with the idea that implementing extreme asset allocations at market turns is bringing the best risk management techniques of large investors to the masses.  It is the little guys who go to cash.  For the largest investors, it would never happen.

Well…That Was Easy

The Pinnacle investment team has been patiently waiting for a serious correction in the recent torrid bull market for months.  To us, a correction in a bull market means something like a 10% – 15% decline – enough for us to feel good about buying a dip in an upwardly trending market.  Unfortunately, the market has not given investors the opportunity to jump in and buy a dip for months, with the closest thing to a correction being a 7% decline that occurred from June 12 to July 10 earlier this year.  But now, for the first time since July, the tone of the market seems to be changing with the market once again declining 6% from its high of 1097 on October 19^th.  We are going to implement a hedge position as a trade to take advantage of a possible nasty short-term correction.  It seems like it aught to be easy enough to do, but….

• Should we hedge by buying a 2X position in the U.S. dollar assuming the dollar will rally on a market decline, or buy a 2X inverse S&P 500 Index fund that should earn two times the decline in the market, or buy the VIX volatility index (Chicago Board of Options Exchange volatility index)?

• If we choose the VIX, can we be comfortable with the tracking error between the exchange traded note for the VIX Index (ETN available through iPath called VXX) and the actual underlying VIX index?

• If we put on the hedge, where do we get the cash to execute the trade?  We have some cash in our managed portfolios for the buy, but what else needs to be sold to take a 4-5% position in the hedge?

• We first looked at this transaction last week and since that time the VIX has had a big move to the upside.  Is it too late to buy it now that it moved more than 10% higher last week?

• We executed a complicated transaction in our fixed income allocations last week and now we can’t execute the hedge trade until the prior week transactions settle.  Will the market allow us to still get in while we wait the extra days for the prior trades to settle?

• One of our analysts feels like we have seen the ultimate top to this cyclical bull market that began in March of this year and so he likes the hedge trade.  Another analyst is worried that we won’t get much more on this correction and doesn’t like the trade.  Another analyst thinks the trade works as is. 

For Pinnacle’s investment team, the details of this transaction are just business as usual.

Pinnacle’s Proprietary Investment Process

Of late, for one reason or another, I’ve spent a lot of time describing Pinnacle’s investment process.  For the record, the best explanation of our process is that we have a multi-faceted approach to decision making that considers fundamental or traditional valuation analysis, analysis of business and market cycles, as well as technical analysis of investor behavior.  This is but another example of why we believe in diversification, although in this case it results not only in portfolios with diversified asset holdings, but a portfolio where decisions are based on more than one kind of analysis. 

I’ve written previously in this space that I believe that investors who are interested in active management will first explore the technical method of tactically allocating portfolios.  Using technical analysis has many benefits, perhaps the most important of which allows the advisor to develop several “rules” for following favored indicators.  These rules then become a quantitative approach to decision making that is relatively simple and relatively effective.  Most of the active managers that I’ve reviewed are using some type of quantitative system based on simple trend following or momentum rules – all of which are based on technical investing techniques such as relative strength, oscillators, trend lines, etc.  The resulting system becomes a “proprietary decision making process,” a very valuable product to sell to investors.  For the record, a proprietary process implies a secretive, valuable, exact, scientific, repeatable process that no one else can duplicate. 

At Pinnacle we have also developed a proprietary investment process.  It’s called “doing the work.”  Unfortunately our process requires us to make qualitative as well as quantitative decisions about asset allocation.  And to my knowledge, there is no easy way to make a decision based on the weight of the evidence as determined by our judgment, experience, and expertise.  For us it means slogging through the 100-plus economic releases each month to find clues regarding the market cycle, Fed policy, currency direction, etc.  It also means reading daily, weekly, and monthly research reports from dozens of brilliant analysts who disagree with each other all of the time.  Marrying this process with our own proprietary quantitative approach is nothing but hard work.  But it sounds a lot better when we call it our proprietary investment process.  For the record, our proprietary process is inexact and messy, but I have a great deal of confidence that it is the lowest risk method for making investment decisions.

Found: A High Conviction Forecast

Task number two this weekend was to catch up on my investment research, a seemingly endless proposition that punishes my weekly tendency to procrastinate in my reading. Task number one was to write a marketing brochure for Pinnacle to use in a potential new venture.  I have written our story so many times that it’s difficult to get overly enthusiastic about doing it again, but I am the Chief Investment Officer and explaining what we do is a big part of the job.  An important part of our story is our belief that relative value investing makes sense.  For us, relative value essentially means that we will vary our portfolio construction based on our conviction in our investment forecast.  We measure our success in earning excess returns for our clients by comparing our results to a portfolio with a fixed asset allocation.  The special name for this hypothetical portfolio is our benchmark, and if we are successful in identifying good investment values we will earn excess returns relative to our benchmark.

While pondering (once again) how to explain the intersection of benchmarks, value investing, tactical asset allocation, and high conviction forecasts, I decided to take a break and read a research piece from Lombard Street Research called, Deflation to hit Germany and America.  Charles Dumas is the well respected analyst who penned this somewhat technical and very detailed piece on his views regarding the outlook for deflation in the U.S. and Germany.  While I shouldn’t have been rewarded for deviating from task number one to dally in task number two, I couldn’t help but be struck by the certainty in Dumas’s forecast.  In fact, the Pinnacle investment team reads hours and hours of research, and I can safely say that Dumas went way out on the limb of high conviction writing.  Here are a few examples:

“For the time being, with stock and house prices down some 30-40% from their peaks, people worrying about booming asset prices causing inflation have to be seriously detached from reality.”  Or, “In these conditions, financial collapse centered on the dollar is verging on the impossible.”  And my personal favorite, “To talk of inflation resulting from this is plain stupid.”  I say bravo to Mr. Dumas.  We highly value analysts who advance clear points of view and back them with sound analysis.  This is not to say that I personally agree with Lombard’s deflationary case for the world, which is by the way, rather gloomy reading.  However, it is a good reminder of how our investment process works.  When we occasionally have the same level of conviction as Mr. Dumas, Pinnacle clients can expect larger rather smaller deviations from our benchmark portfolio. And if our forecast is correct, it is from these conditions that we would typically generate the most excess returns for our clients.

Thoughts on Investment Time Horizons

Sometimes I pine for the good old days at Pinnacle when the prime ingredient for measuring investor success was patience.  Back in the day when we were strategic buy and hold investors, the returns of the asset classes that we owned in our portfolio were assumed to be a given, as long as we waited long enough for them to appear. Since the underlying theory suggested that markets were always efficiently priced, and since our clients agreed that returns could and should only be measured over the “long-term,” we could asset allocate our portfolios based on past returns.  With the backing of the financial media and virtually all of our industry pundits and thought leaders, everyone involved agreed that patience was the key to success.

Times have certainly changed for the Pinnacle investment team (Truth be told, in the old days we didn’t have a Pinnacle investment team because there wasn’t a need for one!).  Today we actively manage portfolios to take advantage of changes in asset class valuations, changes in the market cycle, and changes in market internals such as investor sentiment.  The challenge of this strategy is that in today’s markets the data comes fast and furious and the financial markets can be influenced by the news in unforeseen and unpredictable ways.  The inevitable result of such fluid market conditions is that the holding period for securities in the portfolio continues to shrink.  Where we used to hope to hold equity positions for periods of years, we now would be happily surprised if that were the case.  The market rally since March 9^th is a good case in point.  As the markets have violently rotated from defensives to early cyclicals to late cyclicals, investors who were not nimble enough to follow the cycle missed out on excellent opportunities for excess returns.

Last week, our portfolio manager for our Dynamic Ultra Appreciation portfolios, Rick Vollaro, put on a trade to possibly take advantage of what we perceive to be the short-term overbought condition of the market.  He sold a position in an exchange trade fund that owns the Materials sector and bought a 2x inverse position in the same sector, effectively reducing our equity exposure in that portfolio by 10%.  He intends to take the trade off as soon as we get the correction that he is anticipating.  The good news for me is that Pinnacle has the expertise and the technology in order to execute such an innovative transaction with ease.  However, I can’t help but smile at the gigantic changes that have occurred in our portfolio management philosophy over the past 7 years.  We wouldn’t have considered this trade, even in our most aggressive portfolios, as little as two years ago.  Today we consider these kinds of transactions to be a reasonable and necessary part of our risk management process and an integral ingredient in our quest for excess returns in difficult markets.  We’ve come a very long way from patience being the primary strategy we rely on to earn expected returns for our clients.