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Lots to cover this week.
We’re going to take a look at where the markets are at and where they might be heading as summer edges towards a close. And we’re also going to talk about another top-level investment strategy that I think works really well in this kind of environment. Warning: it’s a tough one to practice and implement. We’ll see if you’re up for it.
But first, a brief visit to Jeffrey’s Movie Corner.
“Change isn’t good or bad, it just is.”
- Don Draper
Floored
The other night I watched James Allen Smith’s Floored, a documentary about the floor traders at the various Chicago exchanges.
It was fantastic. If you work in the industry or have an interest in trading, I will guarantee your satisfaction.
Perhaps it was merely chance, but I found it rather fitting that I had finished up season three of Mad Men a couple nights before. ”Change”, of course, is one of the major themes that runs implicitly throughout that show and that theme becomes rather explicit as the third season draws to a close. The novelty of the whole Mad Men era is a really neat hook, but what really grabbed my attention and kept me watching was the subtle dramatic irony. It’s ridiculous fun getting to know these ad men, their secretaries, clients, and wives. All the while the 1960′s loom on the horizon and none of them can see the tempest that’s coming.
Watching Floored was a similar experience. It was shot during the middle of this last decade on a shoestring budget of only a few hundred grand. These are the final days of the floor traders, the descent of whom dovetails the rise of the machines. I’d say that here too is another situation rich with enough dramatic irony to satisfy the ancient Greeks, but Floored‘s characters are in on the joke. These guys are aware that they are dinosaurs, nobly plodding along toward their ultimate, collective demise. Their world is burning down around them but they carry their heads up high. There’s something to be said for that, I suppose.
Different traders respond to this in different ways: a few embrace the computers, others deny their significance. Some leave the industry altogether while a tortured handful rage, rage against the dying of the light. Gentleness is not part of a floor trader’s DNA.
I think the movie speaks more broadly to everyone in the industry. Those of you that work in finance don’t need to be told how dynamic a world it is. I came of age during a technological tsunami; my first job was at a traditional retail brokerage while stocks like E*Trade and Ameritrade IPO’d and shot to the moon. Talk about irony!
All my generation has known is change, especially those of us that work in finance. Trying to keep up is impossible at best and anxiety-inducing at worst.
Some of these traders in the film are a little rough-and-tumble, a necessary characteristic for survival on the floor. But they share that same struggle as the rest of us, the endless battle to keep up. You may just sympathize with them. Beyond that, I think there’s a deeper theme that speaks to all men specifically. On a fundamental level it’s about the challenges of providing for one’s family and those who trust you to succeed. Each day these men venture into the jungle; to eat, they must kill. One of the traders that Smith chooses to follow is also big game hunter. That wasn’t an accidental decision on the director’s part. The metaphor is clear.
Mark my words now: this movie is destined to become a cult classic within the industry, much the way Wall Street and Boiler Room and Glengarry Glen Ross have. Those are all excellent films. But the difference with Floored is that it is true story. These traders and this industry are not romanticized. This isn’t a glorification of the capitalistic dream. There is a brutal honesty here that you will respond to in one way or another.
Be careful, however. If you let yourself in, if you allow yourself to empathize, you risk overwhelming sadness. You will see parts of yourselves in these traders, ugly parts. These guys are a dying breed, and so, you will discover, are you. There is a river of melancholy that flows beneath the film. Jump on in if you know how to swim in those waters but keep it at arm’s length if you don’t.
Anyway, Floored is still very much under the radar right now. It’s not for sale on Amazon yet and you can’t just walk in and buy it at Best Buy. I notice that you can save it in your Netflix queue but the availability date is still unknown.
If you want to pick up a copy, you can order the DVD straight through their website at FlooredTheMovie.com.
I’m a believer in supporting smaller, independent works of quality. We should reward those that produce this kind of art and encourage them to make more of it.
Oh yeah, here’s a trailer. It contains some bad words, but that’s how these guys talk.
On with the recap…
Market Recap
It’s been an exceptionally bumpy couple of weeks in the stock market. Did you know the market is currently in a 13% drawdown? Do you still have profits from the stocks you bought this year or last year? Maybe you thought I was crazy to call for a 20% correction at some point this. In July the market was down -17% from its highs, and it appears that it right now is attempting to make another run a testing those lows. That’s a big dip! Mr. Market is a mean ol’ S.O.B.
All you regular readers know that I like to look at broad trend lines and the S&P’s movement around the 200-day moving average has been downright fascinating.
Look at how many times it’s bumped it’s head on that 200-day moving average.
It just can’t establish itself above that level!
Since the financial crisis I’ve noticed that the fundamental picture has become a little… murky. Forecasting earnings and determining the true health of a company was always a tough thing to do, but in this environment it’s more difficult than ever. In the case of the bank stocks, I’m of the belief that assessing what they’re truly worth and breaking down their balance sheets is actually impossible. If Chuck Prince couldn’t understand all the stuff that Citigroup was doing while they were in the middle of doing it, how on earth can a guy like me or any other analyst on Wall Street truly understand what’s going on inside these firms with trillions of dollars of assets and liabilities.
With fundamental analysis so difficult to perform now, I’ve seen a lot of investors turn to technical analysis. Every so often on CNBC when they’re at a loss to come up with an explanation for the day’s market movement I’ll hear them say something like, “the market is being driven entirely by technicals right now.”
I’m not sure I’d agree — a million different things drive the market every day. Plus, technicals don’t drive the markets; they are a way of interpreting the market’s movement. So I think they’re right to point out that technical analysis is one of the few ways to make any kind of sense out of all this movement. Moving averages may seem kind of simple but they’re a solid place to start. Don’t discount them.
In the meantime, be skeptical of any rally until the market can establish strong footing above that long-term 200-day trend. I’m slowly getting a little bit more bullish on quality stocks. Now is a good time to assemble a shopping list for the next deflationary washout.
Bonds
Bonds have rallied ferociously in the last couple of months. Those of you who have been following along in the last year know that we have been pushing bonds of many different flavors — high-quality corporates, intermediate term Treasuries, and TIPS — pretty hard. Quite simply, that trade has been a winner. The healing of the credit markets combined with increasing deflationary expectations has made for a record-breaking environment in fixed income. But I had no idea it would work out that well. I just liked them because they provided modest upside with minimal risk. Turns out that type of investment suddenly got very trendy in 2010.
But every trade must come to a close and I think the meaningful gains have already been had. Yes, bonds could rally a little further if the world panics or falls into another deflationary booby trap. In our very Japan-like future, that’s a legitimate probability. But I don’t think those possible gains are worth the risk the come along with it. One of the biggest characteristics that separate the elite investors from the amateurs is the ability to frame return in terms of risk.
For the record, I still like TIPS has a long-term play — not a bet per se on inflation, but a nice thing to have in your portfolio if that someday that becomes a problem. I’m nowhere near convinced that will happen any time soon. But if it does I can see myself saying, “sure glad I bought all those TIPS way back when.” You know, just in case. I like ‘em better than straight Treasuries because what’s the difference, really, between 1% and 2.5%? I’ll pay the extra basis points to get the special inflation features and lower risk.
The back end of the Treasury curve now terrifies me. In February I was listening to analysts call for 5% on the 10-year! Now that’s a really appealing yield. But things have changed since then. We’re at 2.47% today and I don’t think that is nearly enough compensation for all the baggage that comes along with owning a government bond over the course of a decade. Better to hide out in the 2-year and wait around for another shot at better long-term yields.
The 30-year long bond is yielding 3.5% and that’s borderline insanity. It may take a while to materialize and it’s not without certain risks, but shorting the 30-year may wind up being one of the greatest shorts in the history of shorts.
Is it a bubble? You tell me:
Bonds have gone in one direction for thirty years. They probably are in a bubble. I think the best argument to made for the bubble case is not the price, but the eerie psychology in the bond space right now. Everybody seems to know that bonds are too expensive and yields are too low. Everybody agrees that ultimately, some day, at some point bonds will be a lot lower. But in the meantime we all keep buying them because, darnit, it’s just the thing to do! This was the same psychology during the dot-com boom and the housing bubble.
Anyway, I think it’s time to listen to what the bond market is telling us.
If you’ve owned bonds, enjoy the gains. Think about realizing those gains and moving in on the yield curve. If your portfolio is still underweight bonds, be careful when and how you scale in. If you need more yield and are aware of how the risks work, take a look at the corporate bond space instead of going too far out the Treasury yield curve. Pimco’s $28 billion Total Return Fund will get that job done in a balanced way, but if a super-gigantic fund isn’t your style there are other options. I’ve long been a fan of and currently own Vanguard’s Short-Term Investment-Grade Bond Fund (VFSTX). It yields about 2% and is very low risk. VFICX is the intermediate-term variant and that one yields about 3.5%.
The Strategy of the Moment
Assuming the bond market is to be believed — and let’s face it, it’s smarter and more powerful than either of us — then the right strategy is a cautious one with an overweighting of cash.
I’d modify that strategy a bit, and restate it as follows. If all that previous talk about interest rates and yield curves put you to sleep, now is the time to wake up. Wake up!!!
The Strategy of the Moment is to hold a bunch of cash and wait for the market to give you opportunities.
The bad news is that this is quite possibly the most difficult investment strategy in the world. It’s difficult for the amateur investor at home and it’s damn near impossible for professionals.
It’s such a difficult strategy because it requires the two rarest of disciplines, disciplines which are almost never found together.
- Patience
- The ability to identify great opportunities
I know people that are patient and I know people that can spot great opportunities, but I can probably count the number of people I know who can truly do both one one hand. Take a glance at the cream of the crop of investment industry and you’ll notice that a disproportionate number of these guys — particularly those that call themselves long-term investors — are both patient and have that knack for finding the right opportunities.
Your humble narrator will cop to his own deficiencies. I am plenty patient but have much to learn when it comes to assessing opportunity. My other problem is that of inaction, of being perhaps too patient. ”Analysis paralysis” if you will. I’ll see the opportunity in front of me, recognize it, but fail to act or find some silly reason to talk myself out of following through. I know I’m not the only one that suffers those very human flaws. I’m actively aware of these faults and it’s part of the reason why I enjoy working with people who are so different from me; their skill set balances the flaws in my own.
I mentioned that it’s damn near impossible for professionals to follow this kind of strategy because it’s damn near impossible for investment professionals to sit still. One of the big problems this industry has is that it’s overpopulated by people who feel they need to constantly be doing something to justify their job. Financial advisors encourage their clients to rebalance their portfolios just to remind their clients (or themselves) that the advisory service they provide is defensible. Perhaps we all have this latent fear, this innate knowledge that we are a value-obsessed culture that feels entitled to receiving something for nothing. Financial professionals are deeply aware of this and I think it makes them nervous.
So just hang out for a while.
There isn’t much upside in fixed income anymore, certainly not the way there was a year ago. The low-hanging bond fruit is long gone. Yields are depressing to say the least.
Stocks right now are a decidedly mixed bag. I wouldn’t touch most of the S&P right now, especially the banks and consumer discretionary stuff. But I think there are some gems to be found in the high quality space. In prior weeks I’ve talked about Uranium / nuclear power, timber, and value plays like Intel. Johnson & Johnson is yielding 3.7%. Do you have more faith in a company like that than the Federal government? I kinda do.
Gold has me terrified right now; I’m at that weird phase of the investment where I’m definitely not buying any more but haven’t quite begun to reduce my allocation weighting. I’m sorry if you guys missed out on the meat of the gold trade. I wish I’d started this newsletter in 2004! Gold could still go to $2,000/oz and everybody needs to own at least a little bit in their portfolios. But risks are now abound, especially over the medium term as long as these deflationary worries are present.
I see a lot of people getting involved in gold who don’t understand how violently this market can correct and the extent to which it can piss you off. I wrote about this in our epic gold newsletter. No other market in the world baffles traders the way gold does. It rarely does what you want it to and it never does what you think it will. Next week I’ll tell you a funny story about how much things have changed in the gold market.
I’m of the opinion that real estate has further to fall, especially non-distressed properties. I subscribe to the Northern Nevada MLS and watch all the new listings and sales come up every day. This is entirely anecdotal, but the properties that are selling are the cheap ones. It’s like there are two totally different tiers of houses: those that are priced right and those that are priced wrong. And it’s really obvious which is which. Eventually this bifurcated market will normalize. All the distressed sales will finally run through and prices on the non-distressed sales will come down as people slowly come to terms with the true value of their house. That’s a process that is going to take some time. Like equities, I think there are nuggets to be found. If you know how to navigate the distressed market there are opportunities where the risks have a solid floor and the upside is compelling.
I know. This isn’t what you want to hear. You don’t want to be told that it’s a historically tough environment in which to make money. You don’t need to be told that — you live it every day. And what’s more, you certainly don’t want to be told that the best way to cope with generally crappy yields and generally crappy opportunities is to learn to live off of less. It’s difficult to hear because it goes completely against our American DNA and everything that we all learned in the 80′s and 90′s. But be careful and lower your expectations.
I think at some point towards the middle or back end of this decade there will be great opportunities all over the place. In the meantime, work on keeping your powder dry.
Look: the markets have undergone tremendous change. In a “Don Draper style,” existential sense this change is neither good nor bad. It simply… is.
Your job is to adjust to it and it is your reactions that will be judged.
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