Author: Paul Franke, Quantemonics
Covestor model: Relative Value
We have been able to accomplish much of what we wanted during 2011 in the Covestor Relative Value portfolio. A low-risk, hedged, diversified portfolio was perhaps the most intelligent design win for the year, outside U.S. Treasury bonds and gold-only investments.
In early 2011, the vast majority of market pundits and experts were overly optimistic about the economic future for the world, and had bid stock prices well above their long-term intrinsic value with the help and support of the Federal Reserve bank’s Quantitative Easing 2 (QE2) liquidity effort begun in late 2010. But a structured and intelligent, yet cautious approach, mindful of future risks and changes in investor behavior looks to have won the battle for stock market profits this year.
With a few days remaining in 2011, our low volatility design, since inception in early February, has been able to both outperform the stock market averages and generate some profits for investors, our two main objectives each year. The Quantemonics Relative Value design produced one of the lowest volatility and beta readings of the nearly 200 Covestor portfolios in 2011, as we maintained a rough net neutral stock market weighting (gaining or losing little with the market swings in pricing overall) while holding an average 80% invested portfolio. The inverse (short) ETFs owned largely did their job, while the decay and compounding was more than what we were projecting in the October-November span.
We did a better job of going long stocks at the November bottom than the early October one, though we were in the process of covering a greater number of ETF shorts and entering new regular equity positions in operating companies at both bottoms in pricing.
Overall, I give ourselves a B+ rating for portfolio decisions in our first year. We have been busy in 2011 refining a short-term market risk indicator, and researching another longer-term trend following mechanism to compliment the Market Breadth Index (MBI) score of 20 different indicators we track each week. Our goal is to constantly improve the decision making process, to remove human emotion as best possible.
During late November we started to prepare the portfolio for changes in the world of finance in 2012. The sell-off in stocks in the second half of 2011 provided a welcome opportunity for us to deploy additional capital in undervalued companies. Plenty of stocks holding decent-to-excellent long-term value exist right now for our investment money. When we began the Relative Value portfolio in early February, it was difficult to find stocks with the investment characteristics and upside we desire. In late November and early December, there are literally hundreds of companies that look like good candidates.
We have been buying plenty of them, and hope to own around 30 soon, alongside an increasingly net long weighting to the stock market direction into early 2012.
With the changes in risk rankings at Covestor in November, we have decided to focus on three different strategies in the Quantemonics Relative Value portfolio to maintain our Risk Score of 2. Alongside intelligent equity, bond and commodity market weightings (using ETFs to hedge downside and participate in upside) in the coming years as we work through our too-much-debt and income inequality problems in America, Quantemonics operating company selections will also focus on core, undervalued blue-chips and special situations – turnarounds and spin-offs in the mid-cap to large capitalization areas of the stock market. This three prong, diversified approach should greatly reduce our portfolio downside, and allow for strong real world gains in a variety of market and economic environments.
While we entered 2011 with a projected range for the calendar year of +10% to -30% for potential returns in the U.S. stock market generally, going into 2012 we are forecasting a more balanced +20% to -20%. This is still a rather pessimistic view of reality historically, where a normal annual return would see a range of +20% to -10%. We expect greater than average volatility in the stock market to continue, with the potential of downward price pressure in early 2012, but on the flip side we are overdue for a strong outperformance year in the deep value, restructuring and contrarian play, blue-chips that Greg and I have developed some expertise trading the last 25 years.
As America deals with (1) the reality of higher federal taxes and lower government spending to slash Uncle Sam’s deficit spending spree to a sustainable level, (2) our Asian trade imbalances becoming a more significant issue going into the 2012 national election, and (3) the high odds of continuing trouble in the oil producing Middle East region of the world, increasingly negative developments for inflation and interest rates and overall confidence in the world’s balance of powers look probable during 2012. Specifically, I think greater friction between the U.S. and China, a slowing economy in Europe, and the quickly growing odds of Israel bombing Iran’s nuclear facilities are all issues for 2012 that could unsettle the U.S. stock and bond markets.
[Sources: Bloomberg story on U.S. & China currency valuations, Margaret Talev and Julianna Goldman, 11/13/2011; Institute for Analysis of Global Security, Gal Luft, 2005 article on battle for oil supplies between U.S. & China; Bloomberg article on slowing European economy, Simone Meier, 11/23/201; Reuters story, Japanese central banker warns on global effect of European debt mess, Rie Ishiguro, 11/30/2011; Reuters article on future downgrade odds of European sovereign debt by Fitch ratings agency, Gavin Jones and Stephen Brown, 12/17/2011; Bloomberg column about Iran vs. Israel confrontation rhetoric, Jeffrey Goldberg, 11/8/2011; Reuters article on potential chaos from disruption in Iranian oil exports, Jonathan Leff and Judy Hua, 11/30/2011; Reuters story on possible Iranian oil embargo, Justyna Pawlak and Robin Pomeroy, 12/1/2011.]
I continue to believe the worst long-term place to park your money in 2012 will be U.S. Treasury bonds, and inevitably cash and basic savings instruments like annuities, CDs, money markets, plus regular bank accounts. While they turned out to be an excellent place to hide in 2011, I believe stagflation or hyperinflation are coming sooner than many imagine. As we saw in early 2011, even a stable world economy led to skyrocketing commodity prices that spawned political revolution in a number of nations around the world, and this trend will continue as inflation rates spike higher either in 2012 or 2013, from ever growing levels of money printing globally. Given a violent overthrow of the Saudi Arabian government, or total chaos in the Middle East after Israel bombs Iran, crude oil prices could easily double in 2012, sending a slow-growth global economy into deep recession almost overnight. Inflation rates of 10% in America could be reality in 6-12 months given such an outcome in the Middle East. At that point, pressure on the U.S. to slash the federal government spending spree would become an emergency as interest expense on $17 trillion in Treasury debt (financed at the short-end of the yield curve with almost zero for interest expense presently) would explode in 2012 and 2013. Our July commentary regarding the U.S. Treasury debt mess is still worth reading, if you have not done so – view it on Covestor Blog or our site.
For our Covestor Relative Value portfolio, we are trying to stockpile both energy related investments and companies we believe will benefit or can withstand a pick-up in inflation and interest rates throughout 2012 – both, upon weakness in price. In the end, we believe such investments will run circles around the big losses in price and purchasing power coming soon to bonds and cash-like investments. For example, long-term U.S. Treasury bonds that have been artificially (and insanely) supported by the Federal Reserve, could see prices decline by 20%-50% in 2012-2013 at the same time as each Dollar purchases 10% or 20% less than it did in late 2011. Much like the 1970s inflation experience, stocks smartly outperformed cash and bonds in total returns and inflation protection over time, despite several years of recession and stagflation in economic output, including wild swings in the stock market price generally.
Over the last few weeks we have purchased a coal company, several beaten down solar companies, and have standing orders to buy oil and gas assets on a decline in price. Energy prices will largely fluctuate in 2012 based on three variables, namely the level of money printing by central banks, the level of economic demand growth, and the events on the ground and seas surrounding the volatile Middle East oil producers. If central banks refuse to print money, we have a serious global economic contraction, and the 2011 Middle East protesting, confusion, and violence trend calms down, oil and gas investments will likely decline in value next year. The odds of all three occurring are near zero in our opinion. The odds of all three doing the opposite seem to be considerably higher – central banks printing money like crazy to offset debt burdens, the emerging market economies forging ahead with decent growth in energy demand, and increasing violence and chaos in the Persian Gulf nations, shutting down supply of oil and gas to the world. If just two out of three take place in 2012, energy prices should lead inflation rates higher, and energy investments may prove the top sector to own.
Another stock market puzzle I have been working on solving for 2012 revolves around which styles of investing (growth or value) and sectors or industries are due to outperform next year. I keep coming up with one answer: value investing, especially blue-chip, brand name centric ideas should do well in 2012. Stock picking may be back in vogue next year! You have to go back to 2006-2007 to find a period where stock pickers actually earned their keep. Stock market assets have been tightly correlated for returns and performance since mid-2007, more so than usual for five years running. As the economy slumped into a Great Recession with nearly all stocks falling together, and then recovered together as a group with QE1 and QE2 money printing, alongside the federal government’s stimulus response, stock pickers have taken a back seat to macroeconomic events. [Source: Bloomberg article on high levels of market volatility, Saijel Kishan and Jeff Kearns, 12/15/2011]
It is quite probable capital will continue to flow to safer, defensive stocks in 2012, similar to 2011’s activity. Wall Street and main street investors are starting to sift through stocks on a selective basis again. As in 2000-2002, I am thinking 2012 could see a strong year for the right undervalued, higher yielding, safer, brand name blue-chips than the typical stock investment. It has been such a long time since stock pickers have added value to portfolios, and stock sectors have been able to trade on their specific and differing fundamentals. 2012 may be overdue for such a year! We started to see value based, blue-chips do better in 2011, and this may be a primary investment trend for 2012. As always we will stay diversified, but we plan to overweight energy, medical products (for defensive reasons similar to 2011), and undervalued blue-chips based on our research and forecasts.
The main reason Greg and I started Quantemonics Investing and the Covestor mirror portfolio partnership comes from our belief the world will continue to see wide swings in overall economic activity and stock market pricing for years, much like the economic and financial situation in Japan the last 20 years. Few investment products either exist today or are run properly to give the average investor a chance at earning significant profits given this environment.
Changing market weightings and forecasts, selective and wise stock selection, and quick reversals in focus are not the hallmark or goals of current investment products available to the average investor. In this vein, we are running something akin to a low-risk hedge fund at Covestor, previously open only to the rich, before Covestor began offering mirror portfolios in 2010.
We hope everyone has a wonderful holiday season! We will do our best to generate stock market outperformance and gains for our mirror portfolios in 2012.
-Paul Franke
