Solid Cushioning for Your Portfolio

As we approach the half way point for 2011, the complexion of the equity markets’ performance appears to have changed… or has it?

Sure we have hit a soft patch as the events of last quarter In Japan combined with higher energy and food prices have slowed the economy. While I believe this to be temporary and the economy re- accelerate later this year, the market’s reaction to the slowdown and the recent bout with sovereign debt concerns has created opportunities for specific ETF’s that should perform even if the economy and markets don’t recover.

First to mind is the high yield bond market (iShares iBoxx High Yield Corporate Bond Fund, JNK). High yield has benefited greatly from the general improvement in credit, demand for yield and economic recovery over the past two years. It’s clear the “soft patch” has resulted in an equity valuation adjustment, but the strong downside correlation and beta of HYG to the equity markets is greater than historical averages. The sovereign debt concerns have exacerbated this move as well, however, the strong profitability and cash levels of corporations backing these bonds equates to a magnitude of decline move in our eyes that is unwarranted. In fact we are at a point where the yield (HYG currently yields approximately 7.6%) is greater than the average decline in this sector. If HYG returns to its 5/31 closing price, this is an additional 3% kicker, but you don’t need the market to move to make money.

Another ETF play is the UUP (Powershares DB US Dollar Index Bullish Fund), a long US dollar play. The dollar has tended to rally over the past three years when stocks drop on a flight-to-quality move, providing a nice diversification. Further, if the decline in US stocks continues as a result of Euro-zone credit issues, the dollar is the likely benefactor. Additionally, if rates start to increase due to growth acceleration, the US the dollar will likely benefit as well. This would only be benefited more by austerity measures in the US.

Now looking to ETFs with direct exposure to equities, most have found tough footing on economic sensitivity and geopolitical issues of recent. Health care (Health Care Select Sector SPDR Fund, XLV) has offered investors some attractive qualities for the current market environment. XLV has been one of the strongest sectors this year, still holding gains over 12% for the year, while offering a yield to investors near 2%. In the month of June, while the majority of broad based indices have declined 4.5% – 6%, XLV has declined by half of that at slightly less than 2.5%. This is a sector that many worried about suffering from a political standpoint as the healthcare bill and other political rhetoric moved around Washington. However, to the contrary, this has been one of the most consistent performers through an up and down year,

These ETF’s we discussed above should do well for the portfolio and provide stability and diversification even if the market continues its recent decline. But from my perspective the recent weakness is “temporary”, and here’s why:

Many are looking at recent data such as GDP and jobless claims to support a slowdown that is a precursor to another recession. But remember that jobless claims are a measure of those who are not working. We prefer to look at monthly payrolls that measure the amount of people who are working (and contributing to the economy). The number of people working each month is increasing at around 200,000 and has been for the past year or so. In fact, one of the better non-farm payroll numbers we had was for April, the same month that saw unforeseen upticks in jobless claims up as high as 478! The “horrible” non-farm number for May was actually a positive number, meaning we ADDED jobs to the economy…again. Also, GDP was revised up to 1.9% again another POSITIVE data point. Let’s not shoot a nickel because it’s not a quarter.

The markets can fluctuate during any 30-60 day period but the trend for the 2-6 quarters ahead generally follows the employment and output trend. After all the market is up over 20% from this time last year so some consolidation/correction is to be expected. The events of Japan and the higher oil prices from last quarter are having a temporary impact on the economy.

But make no mistake the economy is growing! Corporate profits are at record levels, personal income is at record levels, tax receipts are up 55% from a year ago and the S&P is trading at the lowest multiple to earning in over 26 years. While the market may still go lower from here it would be a mistake to suggest a recession is coming. In fact, growth is more likely to accelerate later this year and the more probable direction for stocks in the 12 months ahead is higher

Good News! Inflation!

Written by John Eckstein- Director of Research at Astor Asset Management, LLC

While we all wring our hands about inflation and grim-faced, serious-suited bankers tisk, the fact that we have had an uptick in inflation in 2011 is good news. That and the prospect of a bit more is putting the United States into a position where job creation – and demand creation – is more likely. To explain why, I am going to call upon our trusty friends, supply and demand.

Economists usually think about supply and demand balancing on a graph that shows the quantity of a good demanded on one axis and the price of the good on the other with the price representing what would be obtained in the marketplace and sampled at monthly intervals perhaps, showing at each price where supply and demand met: this many dollars for that many cookies. The chart shows one representation of the US labor market with total labor (in terms of total hours worked) on the horizontal axis and the real (or inflation-adjusted) wage on the vertical axis. Recall what happened at the end of 2008. Many, though not all, economists would describe that period as one characterized by a sharp drop in aggregate demand, that is on the whole the US decided to consume a lot less of some things (houses in Las Vegas for example) and somewhat less of almost everything. As consumers demanded less, producers made less and thus there was less demand for labor. Now if the demand for something goes down: why then our ancient faith should teach us that the price should usually drop as well. Look at the red squares on the chart though: they represent the period 2009 to date and you will see that the real wage – the price of labor – increased over this period.

This scenario seems odd. Of course employees did not find a note on their paystub saying: “business is terrible, have a raise”, but the CPI dropped substantially with no change to the trend in nominal wages – causing inflation adjusted wages to increase – and until the end of 2010 both prices and wages moved together, keeping real wage at its new, higher level. Now it’s a bit of a puzzle why wages wouldn’t fall during a recession. The same thing happened, though not to the same extent, in the 2001 recession but wages fell, as you would expect, in the 1990-91 recession. Logic dictates that if more workers are to be hired they must be hired at a wage firms find attractive but there seems to be a bit of disconnect between the real world and the ultra-rational economic factors our models posit.

Whatever the cause of the increase in real wages, with inflation rising faster than wages over the last few months, we have begun to see some progress toward moving wages nearer to the level they were before the recession started. Call it half way there. At this point we are in the unusual situation of hoping for a bit more inflation and sooner rather than later. Enough inflation, that is, to move the real wage down to induce firms to hire more workers (thus increasing demand and – hopefully – moving the real wage back up again but for the “right” reason) but not high enough to force the Fed to hike rates prematurely. Incidentally, increasing inflation somewhat would also reduce the real interest rate which is good for getting money into the hands of firms who can invest it.

According to the Fed’s semiannual monetary report to Congress from this winter, increasing inflation to more normal levels was one of the goals of the second round of quantitative easing undertaken by the Fed which is due to end this month, Interestingly, one idea which keeps coming up in discussions of Fed thinking is inflation targeting, where the fed explicitly aims at a target for inflation, with a balanced approach of reacting to inflation either over or under the target.

Of course the real wage is not the only thing going wrong with the US economy and it is easy to overdo it with inflation. I believe, however, the recent moves are moving the US labor market towards a higher employment equilibrium.

John Eckstein is Director of Research at Astor Asset Management, LLC

The Employment Situation Road Map

At Astor we are known for creating portfolios of ETF’s using employment trends as a key factor. Research and history have proven that employment trends are an excellent indicator of the long term direction of the economy and sectors. Of course it is not a one-to-one correlation and sometimes employment trends lag a bit, but for my money sticking with the employment trend keeps you out of trouble.

Look at recent history for a few examples. Employment trends kept me out of trouble in late 2000, sitting out much of the pain of the dot com bust. Fast forward seven years, and identifying a contracting labor market in late 2007 just before the subprime debacle saved you a lot of pain, fortuitously. Now that the current recovery is well underway and an expansion is upon us, employment trends can help balance a portfolio by investing in the sectors with the greatest employment growth.

With the latest data on the US labor market released last Friday, new clues as to where the best opportunities lie are available. This will most likely be a very boring, albeit useful and informative article. I promise to have a bit more wit and even humor in the other article posted during the month. There will be, of course, short term opportunities presented with other data points, political events and economic releases, as well as cute moves to capture short term fluctuations using ETFs. My hope is to regularly identify these opportunities as they present themselves. All that withstanding, the employment report is still the grand daddy of reports to build a road map to long term directions and sustained investment goals and objectives.

As I review the latest report areas of strength, those that jump out are the following:

•Healthcare – added 34,000 jobs. Investors can purchase the iShare Dow Jones Healthcare index (IYH) to get exposure to this hot sector.
•Manufacturing – added 33,000 jobs last month. A way to play that growth is in the MZG, the claymore Morningstar super sector of companies that make stuff.
•Construction- Although construction added 33, 00 jobs, recall that it lost 2,200 jobs in January so I would not jump on board yet in this area or related business.
•Transportation – Added 22,000 jobs mostly in trucking. The iShares IYT is an excellent ETF to capture this growth. With energy prices on the rise, this will be counter intuitive and should climb the preverbal wall of worry.
The big losers (from a jobs stand point) were state and local governments which have shed 377,000 jobs since the peak in 2007. I would be careful here and not rush to sell securities related to these municipalities, such as MUNI which is the ETF that tracks the muni bond market. The default rates are very low for munis and one or two bad apples should not spoil the whole bunch, but it could add unnecessary volatility to your portfolio (read opportunity as well).

Our lesson from an employment perspective is that if you add exposure to sectors that are adding jobs and reduce to the sectors that are losing jobs, you portfolio should have lower risk and volatility. After all, job growth is a sign of health and confidence, and pockets of strength are always good. Of course there is no magic bullet that can prevent the economy from losing steam and reversing course but these sectors tend to hold up better in a down turn and run farther in the expansion.

The Time and Place

Much has been written to vilify levered ETFs. In fact, many blame them for the equity market volatility of recent years, specifically the flash crash of May 2010. I find this generalization frustrating. After all, it is just about math.

Leveraged ETFs may not track the index exactly over the medium to long-term. They may even be downward-sloping, meaning they are more likely to go down rather then up due to the effect of daily rebalancing. But, again, it is just math. The daily rebalancing impacts the long-term return and if the market is not trending it has a negative impact on price performance in comparison to the corresponding benchmark. That said, leveraged ETFs have a definite time and place and the best use is to capture short-term moves. With reduced capital requirements, an investor can hedge an entire portfolio without having to sell or raise cash. Or, if an investor is expecting a short-term move (up or down), and wants to take advantage of the short-term volatility it can be done with limited stress on the funding levels. Whether you are a hedger or an outright speculator, there is a benefit to be had from a product like this.

This is all a long lead-in to a recent phenomenon I have noticed in the major indices that have been occurring on the first day of the month. An abnormally high percentage of each month’s return, in the S&P 500 for example, has occurred on the first day of the month. Since the bottom was reached in the S&P 500 in March 2009, we have had 23 first days of the month. Of those 23 periods, the first day of the month has been the same direction as the rest of the month 17 times, or 73.9% of the time. The average return of each month since then (4/1/2009) is 2.35%. The average return of the first day of these months is 0.8%, or 34%. If we look at these numbers since January 1, 2010, these figures become more significant even. In the 14 measurable periods since then, the average monthly return for each month has been 1.35%. The average return for the first day of each month has been 1.05%, a staggering 76%.

There is an additional, equally alluring component to the “first of the month” phenomenon of late. Since April 1, 2009, 82.6% of the “first days” (23 total) have been positive, averaging 1.33%. Of the four days that were negative, the average return is -1.71%. The average return for all days in this sample was 0.81%, with the best day at 2.95% and the worst at -2.58%. A more recent view of this trend paints a similar, more compelling picture. Since January 1, 2010, 12 first days of the month have seen the S&P 500 rally, with only two showing a decline. The average return on positive days has been 1.4%, with a -1.02% on the two down days. The best day in this sample is 2.95% still, with the worst day at -1.72%.

I believe this pattern is due to two things; bullish consensus with low conviction, thus creating a chasing effect on the first day of the month as frustrated investors that missed yet another positive month just buy everything as the new month gets under way, and simply a bull market trend. Bringing this exercise full circle, whatever the reason for this might be if this pattern continues into March this is the perfect use of levered ETFs to capture this pattern. Investors can buy highly levered ETFs like UPRO and SQQQ which give triple leverage to the long side of the S&P 500 and NASDAQ 100, respectively. Since this trade is trying to capture the movement of a single day this is the perfect scenario for these products. While I am not suggesting this pattern should continue to work, and of course past performance is not indicative of future results, if you wanted to “go for it” this is a time and place for levered ETFs. In the spirit of full disclosure, my logical mind would not typically invest much capital on a pattern that I can’t explain. It is hard to ignore what I would dismiss a statistic of this significance to mere coincidence,

More interesting is you can sit out the rest of the month which will clearly reduce the risk/return profile as the lowest risk position is out. So with month end around the corner and the first day’s pop to follow you might want to keep your powder dry.

The Not-So-Secret Alpha Weapon

As the equity markets around the world turned higher in Q1 2009, and were followed by the economy soon after, many investment managers began to lag the broad averages/benchmarks as a result of being defensive. (Can you blame them?) Figuring out how to play catch up was the question, and many investors turned to emerging markets as the secret weapon. And why not? The story sounded good. Most avoided the domestic financial crush simply by not having a banking system that could support leveraged “ponzi paper” that the US and Europe were good at creating. They didn’t have the same issue we had with deficits and housing. They did not avoid the global slowdown 100%, however, their growth potential as a whole looked outstanding as the world rebounded, and they were going to lead us out of the recession.

Emerging markets were going to be the next big thing in the investment world and the upside opportunity appeared limitless. The beta of these markets is historically higher than the developed markets, and as momentum turned it seemed like the perfect trade, creating an allocation opportunity to add portfolio alpha. Emerging markets’ correlation to US stocks grew, but who cares about diversification when everything is going up, right? ETFs became the vehicle of choice for investing in emerging markets and the growth in these products swelled, ultimately breaking into the top tier by fund assets, alongside the SPDR S&P 500 ETF Trust (SPY) and the SPDR Gold Trust (GLD).

As 2010 was a grind up to new recovery highs was complete the tortoise (developed market equities) strolled passed the performance finish line ahead of the hare (emerging markets). But from the recovery lows the previous two years we still saw a large disparity in returns between these two brtheren. To be sure, the total return of the iShares MSCI Emerging Market Index (EEM) from the beginning of March 2009 through the end of 2010 was 131.5%. This compared to a 77.47% return for SPY and a similar 77.59% return for the iShares MSCI Developed Markets ETF (EFA) over the same period. As we enter 2011 and assets continue to balloon, fundamentals are no longer supporting such an large allocation to emerging markets versus developed markets as the recovery matures. The commodity story, which helped bolster resource-producing economies and their currencies, has become long in the tooth and political issues are causing excess volatility. Fundamentals do matter as do valuations. As the slow and steady improvement in the US economy hits stride, the surer bet right now is the tortoise. Year-to-date through 2/9/10 has said it all. EEM is down 4.47% compared to a 5.18% gain in SPY. As we review the fundamentals that drive US stocks, even after the lost decade, they are positively sloped and respond in kind to growing and improving economic fundamentals. This is not always the case (yet) for emerging economies. It has yet to be proven conclusively that these equity markets reflect their economies for any continued period. In fact, I am not even sure emerging market equities are positively sloped. They present great runs followed by almost equal declines. So as the train gets crowded and is about to leave the station, smart money is (or should be) rotating out of emerging equities and into more developed markets and larger capitalization stocks. There will be a place and time to re-enter emerging markets for the “beta trade”, but that may be a few quarters and maybe up to few dozen percentage points from here.

All That Glitters

Gold has become front-page investment news lately and I think it’s time to shed some light on the shiny metal that has no industrial purpose. We do have exposure to gold in our portfolios through the ETF SPDR Gold Trust (GLD). We have been holding gold since late 2007 and have recently reduced this exposure a bit. This is not a comment on our view but rather a rational decision based on correlation and reality. Gold over the long haul has a low or negative return (depending on how you measure it and if you adjust for inflation). Although many consider gold a hedge against pretty much everything, including currency devaluations, political and social unrest, and inflation, I believe this conventional view is flawed. Statistics do not prove that gold is a very good hedge. Actually, stock indices seem to outperform gold and outperform inflation (of course with greater volatility). On an inflation-adjusted basis, gold is still 50% below its all-time high set almost three decades ago while stocks, even after two 50% declines in that period, are up around 1000%.

In fact, it seems uncertain why gold should rise during inflationary times other than demand from other investors. For example, gold is up 33.5% YTD but inflation is down 2%. If gold prices are predicting future inflation then so should bonds, which should sell-off during periods of inflation, and TIPS, which move on inflation expectations. However, both are greatly unchanged from year ago levels and are down from earlier this year.

What is driving gold these days is something I call “investment demand for gold.” This phenomenon changed fair value for stocks in the 80s when anyone with a 401(k) or IRA needed to buy stocks regardless of the price. With the advent of easier ways to hold and own gold, portfolios are being reallocated to include gold in their asset mix. This is creating a new source of demand. Whether investors determine 5% or 25% is the appropriate portfolio holding is unclear. But until those portfolio shifts are completed gold will be supported. Once this shift has completed, gold should move less in line with stocks and more on diversification and correlation principals if not on inflation fears, political unrest and currency devaluations. Signs are on the horizon that this day is closer than you might think.

Buy Dollars Wear Diamonds?

We recently added UUP to the portfolio which give some long exposure to the U.S. dollar. The response was immediate from clients who were concerned about the “free fall” the dollar was experiencing and the negative press the dollar garnishes daily and the impact on the state of the American economy. I don’t see it that way and a further review of the facts looks very different than investor perceptions. Truth be told, I don’t know where the dollar is going any more then I know where stocks are going or, for that matter, any of our positions. What I do know is that each position collectively has a greater probability of going up than down at the current stage in the economic cycle. While any one position can be wrong we look at the portfolio as a whole, with the objective of making more money than we start with. What we have demonstrated, by rigorous analysis, is that the overall portfolio is positively sloped. It has high probability of being worth more in the near future with an appropriate level of risk. If I knew where any one position was going with greater certainty, then I would put only that position on and nothing else.

As for the dollar, I think it is misunderstood. I don’t believe the carry trade actually exists. Who would sell the dollar and buy currencies that have a positive carry of around 2% annually when the currency can move more than 2% against you in a day? It doesn’t seem reasonable. Furthermore, the current correlation to equities is not sustainable and in fact doesn’t even make sense that the stock market should go up when the dollar goes down. We are a net importing country. We buy more from other nations than they do from us. That means a weaker dollar makes it more expensive for us to buy foreign goods. While I know that it also makes it cheaper for other countries to buy our goods, the fact is that the net effect should be a negative. The dollar moves more on trade and investment flows than interest rate differentials. At least in the long run.

If you look at the dollar from a longer-term perspective things look a bit different. One year ago the dollar index was at 79.35 (the end of Q3 2008) and the NASDAQ was at 1584. Today the dollar is at 76.80 and the NASDAQ is it 1720 (as of Q3 2009). So the dollar fluctuated down about 3% while the NASDAQ rallied over 8%. I am not sure what the big concern is here. Adding a long dollar position to the portfolio reduced the volatility and drawdown of the portfolio with limited impact on the returns. In fact, when the markets were in a free-fall during Q1 2009 the long dollar offset much of that loss allowing the portfolio to withstand that drop and to participate in the rally with less risk. If we take a look at a longer time-horizon, such as from the two years when the S&P made its high in September 2007, we see even further the downside protection benefits of a long dollar position, as the dollar index was about 80.5 at that point and the S&P was above 1500. The dollar has fallen only about 5% since then and the S&P has dropped almost 30%. So I find it hard to connect the dots of a weaker dollar impacting the markets. Since inflation is one of the main culprits of a currency’s value, interest rates need to be raised to offset the impact of inflation. The core inflation indices are down over the past twelve months so that doesn’t pose an immediate problem. The bulgering debt burden appears to have some in the currency world concerned but demand for U.S. treasuries remains high and rates remain low which would not be the case if debt burden was hampering the credit markets. In the end it’s all about growth and I expect U.S. growth to exceed that of its trading partners. This should support a bottom for the dollar and eventually lead to a stronger dollar. And don’t worry as that can occur with a rising stock market, but it can also occur with a declining stock market. That is what makes this position so attractive.