Asset allocation for December

The Faber timing model has moved into fully invested mode. U.S. Treasuries, as measured by the Ryan 10-year Treasury Index, crossed above their 10-month moving average last month, so the system is now in Treasuries, as well as all four of the other asset classes. Last month I suggested avoiding long-term bonds, on grounds of their clear overvaluation (if you believe serious inflation is on the way). Having had a month to reflect on that, I've decided to follow the system anyway. Really, you could justify not being in any of the asset classes based on their being overvalued (see Hussman this week for an especially gloomy view). If the current unpleasantness turns into a double-dip recession, Treasuries may well be the only one of the five asset classes with positive performance. They provide needed diversification to the portfolio.

Here are December's allocations:

• U.S. stocks: 20%
• Foreign stocks (EAFE): 20%
• U.S. Treasuries: 20%
• Commodities: 20%
• REITs: 20%

Favorable seasonality looking forward

Today is a good day to revisit the stock market seasonality chart. I've recentered it on January 1 to give a better view of the coming months. There is a modest local low on November 20, marked on the chart by the "You are here" sign. From there we see strong positive seasonality through the end of the year; then slower but still positive movement January through March, followed by strength in April and May.

The market didn't follow the seasonality script during the summer. There is no guarantee that it will do so this holiday season. This is just another datum in our collection, to be pondered and considered with all the others.

The next bubble, now in progress

Quote of the day (actually it's from September) from Pacific Research Institute economist Robert Murphy:

Why do we assume that TIPS traders are genius forecasters, but gold traders are morons?

Leading up to the money quote, Murphy says:

It is extremely misleading when the deflationists say, “What are you nutjobs talking about? Year/year we still have price drops!” Look at this chart of the raw (non-adjusted) CPI for the last five years. Now do you see why I think we are in an inflationary environment, even though the 12-month change in CPI is negative? For what it's worth, prices bottomed in Dec 08. From then until August 2009, the unadjusted CPI level has increased 2.7%, which translates to an annualized increase of just over 4%.

Via Veronique de Rugy:

In an email message, Murphy adds: “I believe we are currently witnessing a bubble in Treasury debt. I consider the current yields on 10-year U.S. government bonds to be absurdly low, just like the price of housing was absurdly high in early 2006. After this bubble bursts, investors will slap themselves on the forehead and say, ‘What were we thinking? Why did we rush into Treasurys even as the government told us it was planning to double the federal debt burden in a decade?’ ”

Asset allocation for November

The Faber timing model, by my calculations, has had no changes since August. U.S. Treasuries, as measured by the Ryan 10-year Treasury Index, came within 0.1% of a buy signal last Friday, but didn't quite make it. So we are still not in bonds. I know it's a bad idea to deviate from your system, but even if a buy signal had occurred this month, I would have stayed out. Looking 10 years ahead, there is no way a dollar will still be worth a dollar. Everyone buying long-term bonds today thinks they will be able to sell ahead of the crowd when the time comes. If the decline is gradual, they will be right. If not, not.

Mr. Faber in his paper uses bond data from Global Financial Data, but if that source is available free on the web, I haven't found it. The Ryan indexes are available both in the Wall Street Journal and on the Ryan web site (you will need to create a free login).

The last change in allocation was in August, after commodities (GSCI) and REITs (NAREIT [pdf]) crossed above their 10-month moving averages.

Here are November's allocations:

• U.S. stocks: 20%
• International stocks (EAFE): 20%
• Commodities: 20%
• REITs: 20%
• Cash: 20%

What we were reading one year ago

Morningstar Blogs, 10 August 2008*, reports Jeremy Siegel's views.

The call got off to a quick start, as Siegel opened with a bold prediction, effectively stating that we've seen the market bottom (particularly in financials). In his view, the market reached a "selling climax" on July 15--the day he thinks will be noted as the low point of this cycle. Referencing what many believed to be signs of a "bottom" in mid-March with the whole Bear Stearns debacle, Siegel made what seems to be a very dangerous claim (given the high-level of uncertainty in the markets): "this time around will be different."

... To support his views, Siegel also took a jab at market pessimists who claim that the stock market hardly looks cheap with a P/E on the S&P 500 index's trailing 12 month earnings in the range of 22 to 23 times. Siegel argued that the huge write-downs from financial firms (and General Motors GM, for that matter) have caused a "valuation gap" to open up, and that if you look at operating earnings, you'd see a much different picture--and a P/E closer to 17. He also referenced the past few market bottoms, noting that the trailing 12 month P/E ratios on the reported earnings for the S&P 500 at each of those market bottoms was significantly higher than what we're seeing today. Simply put, he doesn't believe the market is justified in assuming "trough level" earnings on a going forward basis.

Being wrong comes with the territory in this business. "Predictions can be very difficult—especially about the future." —Neils Bohr, although occasionally attributed to these guys.

John Hussman, 11 August 2008, likens himself to a "nervous bunny."

With bonds and utilities deteriorating, stock market internals are becoming unusually hostile. This sort of joint deterioration in interest sensitive securities has often provided important warning of steep subsequent losses, as we observed for example in 1966, 1987, and 1990. While the market is still sustaining something of a relief rally from the lows of a few weeks ago, I've noted that hostile yield trends have a tendency to cut such advances short, even when bearish sentiment and oversold conditions would otherwise invite more sustained bear market rallies.

Paul Tudor Jones, in Alpha magazine, via Harry Newton.

I see the younger generation hampered by the need to understand and rationalize why something should go up or down. Usually, by the time that becomes self-evident, the move is already over. When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart. Why work when Mr. Market can do it for you? These days, there are many more deep intellectuals in the business, and that, coupled with the explosion of information on the Internet, creates the illusion that there is an explanation for everything and that the primary task is simply to find that explanation. As a result, technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust the price action. The pain of gain is just too overwhelming for all of us to bear!

Today there are young men and women graduating from college who have a tremendous work ethic, but they get lost trying to understand the logic behind a whole variety of market moves. While I’m a staunch advocate of higher education, there is no training — classroom or otherwise — that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market. There’s typically no logic to it; irrationality reigns supreme, and no class can teach what to do during that brief, volatile reign. The only way to learn how to trade during that last, exquisite third of a move is to do it, or, more precisely, live it — a sort of baptism by fire. One has to experience both the elation and fear as markets move five and six standard deviations from conventional definitions of value.

"Irrationality reigns supreme." He wasn't talking about 2009, but he could have been.

*Footnote: That's when I read it, despite the archive now showing a date of 18 August. There's a story in there somewhere.

Mr. Market liked beaten-down stocks in July

This chart divides the universe of the 3000 largest cap U.S. stocks (minus a few that haven't been around for two years) into deciles by their two year total return from July 2007 through June 2009. Stocks that did poorly are to the left, stocks that did well are to the right. The stocks that did best during July are those that did worst during the prior two years.

The relationship is so smooth it's almost hard to believe. But then, if we drill down to the individual stocks, as the scatterplot below shows, the underlying reality is somewhat less orderly.

What stocks are those way to the left that lost 99% of their value over the last two years but still have enough market cap to be in the top 3000? Fannie Mae (FNM), Freddie Mac (FRE) and Ambac Financial Group (ABK).

Asset allocation for August

The Faber timing model has turned bullish on two more asset classes. In July commodities, as measured by the GSCI crossed above their 10-month moving average. So did REITS, as measured by the NAREIT US Total Return index.

Here are August's allocations:

• U.S. stocks: 20%
• International stocks (EAFE): 20%
• Commodities: 20%
• REITs: 20%
• Cash: 20%

Of the five asset classes, only Treasuries are still below their 10-month moving average. I am using the 10 Year Treasury Ryan Index for this asset class.

I should note here a source of cognitive dissonance for me. My two favorite analysts are now on opposite sides of the fence. Here is John Hussman in today's market comment:

Momentum-based, trend-following, simplistic thinkers with a speculative bent generally do very well during bubble periods (though not over the full cycle). Such analysts appear to have no reservation about jumping in here, because they assume that there will be no consequences to the overhang of deteriorating mortgage and commercial debt, even when coupled with “trigger events” such as rising unemployment (not to mention a median duration of unemployment that is far in excess of that of previous recessions).

In defense of John Hussman's market timing

I was surprised last week to read the claim in the CXO Advisory blog that the Hussman Strategic Growth Fund (HSGFX) has not been successful at market timing via hedging adjustments, a claim backed up by some statistical legerdemain. As one who has been following Hussman’s weekly market comment for years and watching his fund performance, I found this result counterintuitive. In fact, it is incorrect.

Generally the CXO Advisory blog does great work. Their digests of the latest finance papers from SSRN are especially valuable. But in this particular case they got it wrong.

Exhibit A. Fortunately, Hussman actually publishes what his fund return would be if no hedging strategy were employed. For the period 21 Nov 2000 (inception) to 30 June 2009:

	$10000 becomes	Annualized return %
HSGFX	21346	9.21
Without hedging	15137	4.93

Subtracting the reported return without hedging (4.93%) from the total return (9.21%) gives an annualized return due to hedging of 4.07%. (Arithmetic on annualized returns is done geometrically. In this case, 1.0921/1.0493 = 1.0407)

Comparing HSGFX with an S&P 500 index fund, Vanguard Index Trust 500 (VFINX):

	$10000 becomes	Annualized return %
VFINX	7939	-2.65
HSGFX outperformance		12.18
Due to hedging		4.07
Due to stock selection		7.79

HSGFX (9.21%) outperformed VFINX (-2.65%) by an annualized 12.18%. Of this outperformance, as we saw above, 4.07% was due to hedging. This leaves the remaining outperformance of 7.79% presumably due to superior stock selection.

Exhibit B. Let’s look at the data another way. I calculated a 20-day rolling beta for HSGFX, using VFINX total return as a proxy for the market. It looks like this:



Hussman turned bullish early in 2003, then gradually scaled back as the market moved higher, reaching maximum bearishness in mid-2007. What’s not to like about that? In 2008 he did turn bullish too early, just before the October crash, which cost him dearly (though his fund holders still came out well ahead of anyone fully invested in stocks).

Now associate each of the betas calculated above with the market return that occurred during the corresponding 20-day period, sort the data by market return, then divide the data into deciles. Down market periods to the left, up market periods to the right. Within each decile, what was the average beta exhibited by HSGFX?



Very clearly Hussman, on balance, was positioned with lower beta during down periods and higher beta during up periods—exactly as he intended.

Why did CXO come up with a different answer? Primarily because CXO put too much faith in statistical regression. The least squares regression formula minimizes squared error, whereas the market rewards or penalizes you in proportion to actual (unsquared) error. In least squares regression, outlying points end up getting disproportionately large weighting. Dropping only two of the oddball data points from CXO’s regression (crash week, 10 Oct 2008, and week horribilis, 8 May 2009, when HSGFX was down 5% while the market was up 6%) gives very different results. Rather than leave out those two data points, however, I leave them in but redo the regressions using a nonstandard method: minimizing the sum of the absolute errors. This method of regression gives the result we would expect if the hedging were successful: a steeper slope (beta) during up weeks than during down weeks. The new regressions are shown by the black lines in the chart below; the original regression is shown in red and green (click on the image for a larger version).



Conclusion: Hussman’s performance has been stellar, with estimated outperformance of 4.07% due to market timing and of 7.79% due to stock selection. Either of the two is beyond most fund managers. For one manager to combine both is truly unusual. I would be surprised to find any mutual fund farther above the security market line over the past 8 1/2 years than Hussman Strategic Growth.

Happily for us, Hussman is very open about his methods. He publishes his current stance on the market every Monday morning in his weekly market comment.

Mr. Market rewarded low quality stocks in June

This chart divides the universe of the 3000 largest cap U.S. stocks into deciles by free cash yield. High free cash (normally considered good) to the right, low free cash (normally considered bad) to the left. During June, the low free cash stocks did much better than the high free cash stocks.

Asset allocation for July

I've been following Mebane Faber's timing model for awhile now. It's simple, and if you were following it, it kept you out of the market during the crash. Here are July's allocations:

• U.S. stocks: 20% [S&P 500 Total Return index has crossed above its 10-month moving average]
• International stocks (EAFE): 20%
• Cash: 60%

The model is still out of Treasuries, commodities and REITS. I'm using the GSCI for commodities and the NAREIT US Total Return index for REITs.

Talking my book

This list of stocks was generated using an algorithm based on that described in Haugen and Baker's paper "Case Closed." In an attempt to simplify the computations, I used only 8 factors rather than the 56 they used. Time will tell if I regret the simplification.

I'm talking my book here: I have a small position (really small!) in all of these stocks in a FolioInvesting folio.

Use at your own risk. The stock market is not a safe place to be right now, for the reasons John Hussman explains in his weekly market comment.

ABMD	ABIOMED INC.	ITMN	INTERMUNE INC.
AEIS	ADVANCED ENERGY INDUSTRIES INC.	JRCC	JAMES RIVER COAL CO.
ANN	ANN TAYLOR STORES CORP.	MBI	MBIA INC.
APL	ATLAS PIPELINE PARTNERS L.P.	MFW	M&F WORLDWIDE CORP.
ARNA	ARENA PHARMACEUTICALS INC	MMR	MCMORAN EXPLORATION CO.
BPZ	BPZ RESOURCES INC	MNTA	MOMENTA PHARMACEUTICALS INC.
BRKS	BROOKS AUTOMATION INC.	OEH	ORIENT EXPRESS HOTELS LTD.
CBL	CBL & ASSOCIATES PROPERTIES INC.	PAET	PAETEC HOLDING CORP.
CPHD	CEPHEID	PCX	PATRIOT COAL CORP.
CPX	COMPLETE PRODUCTION SERVICES INC.	RBCN	RUBICON TECHNOLOGY INC.
CRZO	CARRIZO OIL & GAS INC.	RIGL	RIGEL PHARMACEUTICALS INC.
CUZ	COUSINS PROPERTIES	ROSE	ROSETTA RESOURCES INC.
DAKT	DAKTRONICS INC.	SD	SANDRIDGE ENERGY INC.
ERES	ERESEARCH TECHNOLOGY INC	SFY	SWIFT ENERGY CO. (HOLDING CO.)
ESLR	EVERGREEN SOLAR INC.	SVNT	SAVIENT PHARMACEUTICALS INC.
GCI	GANNETT CO.	TESO	TESCO CORP.
GLG	GLG PARTNERS INC.	THQI	THQ INC.
GTXI	GTX INC.	TISI	TEAM INC.
HERO	HERCULES OFFSHORE INC.	TNC	TENNANT CO.
HPY	HEARTLAND PAYMENT SYSTEMS INC.	UIS	UNISYS CORP.
HRC	HILL-ROM HOLDINGS INC.	URI	UNITED RENTALS INC.
ICO	INTERNATIONAL COAL GROUP INC.	VCI	VALASSIS COMMUNICATIONS INC.
IDTI	INTEGRATED DEVICE TECHNOLOGY INC.	VQ	VENOCO INC.
INCY	INCYTE CORP.	WG	WILLBROS GROUP INC.
ISPH	INSPIRE PHARMACEUTICALS INC	WTI	W&T OFFSHORE INC.

Sell in June and go away

The familiar Wall Street adage “sell in May and go away” might better be updated as “sell in June and go away.” Over the last 20 years, stock market performance in May has been quite good, but June and the following months much less so. Here is a chart of the seasonal performance of the S&P 500 over the last 20 years (blue line), along with longer periods, 50 years and 100 years, for comparison.

It is apparent that seasonal tendencies change over time. Note that the traditional summer rally, clearly visible in the 100-year seasonal, has been replaced by a summer slump in the 20-year. May, which used to be a weak month prior to 1985, has been a strong month since then.

Are past seasonal tendencies of any use in predicting future stock market returns? What if we base each year's trading decisions on the seasonal average of the previous 20 years?

I tested the following trading rule:

• Sell on the day when the seasonal average of the prior 20 years hits its highest point of the first six months of the year. In 2009 this would be June 5.


• Buy on the day when the seasonal average of the prior 20 years hits its lowest point of the last half of the year. In 2009 this would be October 9.

Using this rule over the years 1970-2008, during the period when we were in the market, generally some time in the fall through some time in the spring, the S&P 500 advanced at an annual rate of 7.97%. During the period when we were out of the market, during the summer slump, the S&P 500 advanced at an annual rate of 2.02%. A noticeable difference, for sure, but not one that makes you want to sell for this reason alone.

In 2008, using this rule, we would have sold out on June 5 (not bad—very close to the high for the year) but bought back in on September 24—just in time for the crash of '08 and a 24% drop to the end of the year.

The bottom line is that the market will be facing a moderate seasonal headwind for the next five months, but other factors, as they usually do, will outweigh the seasonal effect.

More on "sell in May" at Investment Postcards and Bespoke.