Trading Range Economy & Markets

We continue to believe that the economy and the markets are now entering a frustrating trading range condition. Frustrating anyway for investors looking for sustainable momentum - contrarian trading around the edges should be profitable. From an economic standpoint the following comment by UBS is typical for this environment: "somewhat mixed data, with greater than expected strength in real GDP growth (3.5%) but weaker than expected labor costs in Q4 (ECI up 0.8%) . . . excluding motor vehicles production, real GDP was up at a 4.8% annual rate in Q4 after 1.2% in Q3. However, we doubt the faster pace in the fourth quarter is likely to be sustained . . . other data continue to suggest that more slowing is underway than is evident in the Q4 GDP report."

The same trading range will likely be in place in the bond and equity markets. In a post several days ago we mentioned our belief that interest rates had then risen sufficiently to create a favorable environment for lengthening bond duration. Today, the iShares Lehman Treasury 20+ Year ETF rose nearly one percent. Stocks will also likely trend sideways to slightly higher from here within a broad trading range.

10 Steps to Retirement

The Motley Fool lists "10 Steps to Ruling Your Retirement". They are:

1. Get your assets in gear
2. Practice smart "asset location"
3. Run your numbers (figure out how much you need to retire)
4. Make your portfolio last
5. Crack your nest egg (how and when to make withdrawals)
6. Make the most of Social Security
7. Prepare your estate
8. Extend the life of your IRA
9. Cash in your house
10. Decide what you want to do in the future.

Most of these points assume you have assets to begin with and that you have built up value in homes and social security. The Retirement Confidence Survey challenges some of these assumptions with its finding that only 19% of people over age 55 have accumulated more than $250,000 in retirement savings (total savings and investments, not including the value of the primary residence). And only 23% of this same age group have $100,000-$249,999. Even if an investor has just enough to get into this top category, they will find it difficult to withdraw more than $1,000 per month and not risk reducing the principal (a nearly 5% annual withdrawal rate). Additionally, we have seen many view their homes as their retirement. But people have to live somewhere - for a home to be a retirement source would require selling and moving to a cheaper location. Others short circuit Social Security by drawing on it sooner than is prudent, resulting in lower lifetime benefits. There will be increasing opportunities for retirees to work part-time in the early retirement years and thereby delay drawing on Social Security.

Point 2 regarding asset location: Most investment professionals will recommend covering the universe with assets: some large cap growth, some large cap value, small cap, international, some bonds, etc. Several problems with this: first, environments of market stress have tended to impact all markets together. In statistical terms, this means all investments merge toward a correlation coefficient of one in difficult times - US Government notes have been one of the few investments that have been a recipient of investment flows during these difficult periods. This means that to disaster-proof a portfolio would require a slug of 5-10 year treasuries, that unfortunately provide little extra return during the good times. The biggest problem actually isn't that investments converge in difficult times, it is that investors blow out of long-term financial plans. We've all read about how stocks do so well over a 20 or 30 year period, but how many investors couldn't stand the pain in 2001-2002 and blew out of stocks, only to miss the ensuing rebound? There isn't much value in a long-term financial plan if there is a pattern of selling at the bottom and gradually returning to the market at much higher prices. We mentioned in an earlier post that if an investor had a goal of 15% per year for three years, that a year-one drop of 15% would require a return of nearly 34% in each of the following two years to realize the average compounded return of 15%. The long-term average returns are dependent on being invested in the big up years. But many typical investors not only sell at the bottom but fail to capture the upside.

Our solution: investors should focus on where the values are at any time in the market. Even at the top of the market in 2000 there were many insurance stocks, home building companies, defense contractors and other stocks selling at single digit P/E ratios which subsequently rose 3-10 times in value over the next few years! We recommend that investors regularly review different segments of the market for value opportunities: Equities (large-cap, small-cap, value, growth, international, domestic, emerging markets, sectors, REITs, etc.), Bonds (long-term, short-term, TIPs, international, emerging markets, high-yield, municipal), Commodities (oil, industrial metals, agricultural, gold, commodity indexes) and currencies (strong or weak dollar). In addition to a wide variety of mutual funds, there are exchange-traded funds and closed-end funds covering all these sectors. An investor no longer needs to worry about individual securities with the proliferation of these vehicles. In fact, we would argue that for most part-time investors, owning and picking individual securities is a distraction that decreases returns. If your portfolio is always positioned in the value areas of the market, your need to worry decreases dramatically. Of course, cultivating a bit of a contrarian way of looking at markets is required. Instead of asking, "whats going up?", ask "where are the values and can I identify a catalyst that might resolve the values in my favor?"

We're skipping around, but MF's step 4 is to make your portfolio last. Two big points here: withdrawal rates and longevity insurance. Don't get caught up in the debate about whether you can withdraw 3%, 4%, 5% or 6% without risking your retirement. We find it best to determine your beginning level of investable assets, and add an inflation factor to determine your baseline portfolio. You can withdraw some percentage of the current value of the portfolio up to the amount that exceeds the baseline. If you started the year with $1,000,000 and inflation was 2%, the ending baseline is $1,020,000. If your actual portfolio grew to $1,150,000 you can withdraw some percentage of $130,000. We would suggest that you withdraw somewhere between 4% of the baseline or the current account value (whichever is less) and 50% of the amount the portfolio is above the baseline; in this case, withdraw somewhere between $40,800 and $65,000. Where does the remainder go? It provides a cushion in the event the following year is a negative return year: the 4% minimum withdrawal will mostly be from year one's gains. Plus you have compounding working for you in year two which may push the current value even higher above the baseline. Why do we like this plan? it provides "bonuses" in retirement in the good years. What do we do when we're working 9 to 5? We put off swapping out the cars and remodeling the kitchen until we receive some windfalls in the form of bonuses or overtime. Why not do the same in retirement?

Second point: longevity insurance. People joke about spending their assets down to zero, then dying. Why not do it since there is a great way to accomplish this without risking getting to zero before getting to the end of your life? If investors purchase longevity insurance - insurance that pays out in the event the insured lives past a certain age - cash flow is assured. Purchasing a $10,000 policy at age 60 can provide as much as $700-$1,000 per month for life, once age 80 is reached. Putting $50,000 to $100,000 in such a policy can provide considerable piece of mind that the cash flow will be available later. The second great benefit is that one can spend much more up to age 80. If you know you are going to have several insurance policies kick in at age 80 it makes it much easier to spend down to zero through age 79 (although we wouldn't advise it). We suggest using several insurance companies to spread the company risk. Retirement can be fun (with such things as paying yourself bonuses) and worry free (longevity insurance). Why stress?

The WRA Strategies & Observations blog is written by officers of Wind River Advisors LLC, an SEC Registered Investment Advisor. See our web site for more information on strategies and account management: Wind River Advisors.

Raining Cash

If you haven't seen this "commentary" on global liquidity yet, it would be worth your time: Sam Zell. Cash continues to spur increases in many markets. However, today's WSJ mentions in column one of the Money & Investment section that perhaps "Investors might not be pushing up prices for assets like art or high-yield bonds because they have so much cash. They might be seeking out more and more cash so they can push up prices while the going is good. Once they lose faith in an asset class they'll turn tail and all of that so-called liquidity will turn with them. That's what happened in the copper market . . . [with] the price of copper [falling] 39% since May."

"By the same token, all that cash doesn't seem to be pushing up prices for Florida condos or oil anymore. 'Liquidity is an ex-post justification for why markets are going up,' says Dresdner Kleinwort's strategist Albert Edwards. 'There's lots of liquidity around -- well, there always is until there isn't, and then it just disappears.'"

Bond Strategy

Over the past two years bonds have provided good opportunities to adjust average maturity and pick up some incremental return. Note the fairly consistent moves in 10-year interest rates in the 2-year chart at the right (the yield is currently 4.77%). It has required some willingness to lean into the wind to see the real benefits of portfolio adjustments. We envision a continued trading range on bonds that will reward contrarian investment commitments.

In the second chart, you can see our Dynamic Duration Select Strategy is up 10% since the end of the second quarter of 2006 (6 2/3 months). Early outperformance was driven by aggressively positioning the portfolio to the decline in interest rates during the second half of 2006. This involved using long US treasury exchange-traded funds. In November and early December, performance was about even with the index due to a tempering of the interest rate bet. Finally, over the last month, performance diverged to the upside relative to the index as the strategy had a slight inverse exposure to interest rates. In the past several days we removed the inverse exposure and returned to a neutral interest rate posture.

Our Dynamic Fx Plus Strategy has a little different objective: to outperform the Lehman Aggregate Bond Index using a core position in US treasury ETFs and adding value through selective investments in strong or weak dollar investments. Interestingly, this strategy was up nearly the same amount as Dynamic Duration Select but with different investments. Recent outperformance is due almost entirely to a long US dollar position over the past several months. We reversed this last week and now have a moderate short dollar position. We continue to believe that, short of terrorist acts or some such thing, the dollar will remain in a fairly tight trading range. Investing around the edges has proven to be a value-added tactic.

Emerging Market Equity

After rallying for 3 1/2 months with barely a correction along the way, emerging market equities have corrected since January 3rd. Even with the rally of the last couple of days, most emerging markets are well off their highs.

We've noted in the past that many emerging markets have a high correlation to commodity prices, which have tumbled over the past several months. But why the delayed reaction by emerging markets? According to Justin Lahart in today's WSJ, "one possibility is that the emerging-market selloff was simply a delayed reaction to what happened in December. The rally in emerging-markets stocks - the emerging-markets index rose 29.2% last year - may have prompted some investors to delay selling until this year in order to avoid a big tax hit. At the same time, some fund managers may have been pouring money into emerging-market stocks in the last part of the year in a bid to improve their 2006 performance. Once the New Year started, that bid went away."

Sounds reasonable to us. Justin's follow-on reason is that as a result of December's strong jobs reports, investors are now projecting a rise in interest rates rather than a fall, and as such, emerging market selling reflected a "worry that monetary policy . . . was getting overly tight." This reason is too large of a reach. Money supply has actually trended strongly up recently - not down, even though fed funds rates remain unchanged.

While it is true emerging-markets are not as commodity sensitive as they once were (partially because of their large trade surplus' built up over the last decade), commodity price correlation remains strong. We believe any meaningful decline in emerging markets should be bought. Consider that the USA uses 25.0 barrels/year of oil per capita. Japan is at 15.0 and Mexico at 7.0. Yet Latin America uses 4.5 and China 1.7 barrels (source: The Economist). Per capita usage of Copper in lbs./annum is 4.7 in China versus 15.8 in the USA; Aluminum is 4.0 for China versus 21.0 in the USA; and Autos per 1000 people are 6.0 in China versus 475 in the USA. This lull in the economy has produced a narrow surplus in oil production versus demand. Yet per capita commodity consumption demonstrates that developing market demand is still at an early industrialization stage. If some economists are right that we've turned the corner on the housing slump, contributing to improved world GDP in 2007, it is unlikely that commodities will experience much of a decline from these levels. This bodes well for commodities and emerging markets.

Contrarian Commodity Note

A recent post by BCA Research mentions the structural demand support for oil: "Crude oil prices have fallen roughly 10% in the past month, reflecting plentiful crude inventories and warmer-than-usual weather in the northern hemisphere. We doubt there is sustainable downside from here. From a cyclical standpoint, the slowdown in the global economy should prove shallow and short-lived, so any demand softness will be limited. Longer-term, the emerging world’s thirst for oil will only increase. On the supply side, OPEC is trying to establish US$60 as a floor, and the lack of spare capacity among cartel members other than Saudi Arabia suggests it will ultimately succeed. Finally, while geopolitical strains are well known, they will keep oil price risks to the upside. Bottom line: we think the correction in oil prices is well advanced and look for prices to trend higher."

Seasonally, oil investments typically do well from February through late Spring as expectations begin to build for the summer driving and air conditioning demand. We view the current lull in pricing as a solid contrarian entry point.

Strategy Update: our Dynamic Commodity Strategy has dramatically outperformed the Rydex Commodity Fund over the past year at much lower volatility (see chart). Part of the reason for this is our flexibility to adjust absolute commodity exposure. We are now fully invested in commodity ETFs in this strategy. With equity markets at highs, interest rates range bound and specialty areas such as REITs overbought, we view commodities as an emerging attractive investment for the next several quarters.

2006 Performance Recap

We closed out 2006 with solid performance across most Strategies. See the attached for a complete recap (click to enlarge). A few highlights:

The following equity strategies outperformed the 13.6% return for the S&P 500 Index for 2006: Select REIT (+32.5%), Focused International Equity (+27.9%), Focused Analyst Growth (+24.3%), Focused Analyst Upgrade (+19.1%), Equity Opportunity (+17.3%), and Select Equity (+14.0%).

The following fixed income based strategies outperformed the 3.9% return of the Lehman Aggregate Bond Index for 2006: Dynamic High Yield (+19.9%), Dynamic Bond Plus (+16.5%), Dynamic Tax-Exempt Plus (+10.9%), Dynamic Fx Plus (+8.8%), Dynamic Duration Select (+5.7%), and Individual Muni Bond (+5.5%).

Additionally, the Dynamic Commodity Strategy was noteworthy with a +8.5% return, outperforming virtually all commodity mutual funds anywhere from 7 to 26 percentage points!

Asset Allocation Models also enjoyed a great year. Absolute Return Income had a return of +10.8%, well above it's benchmark of 8%. Absolute Return Growth has a target of 10% per year and came in slightly under at +9.4%. The Growth Model returned +12.9%, just under the S&P with considerably less volatility. Other models with double-digit returns were Moderate, Conservative and Conservative Tax-Advantaged. The Current Income models returned +8.0% and +6.8%, well above the Lehman Aggregate Index of 3.9%.

As always, note the performance disclosures that state that past returns are not necessarily indicative of future returns, etc.

For more information on becoming a client of our firm, see our website. Here's to a profitable 2007!