Back to an inflation bet

I recently pointed out that real-time indicators are showing that the economy is rebounding. As the markets have rallied from the reflation trade, my inflation-deflation timer model moved from a "neutral" reading to an "inflation" reading last week, which would move the model portfolio from equities to a basket of commodities (see report here).


Ken Heebner buying inflation too
The model appears to be in good company as I see that Ken Heebner has also put on an inflation bet in his portfolio. Heebner is a portfolio manager with a terrific long term record (though he has struggled in the last couple of years). He has a "swing for the fences" style and tends to make big top-down bets.

I reverse engineered his macro bets and my analysis shows that Heebner has positioned his CGM Focus Fund portfolio for a commodity inflation environment. He is at an overweight position in Materials:



...and Energy:



By contrast, he is underweight in Utilities:



...and has an implicit short position in the US long bond:


Long commodities, short bonds and interest sensitives - that sounds like a commodity inflation bet to me.

Heebner zigs but the market zags

Ken Heebner’s CGM Focus Fund has had a superb long term record, but this year Heebner has been struggling. The fund is -13.7% to April 6 YTD, which is 6.9% behind the S&P 500.


Bullish too early?
When I reverse engineer Heebner’s macro exposures, it seems that he got bullish too early and is now in the process of reversing course. As an example, the chart below shows his beta exposure to the S&P 500. He raised his market exposure early and as the market tanked he pulled back, just in time for the bear market rally.

Drilling down to his sector exposures, we can see that he got long the financials a little early and is now selling:

We are also seeing a similar story on cyclical exposure:

Ken Heebner has a bottom-up driven investment process but takes big macro bets as a result of his bottom-up analysis. This style can work well when the economy is showing a trend, but I believe that Heebner tried to call the turning point a little early and got hurt.

The CTA curse?
I wrote before that trend following CTAs are also struggling as the macro backdrop is trying to find its footing as the economy stabilizes. However, stabilization is not equal an upturn and a bull market revival is not yet in sight. In a nutshell, that may be Heebner’s problem.

In a future post, I will highlight a venerable old fund that is showing signs of revival.

More on the CGM Focus record

Following my last post Heebner gets really bullish, I saw that Tim Knight at Slope of Hope questioned Heebner's recent (unfortunate) returns. For the skeptical, you can find the track record for CGM Focus at Morningstar here.

Despite Heebner's high turnover and swing for the fences style, no mutual fund portfolio manager can be day and swing traders like the audience at Slope of Hope. Heebner's batting average is pretty good and his judgement should be respected. He is just one of many respected managers with good track records who have found value in this market.

Heebner gets really bullish

I thought that it’s time to revisit Ken Heebner’s macro exposures after the recent WSJ article about Heebner making a big bet on Financials. I had written about Ken Heebner’s CGM Focus Fund before. CGM Focus has an excellent long term track record and its portfolio manager Heebner manages it as a high turnover fund to make large sector and macro bets.

My analysis shows that Ken Heebner is making more than just a bet on Financials, he is betting on a cyclical market recovery.


Financials an early-cycle sector
As the chart below shows, my reverse engineering of the CGM Focus Fund’s estimated exposures confirms the WSJ article about the extent of Ken Heebner’s overweight position in Financials:


Interest sensitive stocks such as Financials are early cycle movers. This exposure seems to be part of his overall theme of betting on a market recovery. The chart below shows the CGM Focus position in market beta, which shows the fund moving from a defensive position to an aggressive position:


I also estimated the fund’s exposure to the Morgan Stanley Cyclical Index and it shows a big bet on a cyclical recovery:



CGM Focus Fund has neutral to slight overweight positions in Technology, Energy and Materials. The fund's underweight positions are mainly in the defensive sectors such as Health Care...



…and Consumer Staples.


Ken Heebner, who went on record as having turned bullish in October, is showing now that he has turned really bullish.

Heebner pukes his positions

For the uninitiated, the term to puke indicates to flatten a position, usually the result of a stop loss.

I have written about Ken Heebner before – that he is a manager who runs a high turnover, high concentration portfolio with a good long-term track record. Heebner had a hot hand for the first half of 2008 in managing the CGM Focus Fund (CGMFX). The defining characteristic of the fund for 2008 had been its long commodity-short financials exposure – until now.

Using the techniques shown in the sidebar titled Reverse engineering a manager's macro exposures, I updated my estimates of Heebner’s sector bets.

Surprise! Surprise!

Heebner is selling his off-the-charts overweight in commodity sectors (Energy, Materials):


He is also neutralizing his off-the-charts underweight position in financials:


Is this part of the risk control process?
Maybe he is demonstrating that he has a risk control process, particularly with the news that Heebner is starting a hedge fund. The chart below shows the performance of CGM Focus and the S&P 500 on a YTD basis. After an incredible first half 2008, CGM Focus gave up about 29% from June 2008 for a return that is roughly in line with the S&P 500.



Or maybe it’s not just hitting a stop loss, more on that in a future post…

Postscript: As an aside, my “smart fund” sample remains overweight the commodity sectors and underweight financials (see this and this).

More constructive on crude oil

In retrospect it was easy to call the top in oil. When cartoons like this appeared it was clear that high oil prices had penetrated the public consciousness – a contrarian sell signal.

Now that the oil price has descended about $30 from its peak and other commodities have also been hammered, it’s time to become more constructive on crude. While downside risks remain (e.g. cyclical US slowdown affecting commodity prices, China slowing, US$ in rally mode, etc.), I would like to review the bull case for oil prices and detail the reasons why I remain a long-term oil bull.


Peak Oil
I could go on and on about Peak Oil but I refer you to the site Oil Drum and Matt Simmons’ speeches for more detail. It isn’t about the world running out of oil but more about world oil consumption running into extraction limits. Robert Hirsch wrote an important report for the US Department of Energy back in 2005 discussing these concepts and how to mitigate their effects.

Peak Oil Concepts

Peak Oil mitigation: 9 women can’t have a baby in 1 month
Hirsch’s conclusion was that the US needs to invest in alternative technologies now, because mitigation technologies take time. Put it another way: nine women can’t have a baby in one month – no matter how hard they tried.

If we are indeed facing Peak Oil in the immediate future then the secular trend for energy prices is up and will continue to rise until a combination of alternative energy and conservation measures kick in. This bull would have a long way to go.


Global cooling?
What I am writing here may be sacrilege to some people. The popular consensus about Global Warming is that the Earth is undergoing a warming period caused by the effects of industrialization. However, there is another view that global warming is caused by solar activity – sunspots and solar winds.

Currently, the forecast for the latest solar cycle is that it’s late. Such extended cycles have been associated with cooling periods such as the Little Ice Age experienced a few hundred years ago. Indeed, there have been reports that there is more ice in the Arctic (yes – it’s only one data point) and there has been some hand wringing among the scientists about the timing of the solar cycle.

Is this theory about solar activity correct? I have no idea. I do have allow for the possibility that it is a valid one and should the Earth enter a cooling period, this would be bullish for energy demand and result in higher energy prices.

Heebner still bullish on Energy
In s post back in early June comparing Bill Miller and Ken Heebner, I noted that Ken Heebner had a hot hand largely because of his overweight position in resources and underweight position in Financials. Moreover, Heebner does not hesitate to turn over his portfolio if he thinks that it is positioned improperly.

The chart below shows the Heebner’s latest imputed position in the Energy sector. Despite the recent rally in Financials and the air pocket hit by Energy, Heebner may have trimmed back some of his Energy overweight and is now adding back to his position.



You have to respect Heebner's views given his record.


Investor sentiment is bearish
Finally, in the short term, investor sentiment on crude has retreated to levels that warrants taking a less bearish stance. While oil prices may not rocket up from these levels, these readings do suggest a period of stabilization or consolidation in price.

A nervous bull on oil
Given that oil prices have retreated about $30 from their peak, I believe that the near-term upside and downside price risks are far more balanced and would be inclined to be more constructive on the oil price. Does that mean that it can’t go down any more? Of course not, there remain substantial risks to buying here. However, if you are playing the odds then the probabilities are now tilting more in favor of the bulls.

Addendum: The chart estimating the CGM Focus position in Energy has been corrected as the previous x-axis was incorrect. Apologies for any inconvenience.

Bill Miller & Ken Heebner: A study in contrasts

Both Bill Miller’s Legg Mason Value Trust (LMVTX) and Ken Heebner’s CGM Focus Fund (CGMFX) have great long-term track record that would be the envy of most equity fund managers. While Miller has underperformed recently, he is still sticking to his guns in his latest commentary and he continues to focus on long-term value and a low-turnover philosophy. By contrast, Heebner has the hot hand right now (see Fortune article here) and runs a high-turnover portfolio.

Using the techniques shown in the sidebar titled Reverse engineering a manager's macro exposures, I estimated both Miller and Heebner’s sector and other exposures.


Miller is Value and Heebner Growth
I pointed out before that Bill Miller started to tilt towards Value in a significant way back in December 2007 and his bias is unchanged. As shown by the chart below, Bill Miller’s portfolio remains tilted towards Value, while Heebner is tilted towards Growth.

Miller buying Financials and Heebner owns Resources
Much of their style differences are attributable to sector weightings as the Russell 1000 Value Index is significantly overweight Financials compared to the Russell 1000 Growth. Bill Miller main overweight is in the beaten down financial sector of the market, while Heebner is underweight the sector.

Heebner, on the other hand, is still devoted to the resources sector with overweight positions in Energy…

…and Materials:

Both hold high beta portfolios
When considering these two managers one might be tempted to conclude that they are polar opposites of each other, they do agree on some points. Both managers’ portfolios have above average market betas, indicating that they expect the market to rise. Moreover, they are both underweight the traditional defensive sectors of the market such as Health Care and Consumer Staples.

Investment thesis and risks
Not to put words into each manager’s mouth, it seems that Bill Miller believes that despite the financial stresses evident in the system, the large financial franchises remain intact and have real lasting value. Miller’s investment thesis depends on no other hidden landmines blowing up in the financial sector.

By contrast, Ken Heebner believes that the commodity cycle is not over and is betting big on their continued rise. His thesis depends on continued US Dollar weakness and, to a lesser extent, that a US slowdown will not significantly drag down world growth. So far, he has been right, as evidenced by the new recovery high seen in the Baltic Dry Index. However, Heebner’s portfolio is a high-turnover portfolio and Heebner has shown himself to be flexible to reverse himself should the situation change.

The views of both of these investors deserve our respect.