Smart funds surprisingly defensive

The "Idiot’s Market Neutral Fund" 2008 report card
I first wrote about construction of an idiot’s market neutral fund about a year ago here and I further addressed the controversy of why the technique may work here. For the year 2008, this hypothetical strategy was down -0.7%. These returns are roughly in line with the HFRX Equity Market Neutral Index return of -1.2%. (Recall that this strategy goes long 5 Morningstar top rated, low cost and no-load large cap growth funds and 5 top rated value funds, called the smart fund sample, while shorting the S&P 500 Spyder (SPY) against the long positions.)

2008 was a tumultuous year and these returns are not bad considering the market environment the strategy had to contend with. The strategy had a good first half as the mid-year update showed that returns to June 30 was 3.5%. Given that the average annual turnover of the long portfolio was about 50% per annum, it was virtually impossible for any manager, even with good foresight, to outperform the market both in the first half and the second half of 2008. He would have had to be long the inflation bet in the first half and then switch to a low-beta bet in the second half. Indeed, the consensus sample of 20 large cap blend funds from the top mutual fund complexes, which usually perform in line with the market, underperformed by about 5% in 2008.

This strategy has also shown remarkably low turnover. Of the 10 funds in the portfolio, the strategy kept all of the growth funds and turned over only 3 of the value funds. Two value funds were taken out for style drift and only one was taken out for performance reasons.


What are smart funds doing now?
I reverse engineered the macro exposures of the smart fund sample, as well as the exposures of the consensus funds, and looked for significant differences. Smart funds show a surprising level of defensiveness considering the number of well-known investors who have turned bullish in the last few months.

As the chart below shows, the estimate beta of the smart fund investors is significantly lower than the consensus:

Analyzing the exposure by sector, smart funds are underweight Financials:

...and Energy:

While smart funds are overweight traditionally defensive sectors such as Consumer Staples:



…and Health Care:

Surprising defensive readings
I find these readings surprising given the bullishness shown by investors like Ken Heebner (see his record here), John Neff, Warren Buffett, the ValueLine Survey, and many others too numerous to name. After all, the annual turnover of the smart fund sample is about 50% (as is the consensus fund sample) and these funds really don’t turn their portfolios around on a dime. So if these managers see value in the market, I would expect that they would start to be raising their beta exposures now.

Watch smart funds on their long bond position

Further to my last post which shows that smart funds are long the commodity trade (inflation) and long the US long bond trade (dis-inflation), a further word of explanation seems to be in order. I believe that the key macro view underpinning this position is:

• The secular trend is for more inflation and official inflation rate is understated
• The cyclical trend is for inflation to fall, setting up for a rally in the bond market

Official inflation rate understated
The Fed focuses on core inflation and that statistic has been consistently lower than the other measures of inflation. The chart below shows the progression of headline CPI, core CPI, or CPI ex-food and energy, and PPI.

As the chart shows, core CPI is consistently lower than the other measures of inflation. PPI, or one, is more sensitive to commodity prices, which has been rising. Moreover, PPI has none of the hedonic and other adjustments that the CPI has from the recomendations of the Boskin Commission. Others have also commented that even the headline CPI has problems and doesn’t reflect true changes in the cost of living.

Even if you were to focus on one of Greenspan’s favorite indicators of inflation, PCE, the Dallas Fed’s measure of trimmed mean PCE seems to be consistently higher than core PCE.


Inflationary pressures cyclically easing
Recently, there have been abundant signs that the economy is weakening. The latest Beige Book report indicates sluggish growth. Reconstituted M3 growth is falling off a cliff. Various Fed officials have been signaling that inflationary pressures are easing and therefore the pressure to hike interest rates are lessening. In response to these signals the bond market has responded and the spread between TIPS and the 10-year Treasury are in retreat.


What does an investor do?
Mutual funds tend to have longer term time horizons than the average swing trader. Smart funds have been saying: “We are not fooled by the official inflation rate and our long term view is for inflation to stay high. In the short term, however, the weak economy is going result in a bond market rally.”

One of the keys to spotting a bottom to the US equity market will be to watch for smart funds to switch their stance on the long bond.

Smart funds: Still early in the inflation trade

I have written about smart mutual funds and reversed engineered their macro exposures before. One of the benefits of such an exercise is to formulate a longer term macro scenario and examine it for internal consistency and to see if I am comfortable with the general thesis. In looking at smart funds today, their macro exposures can be summarized as follows:

• Still believers in the Inflation Trade;
• Still underweight Financials; and
• Long the US long bond!

Still overweight Energy vs. Consensus
The chart below shows the imputed exposure of smart mutual funds and consensus mutual funds in the Energy sector. As the chart shows, smart funds remain overweight Energy while consensus funds have cut back their exposure to roughly market weight:

Consistent with the hard asset and inflation theme, smart funds are also overweight Materials vs. the consensus (chart not shown).


Underweight Financials
Smart funds are still heavily underweight Financials compared to the consensus:

…but smart funds are long the US long bond
Surprisingly, the imputed duration of smart fund portfolios seem to be higher than the S&P 500 compared to the consensus:

Long inflation, Fed in a bind and behind the curve
On the surface, the macro position of smart funds lack internal consistency. Usually, if you are long the inflation (Energy and Materials) bet, you are short the bond market. The experience of the 1970s showed that if inflation wins, bondholders lose.

However, I believe that the portfolio managers of these funds believe that longer term, inflation is here and rising. Moreover, the Fed is behind the curve in its inflation fight. It is further handcuffed by the fragility of the financial system (hence the underweight position in Financials). In the short term, the combination of the cyclical effects of the economic slowdown and the Fed’s focus on core inflation, which appears relatively benign, will serve to put a lid on long rates (and therefore the long bond bet).

In other words, they are betting on inflation rising and believe that it’s very early in the trade. The long bond exposure implies that inflationary expectations remain contained and are not yet ready to rise.

Crude oil close to a bottom

In contrast to my last post on gold indicating that the correction in bullion has further to go, the sentiment picture for crude oil is far more constructive. I now have doubts as to whether my near term $100 oil call will come to pass.


Investor sentiment now very negative
Sentiment surveys on crude oil show that readings are now at bearish extremes, which is contrarian bullish. In addition, the CFTC Commitment of Traders data shows that large speculators, or hedge funds, have sold down their crude oil positions near levels where bottoms are seen. Indeed, COT Timer has flashed a buy signal for crude oil this week.




My estimate of mutual fund positioning is also encouraging for the energy sector. Consensus mutual funds have sold down their energy holdings to a market weight from an overweight position. By contrast, smart funds remain overweight the sector.




Long term bullish on oil
I have stated the case to be long-term bullish on oil before. In addition to those reasons, Barry Ritholtz at Big Picture found a great chart showing the growth path of world GDP and oil demand as another reason to be long-term bullish on crude.


Volatility a function of tight supply?
Commodities have always been volatile. Recently the oil price has been more volatile than usual with the market seeing regular $3-5 daily swings. Kurt Cobb postulated that queueing theory could explain oil's wild price swings. You could also argue that the current tight supply condition is acting like an inventory control model. The shifts in demand and the fact that incremental production can be brought on at much lower pricing, though with a lead time, suggest that the level of minimum inventory is highly variable. Include the fact that some of the investments are highly levered also adds to the volatility of minimum inventory level.


Buy oil/short gold?
Given these conditions on gold and oil traders could consider buying crude oil and shorting gold. Note that this is a tactical trading call and there are considerable risks involved. Most notably, the chart of the oil to gold ratio below shows that oil is already extended in favor of oil.

Gold correction has further to run

With gold below $800 and investor sentiment surveys in the bearish zone (contrarian bullish), one might think that we may be close to a turnaround on bullion.

Not so fast!


Average bear down 34% in 18 months
Bespoke Investment Group’s report on typical gold market behavior suggests that there is further downside. The average bear market in gold is down 34% over a period of 18 months and we are only down about 21% right now.


Watch what they do: The selling is not over yet
Sentiment surveys are interesting but they don’t tell the whole picture. While readings are low enough to spark a temporary oversold rally, investors haven’t sold enough of their positions to warrant a call for an intermediate term bottom.

The latest data from CFTC’s Commitment of Traders report show that large speculators (read: hedge funds) have begun to liquidate their gold long positions. However, they haven’t gone short yet and so readings aren’t sufficiently bearish to see a sustainable up move.

I reverse engineered the positions of the average mutual fund using the technique shown in the sidebar titled Reverse Engineering a Manager's Macro Exposure. Consensus mutual funds, which consist of 22 large cap blend funds managed by the largest mutual fund complexes, have also started to liquidate their overweight positions in the S&P 500 Materials Index. However, they remain overweight the sector and have further selling to go.

Some reasons to stay long-term bullish
Not all is lost for the gold bulls. The above analysis shows that the smart funds, by contrast, remain stubbornly overweight the Materials sector indicating that they haven’t given up on their commodity bet. Moreover, some of the smarter commentators such as the Aden sisters, who have adroitly navigated the gold bull and bear markets over the years, remain bullish on bullion.

A warning for Tech

The chart below shows that both smart and consensus mutual funds are both selling their Technology holdings. In the face of such selling pressure it will be difficult for the sector to make any headway in the medium term.

This concerted selling is occurring just as this Bloomberg story pointed out that Bank Stocks Cede Biggest S&P Weighting to Technology. Is the story the ultimate contrary indicator?

Still waiting for a market bottom

As the S&P 500 seems to have formed a double bottom in January and March, the question in many investors' minds must be "Have we seen the bottom?" My review of some of my market indicators indicate that it’s probably a little early to flash the all-clear signal for US equities.

In particular, the problem areas of the market, namely the investment banks, housing and employment, continue to struggle, suggesting that the worst may not be over for this bear market. Here are some of the indicators that I am watching:


Insiders are bullish
Mark Hulbert reports that insiders have been buying their own stock at levels that are comparable to other market bottoms. Insider signals tend to have a very long time horizon but their actions does have bullish implications.


Investment bank valuations - more downside?
Since much of the recent stresses that have shown up in the investment banks and brokers, I go back to my rule of thumb that I would like to see a price to book ratio of 1 for the investment banks. The P/B of 1x was a good signal of a market bottom in the 1974-5 and 1981-2 bear markets.

While Lehman (LEH) did reach a P/B of 1x for one day at the time of the Bear Stearns panic, other investment banks and brokers such as Morgan Stanley (MS), Merrill Lynch (MER) and Raymond James (RJF), which is an interesting bellwether as it has no significant prop trading operations, are trading at valuations of 1.5 to 1.8 times book. Goldman Sachs (GS) is trading at valuations that are even higher than that.

I could be wrong here but my guess is that there needs to be more pain in the brokerage stocks before the market bottoms.


Smart funds defensive while overall sentiment is bullish
A check in with my group of smart funds shows that their posture remains defensive. The accompanying chart shows the market beta of the “smart funds” compared to the “consensus funds”. Smart funds have a market beta, or implied market exposure, that is lower than the market while consensus funds are at or positive market exposure. Moreover, the recent Barron’s Big Money Poll shows 50% of their respondents to be bullish or very bullish, compared to 13% as bearish. This is a contrarian bearish reading.

Problem areas of the economy not stabilizing yet
This economic downturn was the result of overbuilt housing fueled by overly aggressive real estate lending. The chart below shows the S&P 500 Homebuilders relative to the S&P 500. The homebuilders remain in a relative downtrend and show no signs of stabilization, which is not a good sign for the health of the overall market.

Addendum: When you get stories like KB Home's Broad Says Home Prices May Drop Another 20%, it doesn't exactly inspire confidence that housing has bottomed.

Similarly, we have seen employment statistics starting to weaken, as is the case in any recession. Rather than looking at the payroll numbers, which are backward looking, I prefer to look at market discounting real-time statistics. My proxy is the price action of S&P Supercomposite Human Resources and Employment Services, consisting mainly of temp and employment agencies. The chart below of these stocks relative to the S&P 500 indicate that, like the Homebuilders, the Temp Agencies remain in a relative downtrend with no convincing signs of stabilization.

How far or how long before a bottom?
If my assessment is correct then the next question would be “how long or how far down before we see a bottom in the market?” William Hester at Hussman Funds, in his recent article Recessions and the Duration of Bad News, suggests that if this was an “average” recession we will likely see much more bad news in employment, housing, earnings, etc. If this was an “average” recession the chart he shows suggests that we are currently seeing a bear market rally but a more convincing market bottom is a few months off (see the last two charts in the article).

Is this an average recession? I have no idea. All I can do is keeping watching my indicators for signs of a market bottom.

Smart funds still underweight financials

A reader recently wrote and asked if the smart funds had reacted to the Fed’s rescue efforts of Bear Stearns et al. A check in with the analysis of Smart Funds show that they remain more underweight Financials than they ever have in the last four years, though they have somewhat moderated their underweight. By contrast, consensus mutual funds have moved to a slight overweight in the sector.

Another shoe to drop?
This posture is suggestive that the Smart funds believe that there are more trouble ahead for banks. Barry Ritholtz at Big Picture recently posted on a RBC Capital Markets research report on 5 reasons why bank stocks have not bottomed. I would also add my comment that in extreme market conditions the brokers tend to trade at about book value. Today, most are trading at 1.6 to 1.7 times book. JPM and C moved to a price/book of 1 in the recent turmoil, but they are financial conglomerates and not pure brokers.

In addition, John Mauldin at Thoughts from the Frontline wrote in his weekly newsletter that:

In an opinion letter posted on the SEC website last weekend clarifying how banks are supposed to mark their assets to market prices is this little gem (emphasis [his]):

"Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability."

…There are two problems with this rule. First, it clearly creates a lack of ransparency. The whole reason to require banks to mark their assets to market price rather than mark to model was to provide shareholders and other lenders transparency as to the real capital assets of a bank or company. Second, can a forced liquidation or distress sale be from a margin call? Obviousy [sic] the answer is yes. but as Barry Ritholtz points out, this opens the door for some rather blatant potential manipulation. If a bank makes a margin call to hedge funds or their clients to make the last price of a similar derivative on their own books look like a forced liquidation, do they then get to not have to value the paper at its market price? Is this not an incentive to make margin calls? One price for my customers and a different one for the shareholders? If a hedge fund was forced to sell assets and then they find out that the investment bank is valuing them differently on their books than the price at which they were forced to sell, there will be some very upset managers and investors. Cue the lawyers.

In other words, this is going to be a mess.