Getting it Right on Oil

oil pipeline

Earlier this year, we perceived significant risk inside the oil market: Large speculators had made extreme bullish bets in the futures market, and there was reduced demand from emerging markets. In response, we took half of our energy stock exposure and invested it in Master Limited Partnerships (MLPs). MLPs are natural resource activity companies, mostly involved in the distribution of oil or natural gas through pipelines. This side of the energy business is not directly tied to the price of oil, as oil needs to pass through pipes regardless of price. Additionally, oil supply in our country is skyrocketing and demand for the pipes is increasing. These two factors are major reasons why we were attracted to the investment, and why we remain constructive on the future of MLPs.

Our timing was good: Starting in mid-June, crude oil entered a four month period in which the price dropped from $108 per barrel to $79 dollars per barrel. Gasoline prices in the U.S. have also fallen about 18% from $3.70 to $3 per gallon, which equates to about $84 billion in freed spending power (assuming every $.10 drop in gasoline prices leads to $12 billion in freed spending power for consumers). This economic stimulus is welcomed by everyone… except energy investors, whose stocks fell over 20%.

Because of our shift to MLPs, the energy section of our portfolio experienced significant outperformance, as the MLP fund only fell 7% during the same period.

[Energy stocks comprise 9.8% of the S&P 500, which means that a Pinnacle DMG client is benchmarked to 4.3% U.S. energy stocks (44% of the DMG benchmark is the S&P 500).]

Will Europe’s Recovery Continue?

European Recovery Threatened

Renewed signs of economic weakness in Europe have spooked investors and led to a significant correction in European stocks. In particular, there has been a spate of disappointing economic releases from Germany with industrial production, exports, and business confidence all coming in below expectations. This is concerning because Germany has been the backbone of the overall recovery with better growth relative to other European countries.

10-Year Bonds YieldsThere are still some bright spots, however: Bond yields across the Eurozone are low and falling, which is a much different backdrop compared to 2010 – 12 when yields in some countries were soaring due to fears of widespread defaults. Low interest rates should be helpful for consumers and business. In addition, the value of the euro has declined by nearly 10% relative to the dollar since June, which should make their export sector more competitive. Finally, and perhaps most importantly, monetary policy is becoming increasingly supportive with the European Central Bank announcing a series of new measures designed to give a boost to the recovery (including an asset purchase program that just commenced this week), with assurances that they’re prepared to do more if necessary.

Overall, while risks to the outlook have risen, we still believe that the evidence on balance suggests that the recovery should continue, although third quarter growth may have stagnated. Faster economic growth would certainly be welcome, but as was the case here in the U.S. for the past several years, slow growth combined with increasing policy support may yet be a potent combination for European risk assets.

Why is the Market Going Haywire?

Please Stand By

With markets moving and volatility picking up, the investment team has had some lively discussions recently. When turbulence breaks out there is often a tangled web of items to sort through in determining what is the major driver. Our summary view is that we’ve had a collision between complacent markets that have lost momentum as the Federal Reserve’s quantitative easing program winds down, and a European growth scare that has moved to the forefront. Negative daily news headlines don’t help either (e.g., Ebola), though these are likely temporary factors.

Our current base case is that the U.S. economy is likely strong enough to handle the potential for the Fed to begin raising interest rates sometime in the next couple of quarters, as long as Europe doesn’t slide into another recession. While Europe has exhibited renewed weakness recently, the decline should compel European authorities to take additional monetary (and perhaps fiscal) action to support the recovery.

The Correction and Our Mission

A Garden Variety Correction: S&P 500In terms of the current correction, it’s helpful to reflect on the ongoing bull market we’ve experienced since 2009 (see the chart on the right). A little perspective shows this 6-7% decline in the S&P 500 Index doesn’t look much different than a number of other corrections that have occurred during the overall bull run. Keep in mind that the market hasn’t had a 10% correction in a couple of years, and that certainly seems to be amplifying fears in this market retracement. When correction fears take hold, it is important to remember that an occasional pullback is usually healthy for markets and more often than not serves to shake out the weak hands and refresh stocks for more gains.

Major Turn or Interim Volatility?It’s important to remember here that our investment method is not intended to catch smaller moves or corrections. Despite the current feeling that the world is coming apart, the reality is that what we have experienced so far doesn’t even qualify as a bonafide “correction” for most analysts, as they would reserve that term for declines of at least 10%. Our process is designed to guard against major turns in the market cycle (in our definition, a major turn from bull to bear market entails a move of at least 20%). The chart to the right offers a good illustration of what we’re defending against.

Since we make our investment decisions based on the weight of the market evidence, let’s look at that now.

A New Message?

In terms of the evidence, technical conditions have been deteriorating slowly over a period of months, and we rate that input as mildly bearish. (The term “mildly” is close to being downgraded to simply “bearish” if the market declines much further.)

After weighing the evidence, we’ve concluded that the backdrop has gotten marginally worse, and we should take an incremental step in regards to portfolio positioning to reflect that change. Because we’re already very close to neutral from a volatility standpoint, this can be accomplished easily by purchasing longer duration bonds with cash-like instruments that are in most portfolios. This approach allows us to keep the rest of the allocation fully intact to try to ride out what may be a deep correction. If the correction runs its course without getting much deeper, it should be relatively easy to sell this position out of the portfolio if necessary. Like all hedges, it has a cost in the form of interest rates potentially moving higher in a market recovery, which would hurt bonds. Unfortunately, there’s no free lunch with hedges since they involve a tradeoff between helping to insulate the overall portfolio against declines versus the possibility of losing money on the hedge if things quickly rebound.

In terms of timing, we will likely give the market a chance to bounce off severely oversold levels in the short-term, but institute a stop-loss point to limit its drop before we move to a fully neutral position. Hopefully the pain is almost over, the market can reestablish its trend, and we can look forward to the best seasonal part of the year beginning in November. If not, we will be properly hedged for the evidence as it stands today.

Developing Opportunities?

While we’re prepared to bring the portfolio in line with the evidence from an overall volatility level, that doesn’t mean we aren’t looking for opportunities. Here are some specific ideas that we believe might be great multi-year opportunities, so long as our base case stands and the evidence doesn’t continue to deteriorate.

Technology is one of our favorite U.S. sectors. It’s cheap, well liked by independent reads, and fits into an expanding capital expenditures and stronger dollar story. We’re already overweight and are feeling some short-term pain as those stocks have declined, but rather than cut this we will likely use additional selling as an opportunity to build into a bigger exposure in this area.

Europe has underperformed in the short-term, but it may represent one of the best opportunities for us on a multi-year horizon. Europe is cheaper than the U.S., and the weak economic data will likely force their authorities to expand monetary (and maybe fiscal) policy at a time when the policy impulse is beginning to fade in the U.S. It’s easy to view Europe skeptically in the short-term because the interim results are negative, but we view it as a potential opportunity over a multi-year horizon on the basis of attractive relative valuation and increasing policy support.

Evidence Report CardWe also believe the U.S. dollar may have made a longer-term bottom and might be starting a multiyear bull market. Some of this comes as a result of diverging monetary policy and relative growth rates, and some of it has to do with a sounder structural footing for the U.S. economy through improvements in twin deficits, a stronger banking system, etc. At the moment the dollar is coming off very short-term overbought levels and seems like a poor entry point from a timing perspective, but we’ll be watching for a pullback that may provide an opportunity to enter. That trade may come in many forms — less international holdings versus domestic, currency hedged foreign positions, below benchmark weightings in commodities, and maybe even positions that track the value of the dollar as a fixed income alternative. We haven’t made any firm decisions on these, but analysts are watching their sectors to see how a multi-year trend higher in the dollar might be reflected in portfolio allocations.

Volatility is tiresome for everyone, and the short-term pain is not helping our cause for this calendar year. But perspective is important, and volatility often creates lasting opportunities. Most importantly, our investment process will continue to dictate broader portfolio changes; if this is truly the beginning of the next major bear market, we’re confident that our process will help position us more defensively as the evidence emerges.

We’re Not Pulling the Portfolio Ripcord… Yet

Pull the portfolio ripcord?

The second quarter started in somewhat choppy fashion as small cap and other high flying momentum stocks continued to face pressure as investors decided to shed stocks with swollen valuation multiples. The major averages fared better than their risky counterparts, and after a brief dip stocks began their ascent towards record breaking highs on the back on improving economic data, decent earnings growth, and continuing liquidity support from global central banks.

Meanwhile commodity markets appeared to work off some of their overbought readings from earlier in the year as they treaded mostly sideways during the quarter. Within fixed income, the bond market also fared well as investors continued to flock towards anything with a yield, foreign bond markets bubbled, and a number of technical factors came together to keep bond investors satisfied despite meager nominal yields.

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Time for a Portfolio Fire Drill

Time for a Financial Fire Drill

NOTE: There is a 100% probability that bull markets will be followed by bear markets. This article is not a forecast about imminent market behavior. For our latest views on markets, clients should read our market review. Financial fire drills are all about testing your emotional response to a bear market, which you should be doing all the time. (And it’s not a bad idea to check your emotional reaction to bull markets, as well.)

When I was a kid, my family lived in a two-story colonial in South Jersey. Once each year, to the great excitement of all concerned, my parents had my brother, sister, and me conduct a fire drill. We got to climb out of our bedroom window onto the roof of the garage, and then down from there.

Our house never suffered a serious fire, and we never had to make a rooftop escape, but my parents were still glad that we’d practiced what we had to do, just in case. It was a very good idea.

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A Helpful Change to Maryland’s Estate Tax Law?

Toy House

Governor Martin O’Malley recently signed a new law that will reduce the sting of estate taxes over the next several years for Maryland residents. So how does the Maryland tax compare with the federal version? As defined by the IRS, “The Estate Tax is a tax on your right to transfer property at your death.” The federal government imposes a tax on taxable estates in excess of $5.34 million (the individual federal exemption amount, which increases for inflation annually). Maryland currently imposes an estate tax on taxable estates in excess of $1 million (the state exemption amount).

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Five Affordable Retirement Locations for the Outdoor Lifestyle

Florida Beach

If you’re a lover of the outdoors and thinking about where you want to live in your retirement, you probably already have some candidates. But have you considered the financial ramifications of living in those areas? While financial implications should not necessarily be your primary focus, you should consider such things as taxes and cost of living when making your decision.

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Is the Market Heading for a Pause?

We're heading for a pause in the market

First quarter market performance was as whippy and volatile as the weather. Unusually cold temperatures in the U.S. not only froze much of the country’s population, but it also wreaked havoc on the quality of economic data, and kept markets on edge regarding how investors should be positioned. Geopolitical issues also rose from the ashes as various emerging markets had currency issues and Russia showed poor sportsmanship and invaded the Ukraine shortly after the conclusion of the Olympic Games.

By the end of the quarter, the markets showed mixed results, with U.S. stock and bond markets logging roughly equal returns, and international markets showing large variations depending on country and region. Commodities appeared to benefit the most from the weather and geopolitical environment, and they bounced to a very strong quarterly return.

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Secrets of a Successful Retirement Transition

Retirement Transition Secrets

For most Americans, retirement is one of life’s major turning points. We’re no longer required to take part in the work-a-day world, and can turn our attention and considerable experience to family, friends, service, and personal interests.

But it isn’t as easy as it sounds. Many people find retirement jarring, and have trouble adjusting to the new lifestyle. With that in mind, we’ve asked our retired clients for advice for those about to make the leap — what lessons they’ve learned, what they did well and what they wish they’d done differently. The responses are full of fantastic insights, important reminders, and creative ideas. Whether you’re facing retirement now or at some point in the future, you will find something of value here.

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