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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The Most Wonderful Time of the Year

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2013 has treated investors to a wonderful meal of huge equity returns, and there may still be a fine port waiting for us at the end. To steal from the Pola and Wyle song, we are entering what is typically the most wonderful time of the year (and right on cue, Bernanke Claus handed the market a dovish communique for the holidays). December is the second strongest month over the last 10 years and has a very clear pattern of strength during the last half of the month, as you can see from the chart to the right (from Jeff deGraaf, with RenMac).

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Are We Making Too Many Trades?

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Actively managing a portfolio requires buying and selling securities with the goal of managing risk and outperforming passive benchmark portfolios. Clients are correct to question the number of trades that are being made in their portfolio in pursuit of this objective. After all, one trade can generate several trade acknowledgments from our custodians, and each trade acknowledgement shows the brokerage commission charged for each transaction. Clearly the cost of trading has a negative impact on total portfolio return. As we approach year-end and Pinnacle’s investment team continues to generate commissionable transactions in our managed accounts, it might be helpful to analyze the cost of brokerage commissions relative to our ability to implement our active management strategy.

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The Problem with Monthly Returns

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I recently wrote about three “red flags” that I look for when evaluating portfolio manager returns. The third item – a firm dropping a specific time frame from its performance reports – is particularly relevant, because we’ve decided to make our own change to the time horizon for our performance numbers. Beginning next month, Pinnacle will no longer publish monthly portfolio returns.

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Why We’re Changing Our Performance Benchmarks

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As a longtime observer of portfolio manager performance, I have noticed a few common warning signs that there might be trouble brewing with a money manager. They are, in no real order of importance:

1. When there is a major change in the management team of a fund

2. When a specific time frame of historical portfolio performance is no longer reported by the firm

3. When a firm changes the benchmark for its performance reporting

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Why You Should Evaluate Portfolio Returns Over A Complete Market Cycle

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How to determine the proper time horizon to evaluate portfolio performance is always a subject for an interesting conversation. In a recent client survey on investment issues, we asked our clients “What time horizon do you feel is the best time frame to evaluate portfolio returns?” The results varied: 16% said “Monthly,” 43% said “Quarterly,” 37% said “Annually,” and 4% said “Over a complete market cycle.” (As an investment professional, I would have selected the last option.)

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Searching for a Performance Tail-Wind

For the past three years our insistence on maintaining a globally diversified portfolio has not been especially helpful in outperforming our blended benchmark on a consistent basis. If we use the EAFE Index (the MSCI Europe Australasia Far East Index) as a proxy for international markets, the returns versus the S&P 500 Index (the stock index in our benchmark) look unattractive:

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Using Valuation to Project Market Returns

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There are many different ways to go about making projections for prospective returns of the stock market. On one side of the spectrum, at the beginning of each year Wall Street analysts give their projection for the price of the S&P 500 at the end of the upcoming year. Their sophisticated methodology usually consists of applying to the current price a mark-up that conveniently ranges between 8% and 12%. On the other side of the spectrum, financial planners build clients’ portfolios by projecting returns of different asset classes over time frames as long as their clients’ life expectancies. In this case, the very long-term average historical return of each asset class is usually the way to go. Somewhere in between these two extremes lies a methodology grounded in economic theory and valuation and which is used by some prominent portfolio managers (John Hussman and Jeremy Grantham, among others) to project stock market returns over periods of 5-10 years.

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Looking Ahead to the Second Quarter

Recently the Pinnacle investment team met to discuss the state of the world, the views of the independent analysts we follow, our market expectations, and what it all means to the asset allocation of Pinnacle portfolios. As always, it was a lively discussion that swung between business cycle dynamics, technical condition of markets, valuation, and bigger picture themes.

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Three Ways to Evaluate Portfolio Returns

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Consumers of investment management might consider three different methods to analyze investment returns. The first method is to look at absolute returns in the context of your financial plan. If the portfolio return was 7% annualized for ten years, was that return high enough for you to achieve your financial goals? What about 3% annualized returns, or 12% annualized returns? Of course, looking through the lens of absolute returns would disqualify negative returns as helping anyone to achieve their goals, so investors often look to other methods to evaluate portfolio returns. Today it is rare to find a manager in any asset class, including hedge funds, who claims to be able to consistently generate absolute returns.

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