2009, Third Quarter - Mark Pankin Home Page

2009 Third Quarter Volume 15.1
Mark Pankin Managed
Accounts Newsletter
Please Note
I will be contacting clients for my more or less annual or more frequent follow-up discussions
about your investment objectives and overall financial picture. The default method will be over the
phone, possibly using e-mail to determine good times for me to call you. If you prefer, we can do it
all via e-mail or not at all if nothing significant has changed. Just drop me an e-mail at
“mdp2@pankin.com”.
Third Quarter Review
It was another strong quarter
for stocks as the chart to the
right shows. After pulling
back a little in early July, the
major indices gained steadily
until mid-September. For the
last half of that month, they
moved slightly lower. All
three indices gained between
15% and 16% in the third
quarter.
Percent Change
20%
15%
10%
5%
0%
Daily Quarterly Cumulative Percent Changes
As was the case at the end of -5%
the second quarter, the
sideways movement late in -10%
the quarter resulted in many
pundits saying the move up
that began in March may
well be coming to an end, so the stocks were
about to move down to test various possible
“technical support” levels. That may or may
not happen, but I tend to get skeptical when I
read the same sort of thinking in too many
places. Those opinions do not influence my
trading, and the models I pay the most attention
to are all currently positive with almost no
chance of turning negative for at least a few
weeks.
6/30/2009 7/30/2009 8/30/2009 9/30/2009
Dow S&P Nasdaq
The graph on the next page takes a longer look
at the markets by showing the weekly
movements so far this year. The gains of the
last six months have, for many investors,
earased the painful memories of the major
indices plunging in the first two plus months of
the year. The rally off of the March lows has
now brought all three of the major indices well
above breakeven for the year. The Dow by far
has been the laggard of the group by gaining a
little over 10% for the first nine months of the
Mark Pankin Managed Accounts Newsletter 1
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year. The S&P is doing
considerably better being up
17%, but the real star has 40%
been the Nasdaq Composite,
30%
which has more than
doubled the gains of the
20%
S&P by climbing almost
35% for the first three
quarters. It is typical that the
10%
0%
Nasdaq, which is heavily -10%
influenced by high tech
stocks, moves up faster than
the other two. However, the
-20%
-30%
extent of the difference this
year is unusually large,
which might suggest that the
market is getting a bit “frothy” and may be due
for a “correction” in the not too distant future.
The traditional seasonal patterns have not held
so far in 2009. January saw the S&P fall by
over 8%, so according to the “barometer” based
on that month, the remainder of the year did not
figure to be a good one for stocks. The fourth
quarter would have to see a substantial pullback
for that to be true. One old saw is “sell in May
and go away” to take advantage of the
historical pattern of the November through
April six months being much stronger than the
May through October period. Clearly that has
not been so this year. The November-January
period is historically the best three months for
stocks although that was not the case last year.
It will interesting to see if that behavior
resumes later this year or if the pattern of antipatterns
1 continues.
Managed accounts did well in the third
quarter and for the year to date:
The active management style I use for
managing accounts is designed to manage risk
by avoiding large drawdowns in account values
as well as generating substantial profits in
favorable market conditions. For the most part
that has been the case so far this year.
1 Am I trying to write my own Wall Street Gibberish?!
Percent Change
Weekly Cumulative Percent Changes for 2009
12/31/2008 3/31/2009 6/30/2009 9/30/2009
Dow S&P Nasdaq
All of the returns shown below are based on
trading in typical accounts. With the exception
of the model for trading real estate funds, the
values include the effects of my management
fees.
Selects Switching: My oldest managed
account program, which began in late 1994,
trades the Fidelity Selects group of sector
funds. All accounts began the third quarter
fully invested holding two Select funds. The
weakness of stocks in early July resulted in our
moving to being entirely in cash by the middle
of that month. Later in the month, accounts
were half in a single sector fund and half in
cash. After Labor Day, they were again fully
invested by holding two Select funds, which
was the position at the end of the quarter.
For the third quarter, accounts gained 6.7%,
and they are virtually even for 2009.
Performance for the year was hurt by not being
able to buy a fund in April that Fidelity was
closing in June. That was discussed in the last
editions of this and the program specific
newsletter.
Rydex Sector Trading: I have two methods I
use in managed accounts. One, which I call
Sector Trading Adverse to Risk (STAR), places
more emphasis on risk reduction than
exceptional profits. With the weak markets for
the first two months of the year, the accounts
were totally in cash far more often than they
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nibbled at attractive sector funds. Trading
activity picked up in the second quarter and
continued through the third quarter. However,
much of the time there were partial holdings of
the money market fund. One reason is that the
method requires a pullback before buying a
fund, and in very strong markets such actions
may not occur very often. Nonetheless, the
cautious approach has worked well this year as
the typical account gained 12.8% in the third
quarter, which brought 2009 gains up to 27.5%.
The other method is called Aggressive Rydex
Trading (ART). While STAR may own up to
three sector funds at a time and will be partially
or fully in money market more often than not,
ART normally owns just one sector fund at a
time and will be out of the market only when I
judge that the risks of stock ownership in
general and trading sector funds are too high
relative to the potential rewards. Also, ART
may own Rydex Precious Metals instead of or
in addition to one other sector fund. That fund
has been owned for more than two years.
Originally about 20% of assets were placed into
the gold fund, and in January 2008 those
positions were increased.
ART accounts had stopped trading sector funds
in mid-January as the weak markets made the
risks of aggressive sector fund trading too high
relative to the potential profits. Trading of
sector funds resumed in early April and has
continued through the end of third quarter
except for a few days in July. For the third
quarter, the sector fund trading gained 6.5%,
which moved it ahead 3.1% for the nine
months. The gold fund has showed nice gains,
although with a considerable amount of
volatility, so far this year. For the last quarter,
the fund was up 23%, and for the year so far it
is up almost 45%. The combination of the two
trading types gained 10.1% in the third quarter,
and ART accounts are up 10.4% for the year so
far.
Dow Turnarounds: Unlike those above, this
managed account program can buy individual
stocks instead of or in addition to mutual funds.
Mark Pankin Managed Accounts Newsletter 3
Some accounts may also employ options
strategies, usually fairly conservative ones. All
the stocks it buys are in the Dow Jones
Industrial Average when they have been beaten
down enough. The plan is holding them for two
or three years until their prices recover.
Sometimes, the recovery comes in less than a
year.
Up until this past year, my thinking was those
Dow components and other “blue chip” stocks
that had seen their prices drop significantly
could be considered as relatively low-risk
investments. However, we have seen too many
of them—AIG, Citigroup, and GM in
particular—have virtually all of their value
wiped out, and they are unlikely to see any
meaningful recovery in their worth for years if
at all. All three of those have been removed
from the Dow. I still think beaten down Dow
stocks can be outstanding investments, but in
the current market environment, the risks of
owning them are far higher than they have been
historically.
It is fortunate that the one remaining Dow
Turnarounds account has never been invested
entirely in Dow stocks. It currently also holds
positions in an index fund, a gold fund, and a
real estate fund. For the third quarter it gained
12.8% and for the year it is ahead 18.4%.
Tactical Asset Allocation: These accounts
sold their equity fund holdings in December
2007 and were out of stocks until early June
except for a one-week whipsaw trade in an
S&P index fund in late May 2008. The S&P
index fund purchased at the beginning of June
was sold in late July, and bought again in late
August. It is still held at the end of the quarter.
There is no “pure” TAA account, but the TAA
newsletter has examples of how such an
account might have performed.
The typical managed account in this program
holds a gold stock fund and also trades
according to non-TAA models, such as the one
for real estate funds. This program provides a
wide range of options in the conservative-to-
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aggressive spectrum. The choice of target
allocations and possible trading according to
other models is customized to fit client needs in
order to achieve financial goals within the
anticipated investment time frame and at
acceptable risk levels.
The gold stock fund has done well as discussed
under Rydex sectors as has the real estate fund,
which is discussed below. Combined with the
index fund trading, the typical account gained
almost 15% for the quarter and is ahead 23.5%
for the year so far.
Some of these managed account programs have
separate newsletters that provide details and
additional commentary. Please request any of
interest.
Real Estate Fund Model: About three years
ago I developed a trend following model based
on the Fidelity Real Estate Investment Fund
(ticker symbol FRESX). That fund has the
longest history of any fund in the sector, and I
base my research on historical performance,
which is why I used it. Funds from some other
companies perform quite similarly as does at
least one exchange traded real estate fund.
The model I developed had been negative since
November 2007 as real estate property values
fell sharply as part of the financial crisis in
2008. In late April, the model gave a buy
signal. The fund gained 41% in the third
quarter bringing the open trade profit to about
50% at the end of September.
As is the case with gold stock funds, real estate
funds can be quite volatile, so trading them
entails a significant level of risk. Consequently,
it is best to limit ones exposure to such funds.
Depending on how risk tolerant one is, 10-20%
of the portfolio would be an appropriate
maximum exposure.
As always, you should not assume that any of
the investment performance discussed here will
be achieved in the future. Also, there can be no
assurances that any of the trading methods or
client accounts will be profitable in the future.
Stock Market Perspective: Is the Secular Bear Losing Its Claws?
Conventional “wisdom” defines a bear market
as a 20% drop from a previous high, and also
uses a gain of that size to establish a bull
market. 2 The size of the gains since early
March has generated a lot of talk and writing
about whether the March lows will be the
ultimate lows of the secular bear market that
began in 2000. If so, we may now be in a
secular bull market.
historically low levels. For example, in late
1974, the price-to-earnings ratio for the S&P
500 fell to about 8, and in late 1979 and early
1980 is was around 7. Currently, its P/E based
on estimated earnings for the next 12 months is
in the 15-17 range. Bullish pundits say that is a
“fair value” because it is close to some
historical average or another depending on the
period of the average.
My guess is that the secular bear is still on the
prowl, so the current rise is a cyclical bull
market rather than the start of a very long
period of rising markets. I say that because
secular bear markets in the past have not been
over until valuations are beaten down to
2 Since it takes a 25% gain to recover a 20% loss, the
definition of a bull market should require that much of a
gain. Wisdom is in quotes due to “thinking” that a fixed
percentage can define a change in the animalistic nature
of the stock market.
Mark Pankin Managed Accounts Newsletter 4
There are a couple of problems with that
reasoning. Since current earnings are
depressed, the current P/E based on trailing
earnings is quite high, over 70 according to The
Wall Street Journal. Since earnings are almost
certain to improve, it makes sense to use
estimates, but earnings estimates are
notoriously inaccurate. Even if a P/E around 15
is some sort of “fair” value for stocks, markets
typically overshoot “correct” valuations in both
directions. If prior secular bear markets are any
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guide, we are going to see a P/E based on real,
not estimated, earnings much lower than 15.
In order to get some idea of how the current
secular bear may play out, I will compare what
we have seen so far with the last full one in the
1966-82 period. That will at best provide a
rough idea. One prior comparison has no
statistical significance. Moreover, the end of
the period was more than a quarter century ago
and its beginning was more than four decades
in the past when LBJ was the President and
Obama was starting elementary school.
The approach is looking at the changes in
percentage terms of the S&P 500 from the high
points in 1966 and 2000. I use close of the
week data to keep the graphs from becoming
too messy. In 1966 the weekly high of 93.81
was made on February 11. In 2009 dollars,
using the Consumer Price Index (CPI) to make
the adjustment, that value is 626.93. That is less
than ten percent lower than the low the S&P
made this past March, 43 years later, which
shows how secular bear markets can be
devastating to longer term investment returns.
The highest weekly close in 2000 was on
March 24. The index was at 1527.46, or
1908.04 in constant 2009 dollars.
The graph below is based on the inflation
adjusted weekly index values. The longer solid
line tracks the index in the 1966-82 secular
bear market. The chart goes through the end of
1982 even though the market bottomed out in
August. The shorter dashed line shows the
index changes since March 24, 2000, the start
of the current secular bear market, which is
now more than nine years old.
There are some striking similarities and
differences. The actual S&P made new highs in
the 1969 and again in early 1973. Adjusting for
inflation, the movement was essentially
sideways, which is not unusual in a secular bear
market. In contrast, the index lost about half of
its “real” value in the first three years after
2000. About seven years into the periods, the
Inflation Adjusted S&P 500 from Start of Secular Bear Markets
10%
0%
-10%
-20%
-30%
-40%
-50%
-60%
-70%
0 3 6 9 12 15
Years Since High
Feb. 11, 1966 - Dec. 31, 1962 Mar. 24, 2000 - Oct. 2, 2009
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index topped out and fell sharply. In the older
one, it almost reached the 1966 high. However,
when it made new nominal highs in 2007, the
S&P was still almost 20% lower in constant
dollars than it was at the start of the secular
bear market. After those peaks, the sell offs in
the next year to two years were quite severe
leading to drawdowns of around 60% in
inflation adjusted terms.
The cyclical bull
market that began in
late 1974 had its peak
about 15 months later about 43% above the low
in constant dollars. That rise is not as great as
in the current cyclical bull market and it took
quite a bit longer. After that, the overall trend
down resumed for nearly another six years.
The graph on the previous page suggests that
we are about half way through the current
secular bear market. Such is consistent with
bear periods historical length of 15-20 years.
One significant difference between the current
one and the last half of the prior one is the rate
of inflation. After pushing above 5% for a few
months in the summer of 2008, the year-overyear
change in the CPI is now negative and
figures to remain quite low for at least another
year. The greater concern now is avoiding a
prolonged and deep deflation that could lead to
a very severe recession or a full depression.
The annual change in the CPI climbed steadily
in the early 1970s and peaked over 12% in late
1974 3 when the drop in stocks from the early
1973 peak bottomed out. Inflation dropped
briefly under 5% in 1976 before soaring to
about 14% in 1980. Those high values pull
down the inflation adjusted S&P shown in the
chart.
Another major difference between the current
environment and the 1966-82 period is the
dividend yield on the S&P. Back then the yield
level rarely got much below 3%, which was
The secular bear market is now over nine
years old. Have we seen the low point as
we did by one measure in the last one?
sometimes considered an indication that stocks
were overvalued. By late 1974, the yield was
over 5%. It fell to under 4% later in that decade
before rising to a peak of 6.4% 4 in June 1982, a
couple of months before the low at the end of
the secular bear market. In contrast, the S&P’s
yield in 2000 at the end of the long secular bull
market fell to just a bit
over one percent, and
is still below 2.5%.
Dividend policies of
most corporations have
changed considerably, so it is unlikely that the
higher level of yields will be seen any time in
the foreseeable future. One factor in the 1970s
was that the high inflation often enabled
companies to raise their prices, which resulted
in increased nominal earnings and the
capability to pay higher dividends. To improve
the comparison between the two periods’
market movements, the graph on the next page
shows the total return of the S&P 500 adjusted
for inflation. The total return lines assume
reinvestment of the dividends, which is
normally what happens with an index tracking
mutual fund. There were no index funds in
1966; Vanguard started the first one in 1976. A
very low expense ratio fund such as that one,
ones offered by some other fund companies,
and the exchanged traded “spiders” fund will
closely track the total return of the S&P 500.
We can see that when looking at the total
return, the drop in late 1974 was reduced quite
a bit, from almost 60% below the start of the
secular bear to a little over 40%. The drop since
2000 also is reduced, but not by a whole lot,
from somewhat over 60% to a bit under that
level.
The high dividend yields resulted in the total
return inflation adjusted low point during the
prior secular bear being in late 1974. In
November 1980, the purchasing power of the
total return index was back to where it was in
3 You may remember President Ford wearing a WIN
button standing for whip inflation now.
4 Data downloaded from the web site of the American
Association of Individual Investors (AAII).
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February 1966 for a couple of weeks. At least
the “buy and hope” investor in a hypothetical
S&P index fund with a zero expense ratio
lower, which would result in the dashed line
falling substantially. Another reason the current
market may not keep up with the late 1970s is
Inflation Adjusted S&P 500 Total Return from Start of Secular Bear Markets
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
-60%
0 3 6 9 12 15
would briefly have preserved his or her
purchasing power over an almost fifteen year
period. 5 That assumes the investor could stand
seeing the fund lose almost half of its
purchasing power and could hold on and not
sell the fund.
The chart suggests that the worst of the current
bear market may be over. As long as inflation
remains very low, even today’s meager
dividend yields will enhance the inflation
adjusted total return of the index. Due to
current corporate dividend policies, it is
unlikely that the yield on the S&P will rise
significantly unless stock prices move sharply
5 The fund would need to have been held in a
hypothetical IRA or 401(K) type account, which did not
exist in 1966, or there would have been taxes to be paid
on the fund’s distributions. Even in such an account the
taxes due when money was withdrawn would bring the
real after-tax returns to less than breakeven.
Years Since High
Feb. 11, 1966 - Dec. 31, 1962 Mar. 24, 2000 - Oct. 2, 2009
that inflation may well pick up if the economy
starts growing again. There has been a lot of
money pumped in by the Fed. Although it
claims it will be able to drain liquidity to
prevent high inflation when the time comes,
that is a daunting task requiring precise timing
to avoid severely hurting the economy. Based
on the uncertainties and difficulties involved,
the past Fed performance suggests that it will
not be able to achieve its goals all that well.
Another reason I am not optimistic about the
chances of the future course of the dashed line
following the solid one is the P/E ratios
discussed at the beginning of this section. In
other words, despite the two deep drops we
have seen since 2000, I don’t think the level of
fear among the investing public has yet reached
the capitulation point where it takes an
immense amount of courage to continue
owning stocks, much less buy more. That is the
Mark Pankin Managed Accounts Newsletter 7
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sort of pessimism that marks secular bear
market lows. Please note that these views do
not affect my management of your accounts as
well as my personal ones because it is done
using thoroughly tested formulas that tell me
when I should or should not be in stocks.
(Not Quite) Wall Street Gibberish
Normally I use this occasional feature to
expose spoken or written “wisdom” that is
technically correct, but is also misleading and
potentially harmful to investors’ financial well
being. This time I was motivated by a Wall
Street Journal article about a woman in
England who has been on a thirty year
campaign for “Plain English” to make business
and government writing understandable and to
eliminate confusing and ambiguous text. For
example, instead of a bank talking about a
“maximum debit balance,” they should say the
“most that can be owed.” Or the Fed and
Britain’s central bank say they will be doing
“quantitative easing” when it would be clearer
to say they are adding money to the economy.
In that spirit, I found a humorous list of famous
book titles and what they might be if written in
today’s hype filled environment:
Questions and Answers
To make sure I answer the right ones, be sure to ask them.
Original: The Wealth of Nations
Revised: Invisible Hands: The Mysterious
Market Forces That Control Our Lives and
How to Profit from Them
Original: Walden
Revised: Camping with Myself: Two Years in
American Tuscany
Original: The Theory of the Leisure Class
Revised: Buying Out Loud: The Unbelievable
Truth About What We Consume and What It
Says About Us
Original: The Prince
Revised: The Prince (Foreword by Oprah
Winfrey)
How to Contact Me
Questions, comments, requests for information, or anything else you feel like talking about:
Mark D. Pankin
1018 N. Cleveland St.
Arlington, VA 22201
(703) 524-0937 (voice and fax)
E-mail: mdp2@pankin.com
Internet web site: http://www.pankin.com
Mark Pankin Managed Accounts Newsletter 8
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