Call it the new “Paranormal” market–you’ll need some new investing tools but the profits are out there
Can we just go back to the good old days? The days when stocks went up every year? When we all talked “buy and hold?” When a 200-point drop in a day in the Dow Jones Industrial Average was unusual? When the challenge of investing in stocks was finding good, well-managed companies rather than predicting the direction of the dollar or when Greece would default?
Not a chance.
We have, in fact, entered a new era. It’s not the “New Normal” forecast in 2010 and it’s actually even more dangerous than the new “Paranormal” sketched this January by Bill Gross of PIMCO. This era is characterized by extreme swings between radically opposed fears and hopes. We’d better get used to it. Remember 2011? The year before the current rally? That’s the new era in a nutshell, I’m afraid.
And we’d better come up with strategies for investing through this period. The current reality is, after all, the only one we’ve got. I’m going to start this post by depressing all of us with the size of the challenge ahead. And then I’m going to give you five ways to change your investing ways that can, I hope, make this era less painful and more profitable.
Remember the “New Normal?” It was the phrase bond-fund legend Bill Gross and PIMCO CEO Mohamed El-Erian coined back in 2010 to describe the financial world after the 2008 global financial crisis. Everyone would deleverage to get rid of debt. Consumers would go frugal. Banks could forget profits since borrowing would go way down. Houses would lose value—and renting would become the new normal instead of buying. Oh, and investors could forget about anything much better than a few percentage points of yield on their bonds and sluggish growth in stock prices. A 5% annual gain would seem like nirvana.
I found that downright depressing—not least because it wasn’t obviously wrong.
This January Gross replaced the “New Normal” with what he called the “Paranormal.” Gross begins with the observation that rather than deleveraging as described in the “New Normal” paradigm, most economies have not reduced debt (U.S. and EuroZone consumers are global exceptions) but instead have piled it on. The world’s central banks are adding debt to their balance sheets—2.74 trillion euros at the European Central Bank alone after the most recent round of bank loans–so they can lend to banks that would otherwise be broke who can then buy bonds from governments that would otherwise be broke. This has worked to the extent that the global economy has continued to expand instead of experiencing a continued recession as everybody cut debt.
The “Paranormal” economy is obviously more dangerous for investors than the “New Normal” because it has replaced the one danger of the “New Normal” with two potentially painful outcomes. There’s still the previous “New Normal” risk of deleveraging and recession, but there’s now the opposite risk that economic growth, based on global monetary stimulus, will result in runaway inflation and finally global financial implosion. (To read Gross’s January letter on the “Paranormal” economy follow this link http://www.pimco.com/EN/Insights/Pages/Towards-the-Paranormal-Jan-2012.aspx )
And, yes, as much of a downer as the “New Normal” was, as an investor I find the prospect of the “Paranormal” even more depressing.
Gross’s second risk—that of runaway inflation and global financial implosion—is scarier than a “New Normal.” Recession isn’t nearly as scary as implosion and the meager positive returns of the “New Normal,” while meager were still positive. I don’t think I’d make any money during an implosion.
But the possibility of vacillation between the two extremes of the “Paranormal” paradigm makes it more dangerous than even the worst one of those extremes alone. The existence of two radically different alternative outcomes—with a decision between them put off into some unspecified future—will create a financial market where a wild swing toward fear of recession is followed by a swing to fear of inflation/implosion is followed by a swing back to a fear of recession. And so on. With the possibility that investors can lose big money on each swing toward one extreme or the other. A steady average of 3% returns in the “New Normal” would be bad enough for anybody trying to reach a financial goal, but it sure beats getting beat up over and over again.
What if 2011, with its wild swings between what we spent the year calling risk on and risk off, is the normal “Paranormal” that we can look forward to until… Well, until the world has worked off its huge imbalances of debt and cash.
I don’t know about you, but I didn’t find 2011 much fun as an investor. Trying to navigate through all those market swings was a lot of work and I don’t have much to show for it. I’m in the process of finishing my Jubak’s Picks portfolio http://jubakpicks.com/the-jubak-picks/ calculations for 2011—I’m double-checking the data now and I should have it posted a day or two (maybe less) after this column goes up. It looks like my returns are lower than but within hailing distance of the 2.1% return on the Standard & Poor’s 500 index. But I’ve never been through a year where I did as much selling and buying and selling and buying just to hold my own. I finished the year with 40% in cash as I played intense defense. I haven’t run a cash position like that since I started this portfolio.
If 2011 is a typical year for the new era, I think investors need to work hard at developing strategies to cope with more years like this. Otherwise, my fear is that the character of this market will force us into patterns that aren’t particularly profitable—even if they are, on some level, reasonable reactions to the pain and uncertainties of that “Paranormal” economy and market.
I don’t think I need to run through all the reasons for thinking that there’s a danger of a global financial implosion (for example, see my February 13 post http://jubakpicks.com/2012/02/13/when-is-a-bad-loan-not-a-bad-loan-when-chinas-government-says-it-isnt/ ) or for thinking that there’s a danger of a global recession from what EuroZone leaders so glibly call austerity, especially if the United States adopts draconian deficit reduction economics in 2013.
Or even to spend much time reminding you that the key characteristic of the “Paranormal” market is its tendency to swing rapidly and radically from high to low and back again on macro-event hopes and fears.
In 2011 that tendency was so pronounced that John Murphy at StockCharts.com dubbed this the “Tarzan” market for the frequency of its wild swings.
Here’s a brief run down of the bigger moves in the S&P 500 for the year:
December 30, 2010 to February 17, 2011—up 6.5%
March 11 to April 29 (the high for the year)—up 4.6%
April 29 to June 15—down 7.3%
June 15 to July 6—up 5.8%
July 6 to August 10—down 16.3%
August 10 to August 15—up 7.4%
August 15 to August 19—down 7.1%
August 19 to August 30—up 7.9%
August 30 to October 3 (the low for the year)—down 9.4%
October 3 to October 26—up 22.1%
October 26 to November 25—down 6.8%
November 25 to February 29 (the current rally)—up 17.8%.
Looking back, August is my favorite month with three moves of 7% or better between August 10 and August 30.
The total net result of all this volatility, remember, was a return of 2.1% on the S&P 500 in 2011.
What do you as an investor do with a market like that? That’s an especially important question if you believe, as I do, that 2011 isn’t an aberration but a typical year in Gross’s “Paranormal.”
Ideally, you’d like to turn that kind of volatility from an enemy to a friend. After investing through 2011, I know that’s much easier said than done but here are five suggestions gleaned from the pain of 2011. (As I’ve said repeatedly over the years, if you’re going to pay the tuition, you’d better learn the lesson.)
- If the net return on the “Paranormal” market is 2% to 5% annually, then any time a swing down presents a 5% yield in a dividend paying stock (that otherwise meets your fundamental tests for quality), jump on it. For example, on August 24, sort of half way between the August 19 swing down to 1124 on the S&P 500 and the August 30 swing up to 1213, Magellan Midstream Partners (MMP)—a member of my Dividend Income Portfolio http://jubakpicks.com/jubak-dividend-income-portfolio/ –fell to $54.78. At that price the master limited partnership (MLP) units paid a 12-month trailing yield of 5.6%. It turns out that the “Paranormal” market was headed up from there—although with a detour at 1099 on the S&P 500 on October 3. On February 29, Magellan Midstream Partners closed at $73.17 and the yield had dropped with the share price increase to 4.34% (even with an increase in cash payouts in the third and fourth quarters that had sent the total trailing 12-month payout to $3.26 from $3.05 in August.)
- Use buy and sell target prices to make volatility your friend. In effect buying when you see a yield above 5% is a strategy for making downside volatility work for you. You can do the same thing for stocks that don’t pay a dividend (or where the dividend isn’t high enough to make it the primary reason to own a stock.) I bought Freeport McMoRan Copper & Gold (FCX) in my Jubak’s Picks 12-18 month portfolio http://jubakpicks.com/the-jubak-picks/ at $57.63 on December 14, 2010. The stock hasn’t seen $57.63 since. In fact the highest it’s been is $54 and change on April 6 and again on July 18. After watching the stock for a year, I’ve got a buying and selling pattern in mind. When the stock gets down below $40-$42 I’m willing to buy more. The stock has hit lows well below $40 on October 3 ($29.47), November 25 ($34.17), and December 16 ($36.76). At the current price of $42.56, if you’d done buying near those dates you’d still be underwater to my original purchase price of $57.63, but you’d have a substantial number of shares purchased near $40 that were actually in the money even at $42.56. I’d look to sell some shares (at least) if the stock got back close to the $54 it hit in earlier highs. Even at $50 I’d have a 25% profit on some of my shares.
- Buy, sell, and buy and sell again. Even in long-term positions. Sure, I want to own Freeport McMoRan for the long-term. The stock is a member of my long-term Jubak Picks 50 portfolio http://jubakpicks.com/jubak-picks-50/ because global demand for copper will climb with rising living standards in the developing world. But if the “Paranormal” market is going to give me volatility, then I’m going to use that volatility to trade in and out and try to lower my basis cost in my long-term buy-and-holdish positions over time. One of the advantages of owning a stock for a long time is that you get to know its price patterns and to understand how it reacts to macro events. Use what you know.
- Find a few stocks, sectors, or markets that are anti-correlated (or at least uncorrelated) with the main market. For example, Japanese stocks have been seriously out of sync with the global markets throughout the euro debt crisis. That’s because when the euro is in trouble and the market is in risk off mode selling down everything from Sao Paulo to Shanghai, investors are moving money into the yen and yen denominated investments for safety. If you compare the charts of the iShares MSCI Japan Index ETF (EWJ) and the iShares MSCI Brazil Index (EWZ) for October 2011, for example, you’ll see that at a point where Brazilian stocks are sinking to a 20% loss, Japanese stocks are holding rock steady. You can do even better finding assets that zig when others zag with individual stocks. Chart Japan’s Sanrio (8136.JP) against iShares Brazil, for example. You’ll notice that the maker of Hello Kitty killed from March through November, only beginning to falter when the current rally started in that month. Since then, you would have done much better in the Brazilian ETF than in the Japanese equity. You don’t need to find a lot of pairs like this—and in an age of ETFs you don’t need to be able to trade in overseas markets to do it either—but you should have a few possibilities in you toolbox so that your portfolio doesn’t have to track the overall market volatility when you don’t want it to.
- As my example of Sanrio is meant to suggest, in the “Paranormal” market, think of yourself as Dana Scully or Fox Mulder. You’ve got to be willing to go the extra mile (at night with the Smoking Man lurking in the shadows) to find the tools (otherwise known as stocks) that you need. The profit is out there. For example, in a world where the credit ratings of the United States and France are under pressure, what about the stock markets of countries with improving credit ratings such as Chile, Colombia, and Indonesia? Worried about the euro and the dollar? What about putting money into the Norwegian krone with Norway’s Statoil (STO) or SeaDrill (SDRL) with their 7.4% and 4.0% dividend yields, respectively, that will climb if the krone appreciates against those other currencies? If substantial real (that is after subtracting inflation) returns are unlikely in the “Paranormal” market, as Gross suggests, then you’ve got to take advantage of differences in inflation rates, currency strengths, credit risk, and anything else you can figure out.
A final word on the role of my Jubak’s Picks portfolios in all this. In this column I’m advocating some strategies that I can’t execute in these portfolios. (Although I can and do in my mutual fund Jubak Global Equity http://jubakfund.com/ .)These portfolios are binary buy and sell portfolios, for example, so I can’t sell partial positions or lower my basis cost by adding more shares when a pick gets cheaper. I either get the entry and exit points right or I don’t. You can execute more flexible strategies as I’ve listed here. My suggestion now is, as it always has been, to use my picks as tools and suggestions for building your own portfolios.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Freeport McMoRan Copper and Gold, Sanrio, and Statoil as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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