Balance, Grasshopper (Saut)

by Jeffrey Saut, Chief Investment Strategist, Raymond James

May 15, 2012

I received so many requests to put last Tuesday’s verbal strategy comments into written form, and that’s exactly what I have done this morning. To wit, I was always entranced with the 1970’s TV show “Kung Fu” starring David Carradine as Kwai Chang Caine. The show centered on an orphaned American boy (Kwai Chang) that is admitted as a student to the Shaolin temple in China. There his mentor, Master Po, teaches him the ways of the Shaolin priests. In addition to learning the martial arts Kwai Chang, affectionately named “grasshopper,” is also instructed in the ways of life. In one such lesson Master Po says, “Balance, grasshopper, balance” – implying that everything in life needs to be “in balance.” Similarly, investors’ portfolios need to be “in balance,” or more appropriately rebalanced periodically.

Portfolio rebalancing, when done correctly, is an art form. Simply stated, portfolio rebalancing is the strategic redistribution of asset classes within a portfolio to keep said portfolio’s objectives in line with its original objective. As John Valentine, of Valentine Capital, notes:

To provide a simplified allegory, think of investment planning for the future as an automobile, conveying an investor to his or her financial goals. The investment portfolio is its motor, the asset allocation model is the fuel mixture and the assets invested are the fuel. The more efficiently the motor runs, the greater the speed with which the whole vehicle travels toward the destination. Should the fuel mixture, or asset allocation run too rich, the motor wastes precious fuel. Should it run too thin, the car has trouble achieving enough forward momentum. ... Many individuals on the road to their financial goals fail to make these periodic adjustments and still eventually arrive. Not surprisingly, the investor who rebalances his portfolio at regular intervals may arrive sooner and with more fuel in his tank. ... Rebalancing a portfolio is crucial to the investor seeking to reduce the volatility in a portfolio and increase cash flow simultaneously. ... The longer a portfolio is left unbalanced, the more compromised its asset allocation may become. There are two potentially negative repercussions associated with a compromised allocation. Being overexposed to the downside and underexposed to the upside. Don’t let this happen to you!

Regrettably, most individual investors don’t have the discipline, or the skill sets, to actively rebalance their portfolios. That’s why individuals are best advised to seek professional assistance in rebalancing their portfolios, or for that matter seek a professional advisor to help them with all of their investment needs. Manifestly, correct asset allocation can increase investment returns and lower risk when “bets” are scaled to the advisor’s skill level. Most good investment professionals have successful “hit rates” of around 60%. That means they make a lot of mistakes and therefore should make smaller allocation bets. History suggests that large bets will eventually cause large losses and the end of an asset allocation program. Nevertheless, most clients and many advisors want to make bigger bets than their provable skills justify.

Clearly, asset allocation plays a key role in the investment process; however, I have some other thoughts I think you should consider. For example, a lot of what passes for brilliance, or incompetence, in investing is the ebb and flow of investment style (growth, value, foreign, small cap, etc.) and/or sector performance. Since opportunities by style and sectors tend to regress, past performance is often negatively correlated with future relative performance. Still, many investors feel compelled to go with past performance and therefore rotate into previously strong styles, and strong sectors, which then regress leaving them with losses. A good advisor can mitigate this tendency, but a good advisor is harder to pick than a good stock.

To this point, good advisors often internalize decisions while amateurs learn all the rules and procedures. It follows that amateurs can often precisely explain what they are doing and why they are doing it. An expert, however, often just knows when they are right. Since investors typically want to hear a logical and clear-cut investment process, many tend to end up with an eloquent amateur rather than a sometimes-incomprehensible expert. Ladies and gentlemen, never underestimate the effectiveness of an eccentric or unusual advisor since “knack” tends to win out over learned skill in the investment arena. Most important is getting the big picture right and the best long-term predictor of future “big picture” equity returns is the current value of the market – things like, price/earnings, price/dividends, price/sales, price/replacement cost (Tobin’s Q ratio), etc. Currently, all of these measurements indicate the equity markets are reasonably priced.

To this rebalancing portfolios point, I recommended doing so after the “buying stampede” ended in late January. My suggestion was to raise some cash before the envisioned 5-8% correction. At last Wednesday’s intraday low the S&P 500 (SPX/1353.39) was off 5.5% from its April 2 high, and in my verbal strategy comments I recommended starting to put some of that cash back to work in equities. While the “set up” wasn’t perfect, because we never got that pornographic plunge type of hour into the 1320-1340 support zone, at Wednesday’s low of ~1343 the SPX was close enough for government work. Moreover, the NYSE McClellan Oscillator was probing oversold territory (see chart on page 3) and there was a huge downside non-confirmation. Verily, last week the SPX broke below its April 10 reaction low of 1357.38, yet all of the other indices I monitor did not violate their respective recent reaction lows (read: downside non-confirmation). Then there is the continuing divergence between the McClellan Oscillator and the pricing action of the SPX, which often occurs at an intermediate-term bottom. And, then there was this from my friend Jim Kennedy, captain of the astute Atlanta-based hedge fund consulting firm of Divergence Analysis, whose proprietary stock market analyzing software I use and embrace:

After we sent out our email prices continued to slide last Friday. At the close, our S&P 500 and NYSE models closed the day with some divergence bottoming signals. Monday should be the test as to whether prices hold here and rally, or fail (see his charts on page 3).

Plainly, I agree with Jim’s comments for as stated, “While the ‘set up’ wasn’t perfect, it was close enough for government work.” I too think the first part of this week is critical because the SPX has tested overhead resistance at 1366 twice and has not had any success in traveling above that level. This lack of rebound energy suggests the SPX could drop into the often mentioned 1320-1340 support zone, which should mark the bottom for this correction and provide another good entry point for long stock positions. Last week, however, the only major index that was positive was the D-J Utility Index ($UTIL/472.01). Meanwhile, of the 10 macro sectors only Healthcare, Utilities, and Telecommunication were up on the week. The strength in Telecommunication was likely driven by the upside chart breakouts in AT&T (T/$33.59/Market Perform), Verizon (VZ/$41.16/Market Perform), and Centurylink (CTL/$39.52/Strong Buy). Speaking to industry groups, of the 63 groups I monitor the ones currently on “buy signals” for the short/intermediate term are: REITs, Insurance P/C, Banks, Restaurants, Building Materials, Specialty Chemicals, Food, Healthcare Supply/Equipment, and Pharmaceuticals. Some names from Raymond James’ research universe that screened positively on both their fundamental and technical metrics according to my work, and are favorably rated by our fundamental analysts, include: Allstate (ALL/$34.83/Strong Buy), Simon Property (SPG/$156.08/Outperform), Abbott Labs (ABT/$62.04/Outperform), Cerner (CERN/$79.92/Outperform), Intuitive Surgical (ISRG/$558.95/Outperform), Huntington Bancshares (HBAN/$6.54/Strong Buy), and Kimco Realty (KIM/$19.61/Outperform).

The call for this week: The stock market has been consolidating its huge gains from the October 4 undercut low for roughly three months in a ~75 point range (1350-1420). That consolidation has allowed the market’s internal energy to be rebuilt and the oversold condition to be worked off. Because of that process, I continue to think the odds that we will see a move below the 1320-1340 zone remain pretty dim. Accordingly, I suspect the stock market is going to put in an intermediate bottom probably this week.