Sell in May and Go Away is an easily remembered rule that worked very well for the past two years. Last year from April 30 to August 31, the S&P 500 lost 11%. Over more than fifty years it’s been sound advice 47% of the time so slightly less effective than a coin flip. However, when it works the results can be memorable, and some spectacular falls in stocks have occurred during this time period including 1966           (-15%), 1974 (-20%), 2002  (-15%) and 2010 (-12%). Recent years have reinforced the rule, with eight out of twelve Summers this millennium representing an unwelcome vacation distraction. Many a holiday has been ruined by portfolio losses on top of that expensive beach house, and no doubt those painful memories persist. However, during the 80s and 90s it worked in only seven years out of 20. Perhaps unsurprisingly, the overall market direction plays a big role. Two thirds of the time Sell in May worked was when the market’s return for the year was negative. So if you’re skilled at selecting good years to be in stocks, you can make your Summers a bit more enjoyable. And for those who want a little bit of an edge, Sell in May followed the pattern set in the first four months of the year 61% of the time. A bad start for the year is a little more likely to continue a few months longer.

In total though, following the Sell in May adage since 1960 would have “cost” an investor on average 0.5% p.a. — more after commissions and taxes are included. Interestingly, most of the 6.3% compounded annual return over this entire period was generated while school was open. As it turns out the Summer that’s about to end ranks #26 with a 1% return, close to the average.  This is a seasonal pattern that’s worth following, but barely. However, while Sell in May is not a profitable strategy, for some investors the foregone return by being out of the market may seem a price worth paying for a quiet vacation.

Although macro issues continue to hang over the market and rising prices were caused in part by the calamities that did not befall (i.e. southern Europe still uses Euros), it is notable how many companies reporting earnings during the Summer revised down earnings guidance and generally expressed caution.  Even the most economically insensitive companies tempered outlooks.  Examples include McDonalds (MCD) who, citing macro headwinds, reported no increase in monthly global comps in July – the worst since April 2003. Coke (KO) experienced declining volumes of 4% in Europe during the second quarter. IBM saw revenues contract globally and profit growth for many companies is relying on improved operating margins rather than top line growth. While it’s never easy to assess whether macro concerns are fully reflected in market prices (or indeed overly reflected) the more cautious outlook recently being provided at the individual company level is noteworthy.

The “fiscal cliff” is also a perplexing hurdle that isn’t yet receiving the respect it deserves. One major investment bank has in its quarterly GDP forecast a fairly smooth sequence of figures from 3Q12 to 1Q13 (+1.5%, +2.0%, +1.5%) that seem to defy common sense. While Washington is consumed with an election countless organizations big and small are planning 2013 capital expenditures and hiring without knowing whether we’ll have a Made in DC recession on January 1^st.  Anecdotally, many companies are already delaying major commitments until they have greater visibility into 2013 economic activity.

Conventional wisdom is that the lame-duck Congress will amiably defer the mandated tax hikes and spending cuts to later in 2013 and the new Congress, whereas many of us recall that this is the same group of legislators who brought America to the verge of “technical” default during the debt ceiling brinkmanship last Summer (when Sell in May worked). Sometime shortly after the election when the celebrations and recriminations are still fresh, one deeply unhappy party will be expected to compromise with another victorious one. While things will probably work out (because they usually do) a crisis-free experience seems unlikely. The Congressional calendar provides just sixteen days when the House will be in session between Election Day and December 14^th when they recess. There seems plenty of room for a miscalculation.

Meanwhile stable, dividend paying stocks are by many measures relatively expensive (most recently highlighted in Barron’s on August 24^th). It’s not surprising that low interest rates and widespread global uncertainty have made, say, Kraft (KFT) appealing, because demand for Oreo cookies and cheese is more predictable than Chinese demand for iron ore or the ability of large banks to both reinvent their business models and avoid endless debilitating investigations and fines. To borrow from Michael Lewis in Liar’s Poker, an investor in Goldman Sachs must ask where will the firm find their next “Herman the German” (AKA gullible buyer of hard to understand securities).

One interesting lesson in the field of Behavioral Finance is that many investors apply unreasonably narrow ranges to their forecasts of outcomes. In other words, most of us have a tendency to be over-confident that we are right about our investment decisions. Which is why, in spite of the preceding cautious market narrative we are not heavily invested in cash at present. As coherent as this letter might (hopefully) appear, it could also be dead wrong, and the longer the investment horizon the more likely the outcome is to be good. However while we haven’t sold everything, we have over the past couple of months shifted in our Deep Value Equity strategy away from cyclical exposure and towards companies whose risk is substantially idiosyncratic. Will Corrections Corp (CXW) convert to a REIT, which should cause a meaningful increase in valuation? Will JCPenney (JCP) carry out a successful transformation? Will AIG continue to buy back the government’s shares in it at half of book value?  Will Warren Buffett repurchase shares in Berkshire (BRK-B) if they fall to within 10% of book value?  Will Burger King (BKW) and Family Dollar (FDO) improve their operating metrics towards those of their peers? All of these are holdings in our Deep Value Equity strategy, along with cash and gold miners (GDX) to protect against deflation and reflation respectively.

Our Hedged Dividend Capture Strategy is very low turnover by design and so retains its positions in stable, low beta dividend paying stocks such as MCD, KO, KFT and others mentioned above. We believe the combination of these long positions with a short S&P500 hedge results in a portfolio uncorrelated with equities. Performance for the year in this strategy is flat, since the +13% return in the S&P500 has generally favored higher beta names with low or no dividend. Interestingly, without Apple (AAPL) the S&P500 would be up 2.2% less than it is so far this year, 16% of its return. Just being short AAPL has reduced performance in this strategy by a little over 1%. It’s an amazing outcome considering AAPL began the year with a 3% weighting in the S&P 500 (it’s now over 4%). We’re not even negative on AAPL, we’re simply short it through its inclusion in the S&P 500.

Master Limited Partnerships (MLPs) continue to look attractive with 6%+ yields and solid growth prospects. Developing new energy infrastructure to support the growing domestic production of oil and natural gas will remain a vital element of energy independence for many years to come. The likelihood of low bond yields for the foreseeable future combined with the inflation protection such assets afford through their ability to raise prices annually make this a useful income-generating investment for many investors. In August we reduced our position in Sunoco Logistics Partners (SXL) in those accounts where this long-held position had become an overweight through strong performance and reallocated towards Oneok Partners (OKS).

All of which goes to show that, had we embraced Sell in May for many sound reasons at the beginning of the Summer we would have been dead wrong then too.

I thought this was a pretty balanced and investor-oriented piece:

http://www.finalternatives.com/node/21480

Only 25% of Germans think Greece should remain in the Euro or receive further additional EU support, according to a Financial Times/Harris poll. Holding opinions unburdened by the need to implement them is an indulgence afforded voters in all democracies. It feels good to punish the tax-dodging Greeks by kicking them out. But if instead these same German voters were asked if they’d contribute perhaps 300BN Euros towards the probably 1 Trillion that would be requires to support Italy and Spain if Greece leaves the Euro, they would probably reject that as well. This is the unpalatable reality no doubt well understood by Germany’s decision makers. In any case, public opinion was against giving up the Deutsche Mark in favor of the Euro as well, but opinion polls don’t necessarily drive political decision making in Germany. For Europe’s biggest economy, keeping Greece in the Euro is unfortunately probably cheaper than kicking them out.

Greece may wind up leaving, but if that turns out to be the best of available options then the future for EU growth will be pretty bleak.

Towards the end of last year we felt there was an interesting opportunity to be long equities hedged with a short position in the Euro. Our thinking was that equities were attractively priced as long as a crisis was averted, and most of the bad things we could imagine would either begin in Europe (i.e. Euro collapse) or affect it more than the U.S. (such as an Israeli strike on Iran given the EU’s greater reliance of Middle East imports than the U.S.). We employed this bias in Fixed Income where long positions in bank debt were combined with short Euro positions.

That trade is no longer interesting, because a short Euro is a less effective hedge now that it’s weakened. But a similar concept exists with gold miners and equities.

Gold and Silver miners have for many months been trading at a healthy discount to the NAV of their reserves. Although the optionality provided by a long position in a miner should be worth something (since a rising gold price ought to create a disproportionate increase in the stock through operating leverage while if gold falls to unprofitable levels they can simply stop digging) the market continues to price the sector at a discount. One obvious move is to buy the Gold Miners ETF (GDX) and short gold itself (GLD). However, this means simply betting on a reversion to the mean of the relationship, and there’s no knowing when that might happen.

Instead, long GDX and short S&P 500 is an interesting trade. Gold is out of favor and a short position isn’t likely to provide much protection from here. If gold does sink, along with GDX, it’s likely to be in response to slower growth so the short equity hedge should provide some protection. But in that scenario the odds of QE increase, so reflation ought to provide some support for the yellow metal. Conversely, if the world avoids all the various disasters that may afflict it, rising markets are likely to lift commodities with them, and the weaker US$ that would result in that scenario would also provide support for GDX.

The correct hedge ratio is less than 1:1 – we prefer something closer to $1 of GDX versus short $0.75 of SPY. And the correlation between GDX and SPY is not as strong at with GLD, but we think this combinaton of exposures makes more sense. In the long run (i.e. years) we don’t think gold will perform as well as equities. Warren Buffett and others have articulated most eloquently the problems with an asset that does nothing, pays no dividend and costs money to store. But we’re entering a period where developed world central banks will be redoubling their efforts at reflating, with the ECB likely to adopt their own form of QE in the next several weeks. Long GDX allows one to invest in mining stocks at a current discount to their reserves without direct exposure to the relationship continuing to deteriorate. This is why we are currently invested in GDX in our Deep Value Equity Strategy, since we think it offers an attractive risk/return profile compared with the broader equity markets.

The chart below shows the last two years of a position long GDX/short 75% SPY, and also the S&P500 itself, both rebased to 100 on August 2, 2010.

Disclosure: Author is Long GDX

Interesting piece from NY Fed on negative interest rates and the possible behavioral changes they would cause. If banks were charged for leaving deposits with the Fed, they would in turn charge customers for holding balances. It could cause all kinds of odd outcomes; naturally individuals would hold much more cash, but for corporations and institutions that wouldn’t be feasible. It could cause bills to be paid early, or where the recipient is highly creditworthy paid in advance. Many more certified checks could wind up being issued – you could issue one to yourself to avoid bank charges on the deposited cash. And special purpose banks might spring up who would hold deposits in the form of cash in a vault (as opposed  to make loans).

It all illustrates the difficulties presented by deflation, which is why we can expect the Fed to use all means available to avoid such a situation.

I hadn’t got involved in the recent flotation of Manchester United (MANU), perhaps Britain’s best-known brand of (English) football club. Not just because I’m an Arsenal fan either, but because investments in sports franchises can often be a case of heart ruling head and the Glazers (current owners) were unlikely to be selling cheap.

But this morning I came across this wonderful article that shows MANU’s IPO foisted on hapless retail investors was “Facebookian” in its cavalier attitude towards earning a return for new owners. IPO buyers have virtually no voting control, little prospect of a near-term dividend and proudly possess shares trading at 106 times earnings, a level Mark Zuckerberg even failed to emulate. And MANU describes itself as an “emerging growth company” (in order to qualify for more lenient disclosure requirements), a scarcely credible notion for anyone who grew up watching them in the 70s or earlier.

As long as deals like MANU’s IPO can get done it shows that not everybody’s hunkered down waiting for one of the many looming disasters (Euro/Fiscal Cliff/Israel-Iran/China Crash) to hit.

A few weeks ago the London-based Alternative Investment Management Association (AIMA) issued a “comprehensive rebuttal” of my book, The Hedge Fund Mirage. AIMA’s mission is to promote the hedge fund industry, so one might anticipate a breathless endorsement of their paymasters, and in this they did not disappoint.

 
I didn’t bother commenting on their report because it didn’t receive any mainstream financial press coverage. Few serious journalists took them seriously. And in any case, AIMA’s clients (i.e. hedge funds) have (unfortunately for their clients) been helpfully providing further empirical support for my assertion that $2 trillion in AUM is more than they can usefully manage by generating consistently mediocre results at great expense.

 
But Jonathan Ford in today’s FT rightly questions whether the hedge fund industry as a whole is over capitalized. Mr. Ford is providing a far more useful perspective for consideration by those pension funds cramming ever more assets into hedge funds than the industry’s increasingly ineffective and far from impartial lobbyists.

A little known element of the Greek bond restructuring of several months back was the granting of warrants whose coupons were linked to Greece’s GDP. Maybe this was inspired by Professor Shiller’s suggestion (most recently in his book, “Finance and the Good Society”) in which he proposed that the U.S. issue “Trills”, securities whose coupons would pay one trillionth of GDP annually. Such an approach is pro-cyclical, in that it links a government’s cost of financing to economic growth. While there’s no chance of the U.S. adopting anything so radical, the problem facing southern European Euro members is that slow GDP growth impedes their ability to finance their existing debt, perversely driving up its cost as the risk of default overwhelms the subdued inflation expectations that would normally drive rates down.

The Greek warrants were an attempt to share some of that risk with their creditors, and as noted in the FT today these originally unloved instruments have performed quite well of late.

It illustrates the many unconventional tools and limitless ingenuity of the Europeans to maintain the Euro and keep the European project alive.

We have been invested in gold miners through GDX for some time. Gold has been a mediocre performer but a form of quantitative easing is looking increasingly likely in Europe. The London Daily Telegraph today also believes that Germany will endorse “capping” the spreads between the bonds of weaker Euro members and Germany. If implemented, this really would represent the a blank check for the ECB to finance Italy and Spain and thus prevent high borrowing costs from offsetting their budget discipline. While controversial in Germany, it makes financial assets (such as bonds) marginally less attractive and we think improves the case for investments in real assets including gold. We are invested in GDX in our Deep Value Equity Strategy.

Barron’s ran a piece on MLPs (Master Limited Partnerships) over the weekend. Regular readers of our research will know that we have long liked the sector and of course run an MLP strategy. Finding sources of investment income while avoiding the tyranny of conventional bonds manipulated by government intervention is what we do, and MLPs fit with that approach.

The article was positive but nonetheless balanced (at least in my opinion). We’ve avoided MLP funds (such as closed end funds, ETFs etc.) for many reasons, including tax-inefficiency and leverage (investing with leverage is something we avoid). The article made the case for MLP funds in retirement accounts and for smaller retail accounts, and while there’s no reason to contradict what they wrote it remains true that direct investments in MLPs are the most tax-efficient way for high net worth clients with, say, $500K and up to access the strategy. It’s worth reading the article.

Greece is seeking a two year extension of its latest austerity program, arguing that the additional time would improve its chances of ultimately bringing its debt down to a sustainable level. This is hardly news. Many observers had already concluded that the latest plan was as unworkable as prior ones. But it does illustrate that the inconclusive, status quo can persist indefinitely. As with the penalties envisaged in the Maastricht Treaty that ushered in the Euro, fiscal penalties on sovereign states are a nuclear option and as such are only valuable until they’re used.

While many analysts have forecast that Greece will either be dumped out of the Euro or will leave voluntarily, regardless of who initiates such a move the consequences are huge and unpredictable. As long as neither side miscalculates, it’s quite plausible for this seemingly perpetual round of renegotiations in which the Greeks seek forms of debt forbearance but stop short of provoking the EU to kick them out and the Germans keep squeezing but stop short of driving them out. As unsatisfying as this may seem to an outsider, why would it ever end?

By reducing the odds of an imminent Euro disaster it makes equity markets somewhat less risky, and bonds less attractive. Of course we still have to contend with the looming fiscal cliff in the U.S., a potentially far more damaging event for the U.S. economy and one whose resolution has been pushed off to a post-election lame-duck Congress with highly unpredictable results. Whatever your political leanings, virtually everyone must agree that this is an abrogation of responsibility by America’s leaders.