Trade Talk

July 3, 2009

One line in today's Wall Street Journal summarizes why we just cut back (a bit) on stocks in most of our model portfolios:

"Mutual funds saw net inflows for the 15th consecutive week...bringing the total inflows for the past 15 weeks to more than $150 billion....Weekly outflows from stock funds topped $10 billion earlier this year before the market started to rebound in March.

We manage the MAXadvisor Powerfund Portfolios as contrarian investors. When fund investors are panicking and taking money out of stock funds, we try to increase our allocations. When they get their nerve back, often after a big rally, we tend to cut back. This doesn't make gut sense; stocks sure seem safer today than back in early March when the 'D' word (Depression) was being bandied about, but that's the irony of the stock market: It has more upside potential when it seems to have more downside risk and more downside risk when it seems to have more upside.

Another indicator (besides mutual fund outflows) that stocks and higher risk bonds are no longer scaring investors is the discount on closed-end funds.

Closed-end funds are mutual funds with a fixed number of shares. Unlike modern ETFs and old-fashioned open-end funds (which make up most of the holdings of the Powerfund Portfolios), shares are not created or closed because of fund investor buying and selling. Instead the price the fund trades on the exchange moves often more or less than the underlying value of the fund.

Say a fund is priced at $10 a share, meaning the fund has, say, $100 million in assets (stocks and bonds) and 10 million shares outstanding. If that fund is an emerging market fund and it performs well and gets increasingly popular, the assets may climb to $150 million after a 50% increase in the value of the holdings, which would take the fund value to $15 a share, but the fund price on the exchange may zoom up to $20 a share, or trade at a $5 or 33% premium to "net asset value" (the real value per share).

Ordinarily closed-end funds trade at a slight discount (which is why buying them at the IPO from a full-service broker is almost always a bad idea). But when the market is in a tailspin, decent funds can be had for 10, 20, even 30% discounts to fund value (crummy higher-fee funds may always trade at wide discounts).

During the market slide we moved into some closed-end funds that own bonds. As is often the case, the heavy panic subsided and the discount shrunk. We used this opportunity to continue to sell these specific funds, but it is also a good indicator that 'distressed' debt is not so cheap anymore because investors think the economy has turned the corner

Maybe it has and maybe it hasn't. All we know is when most investors think the market's upside is big, that upside tends to be small. It can even make sense to just take a little less risk.

If this market continues to rise at this pace, we'll keep cutting back and eventually return to the stock allocations we had when the Dow was at 14,000.

The trades we just made were specifically to get out of our recent move into financials, near the market bottom in March 2009.

Our roughly 60% return in four months (double the overall market) in the Financials Select Sector SPDR ETF (XLF) marks a good exit point from financial services stocks. While financial stocks may have more upside, the bargains are gone and we don’t expect the sector to outperform the market going forward - the main reason to own a sector fund in the first place. For the time being we are increasing our bond allocation even though bonds are not screaming buys at current yields. We think we may see some more interesting stock fund opportunities in coming months. (For our Daredevil portfolio, we are cutting back on an even hotter fund we bought in March, our Russian ETF (RSX), which is up roughly 80% even despite a recent pullback. We also made some more significant changes to the Daredevil portfolio. (Please read Daredevil trade commentary for more detail.)

As we've been noting during this comeback, it does look like the government, in its infinite costly bumbling, did stop a train wreck in the financial sector, perhaps literally by making a pile of money for the train to ride into softly and safely.

Things were getting ugly, fast and government support helped stop the panic - hopefully for good or at least until the next bubble/crash cycle. This costly adventure for government will keep the lid on future economic growth (and earnings and therefore stock prices) for at least the next few years. We sincerely hope the executives at Goldman Sachs and other banks appreciate the fact that they would have lost their banks a few months ago, like Bear Stearns and Lehman Brothers, if not for the government. Too bad the government didn't get more upside for its efforts. Maybe taxpayers wouldn't be quite so on the hook for our generosity.