I have enjoyed a constructive and helpful relationship with Seeking Alpha, where I was one of the earliest contributors. My message is not the most popular in that group, but I have a loyal audience there. Seeking Alpha runs most but not all of my articles. Occasionally I do something with them that I republish here.
SA has kindly included me in their regular interview series. They ask investment managers about their ideas and opinions on the current market conditions. One thing I like about this approach is that the questions from Jonathan Liss helped me frame answers that went beyond my regular blog agenda.
I enjoyed doing this interview, which they ran last weekend, and I wanted readers of "A Dash" to have the same information while it was still fresh.
Here is the complete interview.
Jeffrey A. Miller, PhD, is CEO and President of New Arc Investments. Also a fund manager at the firm, he has guided the Sector Rotation Fund throughout its exceptional history. Before beginning his financial career in October 1987, Jeff was a college professor who worked extensively with quantitative modeling of sophisticated state and local tax issues. He is the author of the A Dash of Insight blog.
Seeking Alpha's Jonathan Liss recently spoke with Miller to find out how he planned to position clients in Q2 in light of his understanding of how a range of macro-economic trends were likely to unfold in the coming quarter and beyond:
Seeking Alpha (SA): Welcome back Jeff. This has been an extremely eventful quarter with many geopolitical events driving global markets. Before we get down to specifics, how would you characterize your general approach to portfolio building and asset allocation strategies in your client accounts?
Jeff Miller (JM): Thanks, Jonathan. Like other SA readers I benefit from reading this series, and I appreciate the opportunity to join in.
We treat each investor as unique. I start by asking whether the client is mostly preserving wealth or needs to create wealth. If we are building wealth, the big question is, “How much risk is reasonable and appropriate?” Those who approach investing by asking what they want to gain, or swinging for the fences are heading for disappointment. (I’m shifting into baseball analogy mode since March Madness is over.)
Once I have the facts about client needs, I make a proposal reflecting a combination of our various programs. There is no single answer. Too many people that I meet have blundered in trying to time the market with big moves. They read or hear something and over-react, going “all-in” or completely to cash at the wrong times. This often happens when someone has the wrong asset allocation and looks too frequently at returns.
To take two extreme examples, when Warren Buffett or Bill Gross is quoted, it is a general comment, not specific advice. You need to put it in the context of your own specific situation.
SA: Where would you plot U.S. equities as an asset class on the risk curve right now?
JM: There has been a significant change since we last spoke, but not in the way you might think. Things are better.
This is a very misunderstood market. There is a large contingent of fund managers, traders, and investors who have missed a major part of the rally. This has come from a permanent focus on worries and headwinds, without any effort at quantification. Mystified by the most hated rally in history, those who have been wrong call this a “suckers’ rally” and attribute everything to the Fed and money printing.
One of my most frequent themes is the error of mixing your politics and your investing. People should join me in being a citizen in the voting booth and a political agnostic when investing.
As the end of QE II approaches, I think we are going to see something akin to the infamous Y2K effect. The Fed will wind down programs as the economy improves. Fed policy is an overly simplistic explanation for the rally in stocks, and the end of QE II will not be the demise.
To avoid the well-known confirmation bias effect, I have a disciplined weekly review that has an objective focus on data. If you cannot quantify it, it is merely on the “watch list.” Most of the things that generate TV ratings, newspaper sales, and online page views are related to fear. We won’t read articles about why things are OK until it is too late. I wonder how many people were frightened out of their investments last month during the Japan situation because everyone is looking for another 2008 or a new black swan. This was only a 7% correction. We are likely to see larger pullbacks during the year, even if the final result is very strong.
People should look at data, not laundry lists of headwinds. Look to expected earnings, economic prospects, and risk. The market is very attractive on all of these fronts. The earnings yield is comparable to the market bottom in 2009, and the risk is much lower. For those who wish to follow this data-based approach, my wonderful SA editor (who is too bashful to take any credit) has helped me craft a weekly column where I review the data and toss in my own observations.
SA: Last time we spoke, you mentioned that every day you ask yourself: "Which five ETFs are the best choices for the coming twelve months?" What's on your list currently?
JM: Let me start by recapping how we do this. We include a carefully selected universe of 56 ETFs. We chose this fund universe to avoid a situation where our "top five" had all chip sectors, all Latin America, or the like. We picked a top representative for each sector group, based on liquidity and a narrow bid/ask spread.
I want to be clear. We ask the question each day. We are not "buy-and-hold" so we do not hold the positions for a year. This is active management. If you ask the "one year" question every day, you get about thirty changes in the portfolio. The portfolio also includes fixed income ETFs and three inverse ETFs. We can get very conservative, and even go short if that is indicated.
With that in mind, here are the current positions:
- GDX – Gold miners – an inflation hedge, riding the wave to new highs. Many people buy gold in the wrong way.
- KOL – A good US method for playing economic growth and rising oil prices via a cheaper source.
- PXQ – The demand for networking continues to grow, and the stocks reflect the underlying fundamentals.
- XLE – A great way to play energy without specific stock risk.
- XOP – Oil and Gas exploration and production – This gets us more “upstream” as the realization hits home that more production is necessary. This is correlated with XLE, yet different.
1-Year Performance Chart
click to enlarge
chart courtesy of StockCharts.com
As you can see, our Dynamic Asset Allocation model has led us to a significant exposure to energy holdings. It has been an effective move.
SA: The situation in Libya and general unrest we've seen throughout the Middle East during the first quarter demonstrate the inherent risks involved in frontier and emerging market investing. Have you decided to underweight these markets as a result of the regional situation or have you put more money to work in client portfolios on the assumption that the push towards democracy will ultimately be beneficial for these markets?
JM: As a citizen, I applaud the push toward democracy. I am unhappy with the uneven involvement and the potential for “mission creep.” As an investment manager my biggest decision has been that the pressure on energy prices is likely to continue.
There is probably $10 or $15 built into the price of oil due to MENA concerns. Even if those were relieved (and I don’t see how that is likely) we still have some major fundamental factors. Did anyone notice that Warren Buffett is going to sell auto insurance in India? In China they have 25 million drivers. That means about a billion to go. We are way behind in adjusting our national energy policies.
Bad news for us as citizens. Good news for us as investors.
SA: Discussing oil further, how high is it heading and how are you planning to play? Will rising crude prices significantly impede the economic recovery, or will it not be as bad as feared? Are you hedging against rising oil in any way in client portfolios?
JM: No one really knows how high oil will go in the short term, but as I noted in my last answer, there is no easy solution. Higher prices will come eventually from global demand. The current level of prices is probably tolerable for the economy, but I am watching this situation closely. Holding positions in energy stocks is a good hedge.
SA: In the wake of the triple disaster there, are Japanese equities undervalued right now? Has a Japan play crept into your client portfolios in any way?
JM: My first thought always goes to those who lost family members in this disaster. There are many stories of courage, and I am confident that the Japanese people will show strength in rebuilding. I am not yet ready to make direct investments. We are always looking for opportunities, but with a careful eye on risk. I think the risk/reward balance on Japan will be better when we have more clarity on the effects and prospects. Meanwhile, some of our holdings, like CAT, will participate in the reconstruction efforts.
Our proprietary short-term ETF model, 'Felix', has all of the Japanese ETFs in what we call the “penalty box.” This implies a high level of the various risk factors we have identified in our research.
SA: How are you positioning with regard to the situation in the EU? Do European equities remain a bad bet right now? How much are we in the U.S. at risk of contagion from the situation in the eurozone?
JM: The European situation is a great example of my point about worries. This story started almost a year ago, with many highly-publicized sources saying that the euro would go to parity with the dollar. Respected veterans like Art Cashin were warning of a market crash if the dollar got stronger. I love Art, and he accurately reflects the concerns of people on the floor. They noted that stocks were trading inversely with the dollar, but they were dead wrong about the euro.
I follow the St. Louis Fed Stress Index (SLFSI). It has eighteen factors – rates, credit spreads, the VIX – all proven links to market risks. The bond and options markets are sensitive indicators of change. If the European problems do not show up in these indicators, there is no contagion.
There are a lot of countries in the world, and there is always a problem somewhere. If you wait for perfection, you will never invest in stocks. I am not investing directly in Europe, but I will not worry about contagion until there is some tangible reaction in the SLFSI.
SA: Moving over to fixed income, are you still sticking with investment grade corporates? How are you handling the needs of retirees requiring current income in this yield environment?
JM: I wrote a few pieces on what I call "The Quest for Yield.” For investors who should be in bonds, I am doing bond ladders. This allows me to adjust rapidly as rates rise – as we all expect. I emphasize total return, so I look for some good dividend stocks and some accounts participate in my enhanced yield program. We do covered calls in stocks that meet my criteria. This is a great way of getting regular income if you can find stocks with limited downside.
I do not have any junk bond positions since the risk/reward seems to be less attractive than the underlying stocks.
SA: Name one ETF investment that worked out particularly well during Q1 and one that did not.
JM: The best result so far was from XME (metals and mining), one of the ETFs I highlighted in January. We sold the position on March 18th for a 15% gain. We really haven’t had any big losers. GDX (gold stocks) dropped right after the January interview, something you helped me to pass along in an update. We took a 5% loss at the time. Since then we have gotten back in and made back the loss and more. It is a current position.
Disclosure: Jeff Miller own CAT personally and in client accounts, as well as the ETF names as model choices.