[This post originally appeared on Seeking Alpha last week. I enjoy a wide following there, and I appreciate the opportunity to participate in their annual series. As I note at the beginning of the interview, this is a very valuable resource. I share the interview with readers of "A Dash" with the permission of Seeking Alpha.]
This is the tenth piece in Seeking Alpha's Positioning for 2014 series. This year we have once again asked experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond. As always, the focus is on an overall approach to portfolio construction.
Jeff Miller is the President of NewArc Investments Inc., manager of both individual and institutional investments. He is a registered investment advisor, and portfolio manager for NewArc's investment programs. Jeff is a former college professor with a hands-on, real world attitude. He began in the financial business as Research Director for trading firm at the Chicago Board Options Exchange. Jeff investigated anomalies in the standard option pricing models, taught classes for beginning options traders, and developed new forecasting techniques. In 1991 he established a general research consultancy, working with professional traders at all of the Chicago financial exchanges. In 1998 he started NewArc Investments, Inc.
Seeking Alpha's Abby Carmel and Jonathon Liss recently spoke with Jeff to find out how he planned to position clients in 2014 in light of his understanding of how a range of market themes were likely to unfold in the coming year.
SA Editors (SA): How would you describe your investing style/philosophy, broadly speaking?
Jeff Miller (JM): Thanks again for including me in this series. There are many investment previews, but your questions and selection of participants makes the Seeking Alpha preview "must reading" for investors. I always enjoy and learn from the entire series.
Turning to my own investment approach - I emphasize active management, a focus on risk, and attention to each client. We have six different programs, with a wide range of stock market exposure and risk. I am free to change with the evidence, and always with changes in client needs. Like other fixed-fee managers, my financial interests are completely aligned with investors.
The single most important step is to right-size risk. Some people simply need to preserve wealth. Since bond funds are dangerous, I build a bond ladder instead. Most people still need to build wealth, but they also need to protect assets. This means having a solid foundation, a reasonable level of exposure to stocks, and a careful eye on risk factors.
Most investors overreact to headlines. Since I am focused on data and objective indicators, I can help them with that.
(SA): As we approach 2014, are you more bullish or bearish?
(JM): I am expecting another solid year for stocks. The underlying market fundamentals - earnings, reduced risks, improving economy - are all still in place. The indicators that I favor on all of these elements have been spot on. I notice that many people are worried about the market for the wrong reasons.
Here are some current mistakes:
People worry that the cycle is longer than the average. Of course, we had a very steep decline and a recovery hampered by Washington. This economic cycle will definitely be longer - perhaps much longer.
Pundits warn that individual investors are switching from bonds to stocks, marking the end of the cycle. The rush for bonds took decades. The "Great Rotation" to stocks is only a few months old. This theme may play out for several years.
Some highlight the Fed, now switching course. The fixation on the Fed is the single biggest mistake. Defined in traditional terms - very low interest rates - the Fed will continue to be supportive for at least two more years. The gradual end of new QE purchases means very little to market fundamentals. We should worry about "fighting the Fed" when there is a policy that is actually restrictive.
The rise of speculation. I do not mind speculation if the risk/reward and overall size are right. Too many investors are piling into story stocks because they lack confidence in the economy and market fundamentals. Speculation is an alternative - not a substitute for an investment program. It is not a bubble indicator, since it is not pervasive as it was in 2000.
(SA): You seem to be comfortable with current market valuations. What do you make of Robert Shiller's CAPE ratio which is currently well above its long-term average (as of November it was above 25 vs. a long-term average of just 16.5) and his advice to investors to start 'reducing [equity] holdings a bit'? Is it painting an unrealistic picture of earnings because the last 10 years were so weak on the earnings front? Or are the last 10 years of earnings the 'new normal' so to speak?
(JM): I admire Prof. Shiller, whose comments are often taken out of context. He and I have different missions. My main focus is helping individual investors, sharing information that I provide to my own clients. The "valuation debate" is a costly distraction for most. Every interview with Shiller involves someone asking him if we are in a bubble or whether there might be a market crash. His personality and methods lead him to be conservative, but he always recommends that people should own stocks. Those quoting him seem to miss this.
Here are two important thoughts:
Shiller worried about a double-dip recession in the summers of 2010, 2011, and 2012. This is not his specialty so I focus on other sources.
The most informed consumers of CAPE are Barclays and Jeff Gundlach's DoubleLine. Both have implemented Dr. Shiller's method, but neither uses CAPE for overall market timing. (I wrote about the Barclay approach here.) Instead, they use it to identify the best sectors to buy. This is remarkably similar to what I do with individual stocks and sectors - and I was doing it before them.
(SA): What do you feel are the major catalysts for the global market in 2014 and beyond?
(JM): My investment approach starts with the macro, leads to sector choices, and ultimately to stock picks that represent the best value in those sectors. Looking to the major economic themes is therefore a great starting point. Here are the most important ideas for next year - very different from what you might see elsewhere:
A steepening yield curve. The Fed is holding the very short rates at zero and long-term rates are moving higher. These rates reflect an improving economy and perhaps less worry by Europeans.
The middle part of the economic cycle. The recessionistas have been wrong. The best sources (which I highlight every week in my WTWA series) show that we are not yet close to a peak in the business cycle - and that is when recessions start. The fundamental analysis from Bob Dieli's method is confirmed by technical analysis highlighted by Andrew Thrasher (see both here with links for more). Here is another nice analysis from Fidelity - which sectors are best at various stages of the business cycle. It is very important to know.
Housing is improving. There are plenty of skeptics, but Bill McBride of Calculated Risk is the best source on this. He does a great job with many different indicators and has won the respect of the professional economic community. Many other housing "experts" are pandering for ratings or page views. One of the things that has helped me the most is a relentless mission to find the best experts.
Continuing improvement in Europe. This has been a multi-year process of negotiation, compromise, and doing the minimum that was necessary. Traders are uncomfortable with this, and so are economists. It is familiar territory for those experienced with political processes. If you understood that this would be a gradual process, you had an advantage on the European issue. I wrote about it here.
Multiples (the market P/E) will move higher. Most pundits are skeptical, viewing the current multiple as already too high and/or disparaging last year's increase. They need a history lesson! The relationship between the forward P/E ratio and interest rates is curvilinear. When interest rates get very low, it reflects deflation concern and skepticism about future earnings. As economic prospects get better, and confidence increases, the multiple moves higher. Most of Wall Street has an overly simplistic view of this relationship, so the increase in the market multiple has taken them by surprise. This may be the area where my firm's research has been the most helpful in staying the course as conditions get better. See here or scroll to the end of this post (where I explained "upside risk" to see a similar conclusion from JPMorgan.)
(SA): Which asset classes are you overweight? Which are you underweight? Why?
(JM): The market themes each imply an idea for sectors and asset classes.
A steep yield curve favors banks and financials. This is a good theme for 2014.
The current cycle position implies an overweight in economically sensitive stocks, technology, and financials. These are all great choices.
Housing is a more difficult theme, since the direct plays are already richly valued. There are secondary themes in things that people buy with a new home - furnishings and appliances. There is the F-150 play, since pickup trucks are related to construction. This is a theme that I am exploring, but without current holdings.
Gold. I want to comment on this, since it is a continuing theme for investors who are scared witless (TM OldProf). Gold is a good choice when there is huge fear of inflation or depression - neither of which is in prospect. Despite this, I always agree to a smidgen of gold in the portfolio - say 5% or even a touch more. It provides a comfort level that helps people have confidence. Stocks are a better inflation hedge.
(SA): To which index or fund do you benchmark your performance?
(JM): I understand the question, but it applies better to someone with a fund or a single program. I try to set expectations for each client, based upon their goals and market conditions. Most of them do not care about losing less when the market moves lower. Some of them look backward and wonder why we did not take more risk. You can always save money by canceling your fire insurance!
To summarize, some of my programs are geared to a target return. Bond ladder clients know what to expect going in. Enhanced Yield clients have a dividend stock program with covered calls, designed as a cautious bond proxy and targeted for 9% after commissions and fees, even in a sideways or slightly declining market. Other programs are thematic and aggressive, expected to beat the S&P 500 significantly in the long run.
(SA): 'Smart beta' and alternative weighting schemes have been all the rage and continue to gain assets as we head into 2014. Have you considered using any of these strategies (and their associated ETFs) in client accounts? How do you determine when a new strategy is scientifically sound?'
(JM): I do not use these approaches because I am already doing it better with my client-specific programs. The early track record of these methods is not good, despite the fees.
(SA): What is your highest conviction pick heading into the new year and why?
(JM): I realize why the question is relevant, and I have some ideas. I really hope that people think through an investment process instead of jumping to recommended stocks. I had a multi-year record of stock calls that beat the market. Last year my themes were accurate, as was the market take. Some of the stocks stumbled. Let's try to improve this year!
Financials - Some of the pure plays on big banks will work, but I am looking to regional and smaller banks as well. XLF is a good choice if you do not want to analyze specific stocks.
Cyclical plays. I still like CAT, but it has been linked with mining and emerging markets, and we want a pure play on economic growth. There are some good values here, but others are extended. I'm still working on this group, and I will definitely add exposure. I analyze cyclical stocks by using Chuck Carnevale's F.A.S.T. Graphs to view earnings trends in multiple time frames, covering more than one business cycle. (Note the similarity to the Shiller method of valuation.)
Combining yield curve and housing, I like NLY. The call premium is rich, so this is a good candidate for a yield play with sales of near-term calls. There is risk if long-term rates rise too quickly.
Technology is still attractive. I see it in two tiers. Some candidates are exciting upside plays. Others are solid but a bit stodgier. The former group constitute growth stocks like AAPL, CTSH, and GOOG. The latter group has the safety I require for my Enhanced Yield program. IBM, CSCO, or INTC moving sideways works very well when you can collect dividends and repeatedly sell near-term calls.
(SA): Where have you been having retirees turn for income in this low rate environment?
(JM): I created our Enhanced Yield program with income-oriented retirees in mind. Many are jumping on the covered call bandwagon, but most of these programs are lazy (using long-term calls) and have high risk (since they include too many stocks). I developed our approach as a bond proxy. We make most of our return from call sales and some from dividends. The stock selections are very conservative. I manage the program with the retiree in mind. I watch all of my risk indicators and often carry cash when indicated. Our outperformance relative to our target comes from the selection of stocks and options.
(SA): For investors with a long-term horizon and a reasonable risk tolerance, what is the ideal asset allocation?
(JM): I understand the question, but let me answer it a bit differently. Nearly every investor I meet has too little exposure to stocks. Even the most intelligent and best-informed wind up seduced by the fear sites and scary headlines.
Most investors should take their traditional allocation and up the stock portion by 10% or so. Young investors with a long time horizon can have a strong emphasis on stocks. Retirees need a stock component to keep up with inflation.
(SA): What advice would you give to a 'do-it-yourself' investor looking at opportunities in the present environment?
(JM): I can answer this easily by following what I do with a new client.
Find the right level of risk. Be prepared for a 20% market correction that has no fundamental reason. At some point, this will happen, just as it did in 2011. If you have not "right-sized" your risk, you will be tempted to bail out at the wrong moment.
Find a method you believe in and stick with it. Otherwise you will sell the bottom and buy the top.
Go cautiously with stock tips. Make sure that you have a good reason for your purchase and re-evaluate regularly. If you are inclined to "swing for the fences" then allocate a small portion of your portfolio for this. Stick to the fundamentals for your main investments.
Do not waste time reading information designed to scare you. There will be lots of charts that seem persuasive. Unless you are prepared to do a lot of work, you will be a victim.
Find some valid indicators of risk and monitor them closely. If risk moves higher, reduce your position sizes. Investing is mostly about the right level of risk, not what return you hope to make.
(SA): Any additional considerations you'd like to share with readers as they ponder their investing strategy in 2014 and beyond?
(JM): I recommend reviewing results as a part of the strategic process. If someone has been completely wrong about Europe, recessions, interest rates, the Fed, and stocks - and been wrong for years - maybe it is time to tune out from that source!
I started my work on 2014 by reviewing what was hot and not last year.
Disclosure: We own CAT, FEZ, AFL, NLY, AAPL, CTSH, CSCO and INTC.
To read other pieces from Seeking Alpha's Positioning for 2014 series, click here.