This post is part of a new series of newsletters that will be published here once a month by Paul Franke of Quantemonics Investing LLC. Many of you might not recognize him by the name Paul Franke although he has been part of our community from the beginning back in early 2009 and is one of our regular contributors.
The Quantemonics Relative Value portfolio has been lagging the sharp rise in the market since November 2011. Our safety minded and methodical approach to investing, with hedges and intelligent diversification, has been out of vogue. Fortunately, tomorrow is another day for long-term investors, and we continue to position ourselves for what could turn out to be another lackluster or even DOWN calendar year for stocks.
In many respects, the market is beginning to remind me of 1987, before the stock market crash of 40% over six weeks of trading. Back then, the market IGNORED any and all bad news for months, until all buying power was exhausted. Then rising interest rates created a vacuum of buyers and stock quotes plummeted back to reality. 2012 may see the same situation develop. While those throwing caution to the wind to chase stock prices ever higher may be rewarded for weeks or months longer, a laundry list of problems (many of which are GROWING in size) will eventually catch up to investors, in our humble opinion.
Very quietly interest rates in the U.S. having been rising during 2012, and now stand at the highest level in 5 months to 12 months (depending on which coupon date of the Treasury yield curve you are viewing). The Federal Reserve will have an increasingly difficult time keeping rates near ZERO as commodities, particularly oil, have been zig-zagging higher with stocks for months. A complete lack of “balance” in the economy (from all the deficits and money printing going on for years) and disconnect between the various markets is what has Quantemonics more than a little worried about future stock pricing. Honest economic growth requires an honest balance of variables, and we do not have that in 2012. I would argue 2012 is seeing incredible imbalances in the global economy, and ignoring them to chase stock rallies daily may prove quite harmful to your net worth, when the tide changes.
For investors wanting to diversify into a low beta, hedged product, with unlimited upside, but controlled and limited downside, we hope you will consider our Relative Value fund on Covestor. Few others are setting up similar risk-adjusted portfolios, and we have done a respectable job performance-wise since our inception a year ago. With near zero portfolio beta (similar to cash-like investments), but significant potential upside when our stocks outperform the market, our nearly net neutral design is a terrific way to hedge the blues away! A big market sell-off, especially coming without warning, will affect Relative Value very little compared to the mostly long portfolio setups available to investors generally.
With the latest 10% rise in stock prices since December, we are back to the same forecasted range of likely forward 12-month stock market returns as we were in the spring of 2011, with +10% potential upside vs. -30% potential downside. Then we underwent a 20% stock market decline in the summer and fall of 2011. Based on our computer models and 25 years of trading experience, we have pulled back our net market exposure into NEGATIVE territory the last four weeks. Today we are near -10% for market exposure, down from our +40% net long high exposure in January. Our squiggly little Covestor performance line can attest to our lack of upside participation since mid-January, as we are now forsaking additional market gains for the long-term protection of a fully hedged portfolio. We are very worried about losing significant amounts of capital into the summer, by taking on anything close to normal market “risks” associated with a fully long invested portfolio.
We believe our strategy will see just rewards in time, and look forward to the buying opportunity that is approaching on a large market sell-off. In the meantime we have been slowly accumulating energy and oil/gas related stocks since late-2011. We recently explained some of the math regarding the incomparable squeeze in oil supplies globally taking place in 2011-12. We believe oil/energy prices are in the early stages of a shocking and significant spike higher in 2012-13. Please read part one of a two part series posted March 12 on The Motley Fool Blog Network highlighting our projection for a coming jump in oil prices. The linked material, stories and data make a compelling case in combination that sub-US$100 a barrel crude oil may be a thing of the past. Look for the second part of our oil blog series in the coming week or two.