What Do You Think The Real Answer Is?

In This Issue:

An Update on Our Performance
Which Rally Is It?
An Update on Our Performance
Earnings - Great Expectations
Comparing Current Economic Data
The Three Lying Bears
Putting the Pieces Together
Portfolio Performance Analysis
An Important Announcement

Wall Street has been doing the stock hard-sell for more than a year now and you'd think they'd be getting tired. They've been using the financial networks to permeate their message that now is really the best time to buy. However, Wall Street is currently admitting to have jumped the gun the other dozen or so times, but they insist they have it right this time.

And it's amazing the logic they proffer to back these claims. Most, of course, make decisions based on valuations. We've heard it all before-as stock prices fall, valuations get more attractive. They conveniently forget to mention that this approach bankrupted many in stocks like WorldCom, Enron and Adelphia. If you corner them on this, they admit that no strategy is perfect, and follow it up by saying, valuations really are very attractive right now.

And this is not the only evidence they use to support their claims. Inflation is low, interest rates are attractive, and unemployment is nowhere near the level seen during the Great Depression. The economy is still doing fine, or so the argument goes.

What do you think the real answer is? Are fundamental measures so compelling that it is time to jump back in with both feet and buy? Is this really the bottom and are you about to miss the best buying opportunity of your lifetime?

Have you ever heard of the saying - garbage in, garbage out? In this letter I am going to peel back the curtain and show you some of the real numbers I use to truly evaluate the health of our economy. When I say real, I mean the numbers that your government and most long-only mangers don't want you to see or understand. By the end of this letter, it is my hope that you will be better prepared to answer the time-to-buy arguments that you read in the papers and hear on TV these days.

An Update on Our Performance

February was another strong month for our portfolios and another dismal month for the markets. The first quarter is shaping up to be one of our best quarters since the launch of our multi-manager portfolios.

Below are recent performance returns on the four portfolios we currently offer:

 


Past 12

YTD

Feb

Name

Months

2009

2009

Income Builder  (IB)

-10.66%

-5.27%

-1.50%

The Guardian  (GRD)

-0.56%

1.94%

1.84%

Harmony Plus  (HMY)

10.28%

6.70%

4.20%

The Expedition  (EXP)

21.58%

12.18%

6.86%

S&P 500  (SP500)

-43.32%

-18.18%

-10.65%

Important Performance Disclosure




ProfitScore provides separately-managed accounts for individuals, advisors and institutions.  If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

  1. Complete our Private Client Group request form by clicking here http://profitscore.com/clientgroup.aspx and submitting your contact information. (This is the most preferred method.)
  2. Call us directly at (800) 731-5690.
  3. Simply send us an email to info@profitscore.com.

Someone will contact you within 24 hours of receiving your information.

Which Rally Is It?

I find it interesting how comparisons between this bear market and previous bear markets have changed.  When this bear market began, you mostly saw comparisons to the 2001-2002 bear market.  As the market worsened, you started seeing comparisons to the 1980-1982 and then the 1973-1974 bear market.  Around October of last year, Wall Street finally began comparing current events to the Great Depression and now that is about the only comparison you see.  From my observation, it appears that most people now fully understand the severity of economic events.

On cue with March's impressive rally, market cheerleaders (the long-only mangers who have suffered incredible losses on behalf of their clients) are out in force, rooting for people to buy because it is the opportunity of life time.  The current argument is that March's rally is so strong and powerful that you would have to go back to the Great Depression to find a rally this powerful.  There were many impressive rallies that occurred during the Great Depression, so it's ironic that market cheerleaders chose to select one of the rallies that happened near the intermediate term bottom of the market in 1932.      

The biggest monthly gains in the market history can all be found in the grips of bear markets.  These quick and powerful rallies tend to be fueled by short covering and hopeful investors that jump back into the market so they don't miss a buying opportunity.  To give you more insight on the ebbs and flows that occurred during the Great Depression, please refer to the table below.

 

 


Cumulative Return

  

Average Annual Return

Indexes

Mth.

YTD

1 yr

  

3 yr

5 yr

10 yr

  

  

  

  

  

  

  

  

CSFB L/S *

-1.34

-1.51

-19.29


-0.51

3.91

7.53

CSFB Multi-St. *

-0.09

3.26

-19.47


1.31

2.43

5.78

Barclay F-of-F *

-0.12

0.60

-20.36


-3.36

0.70

5.56

S&P 500

-10.65

-18.18

-43.42


-15.11

-6.64

-3.43

Barclay HY

-3.10

2.70

-22.07


-5.45

0.59

2.36

Barclay Agg.

-0.38

-1.26

2.06


4.94

4.00

5.61









* Note:

Estimated monthly performance



Due to heightened levels of volatility, there has been no change in our reduced investment allocation.  We expect volatility to remain at historically high levels for some time, so our overall investment allocation remains muted to normalize the market's volatility.      

The first two months of 2009 made the record books as the worst start to any year in our history.  During this severely declining market, our long/short traders managed to produce high double digit gains and our long bias sector traders also managed to put green on the board.  Government intervention into the fixed income markets continues unabated.  Removing sharp objects from my office has improved my safety as I try to navigate these manipulated fixed income markets.       

Index Advantage:

During February the S&P 500 index was down -10.65% and our Long/Short traders produced gains of 10.79%.  Because volatility remains so high, our overall investment allocation within this allocation remains 25% or less.  Our trading accuracy for the month once again exceeded 80%, with no losing weeks and few losing days.  For the month this allocation outperformed the index by an impressive 21.44%

For the month, this pillar gained 10.79%. 

Strategic Balance:

Because most of the days in February were negative, our mostly long bias traders spent more than 90% of their time in the safety and security of cash.  The small and high probability traders that were placed managed to produce a small gain of 1.0% for this important diversifying allocation.                         

For the month, this pillar earned 1.00%.      

Dynamic Income:

Every month seems to have a different but similar sounding story.  On the bright side, the loss in February got smaller as the month progressed.  However, we had another losing month for this important allocation.  The Government finally publicly announced in March that they are buying/manipulating the long end of the yield curve.  We unfortunately were on the wrong side of the trade on the day they released this hurtful information.  I continue to have faith that free markets will eventually prevail. 

For the month, this pillar earned -1.25%.

Our portfolios are built using varying distributions to the strategic allocations discussed above.  To view detailed performance and risk statistics information about our investment portfolios for the month, please click on the links below: 

If You Are a Client, Don't Be Confused.
Actual management and performance fees are incurred monthly but are deducted from client accounts in the first month of every quarter (January, April, July, and October).  For performance reporting purposes, we deduct fees monthly as they incur and not quarterly, as they are reflected in client statements.  It all washes out in the end, but this may cause your account performance to deviate from our published performance reports on a month-to-month basis.  To be conservative, we also deduct the maximum fees we charge from our performance reports and your actual overall fees paid may be less than our maximum. 


An Important Announcement

I generally discuss something personal in this section of the letter so my readers get to know me on a different level.  For this letter, I ask for your permission to stray from this tradition so I can make an important announcement. 

We have been building technology solutions at ProfitScore for longer than I care to admit.  Heck, on some days I feel more like a technology consultant than a money manager.  This work has finally paid off because we are now able to offer our portfolios at other custodial platforms, expanding our ability to offer our absolute- returns to other investment advisors and their clients. 

If you are an investment advisor and your client assets are held at Fidelity, Schwab, National Financial, or Trust Company of America, you can now put ProfitScore to work as a sub-advisor for your clients' assets.  We were recently approved as a manager on Schwab's Managed Market Place and are about to be approved on Fidelity's, as well.  So putting us to work is as easy as checking a box, printing off an LPOA and getting a signature from your clients.  No other paperwork is required and nothing in your advisory practice has to change.  It will be business as usual, except that you will be hiring me and my team of managers to make money for you and your clients in up or down markets.     

We have spoken to many advisors over the past several months and have worked hard to minimize the effort required to hire ProfitScore as a sub-advisor for your clients' assets.  If you would like to learn more details, please send an email to advisor@profitscore.com or call (888) 981-7799 and someone will contact you within 48 hours. 

Take care and stay in touch.


Working to grow your wealth,


John M. McClure
President & CEO
ProfitScore Capital Management, Inc.


P.S. If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

Someone will contact you within 24 hours of receiving your

 


Table courtesy of http://www.dshort.com/

My question to you is which rally do you think we are in?     

Earnings - Great Expectations

Let's first examine valuations. A March 7, 2009 Barron's article entitled, "Ouch, That Hurt!" began with the following statement.

"In a worst-case scenario, based on current earnings estimates and the most pessimistic reading of market history, the Dow could fall a further 25%, to 5000, and the S&P could drop to about 500. The Dow industrials closed at 6,627 Friday, and the S&P 500 ended at 683, both down 24% so far this year and both at 12-year lows."

This was followed by the earnings estimate and analysis.

"Citigroup financial economist Steve Wieting sees $51 in operating profits for the companies in the S&P 500 this year before big write-downs, down from $66 in 2008.

Based on his estimate, which is in line with the current Wall Street consensus, the S&P 500 is valued at more than 13 times projected 2009 profits. That price/earnings multiple is in line with the lowest levels hit during most bear markets over the past 80 years. Key exceptions were 1974, 1982 and 1987, when the S&P 500 was valued at about 10 times forward earnings, according to Goldman Sachs. If stocks do get to a P/E of 10, the S&P 500 could drop as low as 500, a decline of more than 35% from current levels, and the Dow Jones Industrial Average could drop toward 5000."

Barron's writer Andrew Bary went on to argue that current stock valuations were "inexpensive relative to U.S. economic output, book value and gold. The stock market is currently valued at less than 60% of the U.S. gross domestic product of $14 trillion. That is the lowest stocks have been relative to annual economic output since the early 1990s."

So where is the problem? Earnings for the more than 4000 companies that report quarterly earnings are now negative. In other words, earnings are now losses. This makes Steve Wieting's estimate (above) for S&P500 earnings at $51 in 2009 incredibly optimistic.

But, as we see from the next two charts by Doug Short (http://www.dshort.com/), the fundamental valuation of stock prices are earnings today are anything but cheap.


Figure 1 - Long-term perspective on S&P500 earnings from Doug Short of http://www.dshort.com/


Figure 2 - Another look at earnings, this time using Robert Shiller's trailing 10-year P/Es. Again, earnings (as of February) are still a far cry from past, serious recession lows. Chart courtesy of http://www.dshort.com/

So how can stock prices be dropping like a safe while company valuations continue to remain at historically high levels?  It is because corporate earnings are falling faster than stock prices.  The charts above have actually gotten a little stale because the market has rallied so strongly in March making the P/E ratio go even higher.  If you have a 10 or even 20-year time horizon and you don't mind your account decreasing another 40% in value, then an argument could be made that now is an ok time to buy.  My guess is that no one reading this letter has the stomach to endure the volatility that is still ahead of us.  Given current economic circumstances, there is nothing cheap about the stock market.  As a matter of fact, we would argue, and win, that the market is still overvalued and expensive at these levels.    

Comparing Current Economic Data-Inflation, the Economy and Unemployment

Over the last several decades, politicians have slowly made changes in the way economic data is calculated.  These changes were not made with bad intentions, but over time, these changes have accumulated to such a point that current economic data can be very misleading. 

No single president set out to mislead the American people.  Several different administrations from both parties have implemented what was perceived to be an improvement in the way economic data was calculated.  Because all politicians desire to get re-elected, there is an inherent conflict of interest to any calculation change recommended by an elected official.        

Over time, small changes have accumulated to the point where calculation methods used today are much different than those used during the Great Depression.  I would argue that they are downright misleading, and that based on today's calculations methods, there is simply no way to accurately compare today's recession with recessions/depressions in our past.    

In order to truly compare today's bear market to past historical events, today's data must be adjusted to reflect the same calculation methods used to measure all historical data.  I am not the only one who feels this way.  John Williams and the associates at http://www.shawdowstats.com/ have dedicated their waking hours to accurately calculating today's economic data.  Their data has been used in the charts and graphs below to show you just how misleading current economic data has become.    

If you would like a history lesson on these changes and their misleading effects, I encourage you to take some time and listen to Dr. Chris Martenson explain how and why current economic data is so misleading. 

Fuzzy Numbers - Economist Dr. Chris Martenson - Video 17 minutes
http://www.chrismartenson.com/crashcourse/chapter-16-fuzzy-numbers

The Three Lying Bears-Inflation, the Economy and Unemployment

There are many pundits that would argue that the economy is far better off now than it was during the Great Depression. Are comparisons between the situations now and then realistic? Not according to John Williams of http://www.shadowstats.com/

First, take the GDP.

"Over time, the official GDP series has strayed from reality, based on methodological changes often tied to the deflation process. The Shadow Government Statistics Alternative (SGS Alternate) GDP is an estimate of the historical series net of those changes, and other changes, where quantifiable, that I have been able to identify. The series is far from perfect. [According to official data], the unofficial recession of 1986 is almost there. The shallow 1995 downturn is in place, while the 2000/2001 recession is much longer and deeper than officially reported and already has started into a double-dip. In official reporting, the 2000/2001 recession has been revised away. This SGS series is an attempt to approximate reality, and often is adjusted as an additive function on top of the current GDP series. Accordingly, most of the ups and downs tend to move with each other in both the SGS and official series."

We include a comparison of the official GDP data we are given versus SGS estimates based on the way these data used to be calculated before 1982.

 

 
Figure 3 - Chart of quarterly GDP data comparing how official (not seasonally-adjusted) figures (green) have diverged from reality (red) since 1982. Data from Bureau of Labor Statistics (BLS) and http://www.shadowstats.com/.

Another important statistic is inflation measured by the Consumer Price Index (CPI). How has it changed over time?

According to Williams, "The BLS publishes a "current methods" CPI that restates historical CPI reporting for methodological changes made to the series since the early 1980s. By reverse engineering the series, it is possible to calculate what the BLS estimates the different changes to CPI reporting have added or subtracted to reported annual inflation. With nearly all of the changes resulting in reduced CPI inflation, one would have to add 3.6% to current annual CPI reporting to approximate what inflation would have been, based on the older methodology. This BLS series, however, allocates only 0.2% to the annual effect of the changeover to geometric weighting in the 1990s.

Since the adjustment process is largely an additive to existing reporting, the alternate series tends to show the same general up and down patterns of the underlying official CPI. The July 2006 annual rate of the SGS Alternate Consumer Inflation is 11.0%, which is reasonably close to rough estimates of the fully independent SGS inflation series that still is under development."


Figure 4 - Comparison of annual data CPI data from official sources (green) and as it was calculated before 1982 (red). Data from Bureau of Labor Statistics (BLS) and http://www.shadowstats.com/

Finally, let's look at what we are being told about the unemployment situation. Is the most recent (seasonally-adjusted) estimate of 8.1%, which pundits have used to tell us the situation isn't really all that bad, realistic?

Currently, the payroll survey generates an estimate of the number of non-farm jobs in the U.S. economy based on a monthly non-random sampling of payroll tax filings of about 160,000 U.S. corporations and government agencies. The survey measures the number of jobs and it is important to point out that some individuals hold multiple jobs.

According to John Williams, "Payroll data are haphazard at best, and the BLS has no idea of potential reporting error. The BLS admits the payroll survey's confidence interval is not solid, given built in biases and the lack of randomness in the monthly sample. The payroll survey use to include a regular monthly bias factor of about +150,000 jobs. Those jobs were added each month for good measure, as an estimate of jobs created by new companies. Companies that went out of business generally were assumed to be employing the same number of people as before they went out of business."

There is another important error contained in payroll jobs data-it does not include discouraged workers who have given up in their search for a job.  The Clinton administration took discouraged workers out of the calculation, so when you add them back into the calculation, and use the same calculation methodology used during the Great Depression, the unemployment rate jumps to nearly 20% as of February 2009.  Yes, I said 20%!    

Figure 5 shows a comparison of official versus actual unemployment figures up to the latest payroll figures for February 2009.


Figure 5 - Comparison of monthly (not seasonally-adjusted) data published by the BLS (green) and estimates of actually unemployment (red) from ShadowStats.com


Figure 6 - Table showing unemployment, GDP and spending through the worst years of the Great Depression.

Putting the Pieces Together

Since at least the 1960s, governments have looked for and found ways of presenting data in such a manner that made the picture look better than it really was. And according to our research, they are continuing to get better at deceiving the public. 

Why? They have learned that getting re-elected under the cloud of a deteriorating economy is next to impossible. The same holds true for any election, whether it is federal, state or municipal.

As a result, all kinds of statistical tricks have been devised to accomplish the task of putting lipstick on ugly economic pigs. As Dr. Chris Martenson points out in his video entitled Fuzzy Numbers (see suggested reading), these tricks include imputations, hedonics and substitutions that make the numbers more attractive than they really are.

In the case of GDP, these statistical tricks have the effect of inflating it. The same tricks are used to understate unemployment and inflation (CPI).

At its worst point during the Great Depression, economic growth (GDP) declined 45%, so we aren't anywhere near that point yet. At its peak in 1933, unemployment topped out just north of 25%. As of February 2009, unemployment factoring in the discouraged workers and removing the sugar-coating applied by the BLS, real unemployment in America sits slightly under 20%, compared to the seasonally-adjusted estimate of 8.1%.

And, unlike the Great Depression where prices were being sucked lower in a deflationary vacuum, real inflation is running at close to 12%, which indicates that real price deflation has yet to begin. 

Suggested Reading

Depression Dynamic Ensues as Markets Revisit 1930s
http://www.bloomberg.com/apps/news?pid=20601109&sid=aNlx.TpHF5W4&refer=home

Fuzzy Numbers - Economist Dr. Chris Martenson - Video 17 minutes
http://www.chrismartenson.com/crashcourse/chapter-16-fuzzy-numbers


Portfolio Performance Analysis

Risk & Reward
Each of our portfolios is strategically allocated across one or more of the Investment Pillars of Strength discussed below.  Each Pillar is managed by multiple, uncorrelated, absolute-return investment managers to produce a return stream that is consistent, negatively correlated with the major market averages in down markets and non-correlated with each of our core Pillars of Strength. 

Managing risk is our most important consideration and it is reflected in the way our portfolios are built and managed each and every day.

The market continues to sway back and forth in a violent pattern.  The pattern appears to be trending more than in 2008 because huge daily moves have turned into huge weekly moves, and even multi-week moves.  Our models are adjusting cautiously to these changing dynamics as we may be entering into a new phase of the bear market.  Risk remains excessively high and any negative news could remove recent gains in less than a week. 

Here is a frightening quote I pulled from today's 3-25-09 AP Business Wire:

"Bond prices fell after the auction of $34 billion in 5-year Treasury notes. The yield on the benchmark 10-year Treasury note, which moves opposite its price, jumped to 2.77 percent from 2.71 percent late Tuesday. The yield on the three-month T-bill rose to 0.19 percent from 0.17 percent Tuesday.  The government is running up huge deficits in order to fund an array of plans to provide stimulus to the economy and support to the ailing financial system. Any suggestion that demand for U.S. government debt is weakening is a negative for stocks, simply because Wall Street has been relying so heavily on the government's rescue plans."

In order for this government experiment to work, the rest of the world must be willing to buy our riskier debt and get paid hideously low interest rates.  If they don't, we will have to raise the interest rate our creditors demand.  This will drive interest rates up across the board, putting the death nail into any economic recovery.  The results of today's treasury auction dropped the market from being up 2% to being down 2% in about 30 minutes, until the market recovered to finish positive.  If our creditors (Japan and China) decide to stop lending us money, then 2009 will make 2008 look like a walk in the park.   

Below is a performance summary for the indices we track and benchmark our portfolios to:    

 

 

An Update on Our Performance
Which Rally Is It?
An Update on Our Performance

Earnings - Great Expectations
Comparing Current Economic Data
The Three Lying Bears
Putting the Pieces Together
Portfolio Performance Analysis
An Important Announcement

Wall Street has been doing the stock hard-sell for more than a year now and you'd think they'd be getting tired. They've been using the financial networks to permeate their message that now is really the best time to buy.  However, Wall Street is currently admitting to have jumped the gun the other dozen or so times, but they insist they have it right this time.

And it's amazing the logic they proffer to back these claims.  Most, of course, make decisions based on valuations. We've heard it all before-as stock prices fall, valuations get more attractive. They conveniently forget to mention that this approach bankrupted many in stocks like WorldCom, Enron and Adelphia.  If you corner them on this, they admit that no strategy is perfect, and follow it up by saying, valuations really are very attractive right now. 

And this is not the only evidence they use to support their claims. Inflation is low, interest rates are attractive, and unemployment is nowhere near the level seen during the Great Depression.  The economy is still doing fine, or so the argument goes.

What do you think the real answer is?  Are fundamental measures so compelling that it is time to jump back in with both feet and buy?  Is this really the bottom and are you about to miss the best buying opportunity of your lifetime? 

Have you ever heard of the saying - garbage in, garbage out?  In this letter I am going to peel back the curtain and show you some of the real numbers I use to truly evaluate the health of our economy.  When I say real, I mean the numbers that your government and most long-only mangers don't want you to see or understand.  By the end of this letter, it is my hope that you will be better prepared to answer the time-to-buy arguments that you read in the papers and hear on TV these days. 

An Update on Our Performance

February was another strong month for our portfolios and another dismal month for the markets.  The first quarter is shaping up to be one of our best quarters since the launch of our multi-manager portfolios.        

Below are recent performance returns on the four portfolios we currently offer:





Posted 03-27-2009 2:03 PM by John M. McClure
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