Two Steps Forward and Three Steps Backward

Our Monthly Performance Update
Dollar Reality Check
Are Valuations Justified?
The Mother of All Carry Trades
Market Summary
Portfolio Performance Analysis
Can I Do It This Year?

Timing is everything and being early with your investment decisions can be almost as painful as being late.  Since most investors lost significant sums of money in 2008, they feel a deep-seated fear of getting left behind.  It is called the herd instinct.  This important emotion kept us alive when we hunted with knives and spears, but today it runs investors off a cliff.  In dealing directly with retail clients, the herd instinct is the most prevalent emotion I see. 

Over the past several months, the markets powerful advance has made me feel like I have been standing in front of a train.  I had this same feeling back in May 2006, when I sold my house to move into a rental home because I felt the real estate market no longer made any sense.  I feel the say way today about the stock market.  The Fed and the Treasury have many tricks up their sleeves to buy short term relief. But, what long-term price will future generations have to pay?

The dollar has been bouncing off its all time low for the past couple of weeks and the market continues to rally.  As you will learn from reading this letter, a weak dollar is feeding leverage and liquidity into the market.  Over the past 90 days, there has been an inverse correlation between the dollar and the S&P 500 of approximately 75%.  So when the dollar goes up, the market goes down, and vice versa.  It feels good when asset prices go up, but when these assets are compared in dollars or gold, there has been no gain at all.  As a matter of fact, there have been further declines in the United States global buying power.

In this newsletter, I have decided that a picture is worth a thousand words, so we have provided lots of charts and graphs.  The picture these charts paint about our economy is not pretty, yet the market continues its advance.  Hopefully, our research at least makes you pause and ask why?

"Whether you are investing in real estate in China, equities in Peru, or indexing the S&P 500, you are putting your faith in the ability of the U.S. Government to pull off a miracle.  Expectations will be tough to meet, and the risk of the Administration losing a handle on the situation is a constant threat.  Over the next five years, investors should focus on capital preservation and avoid getting swept up in the inevitable credit-fueled bubbles." 
Boeckh Investment Letter, October 30, 2009

An Update on Our Performance

Interest-rate sensitive strategies continue to lead in 2009.  Shorting the U.S. dollar and being long high-yield bonds has been the easiest trade of the century.  Actively trading government bonds has also rewarded our investors handsomely.  In 2008, fixed-income investments were grossly manipulated by the Fed and Treasury, and in 2009, equities seemed to make no sense.  No one ever said it would be easy, but they sure didn't say it would be this hard either. 

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

Past 12









Income Builder  (IB)





The Guardian  (GRD)





Harmony Plus  (HMY)





The Expedition  (EXP)





S&P 500  (SP500)





Important Performance Disclosure

ProfitScore provides its separately-managed accounts to individuals, advisors and institutional investors.  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: 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 @

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

Dollar Reality Check

Much has been written about the value of the dollar since the stimulus bonanza began in 2007 and before. Pundits have worried that our cheap dollar policy ("Quantitative Easing") has had a clear impact on the dollar, and not in a positive way. As we see from the next chart, they have a point showing the dollar value erosion began in 2000, as the tech bubble began to break in a trend that continues to this day.

Figure 1 - Weekly chart of the US Dollar Index priced in gold. Chart

Stocks Priced in Gold
Economic growth that occurred during the 1990s was accompanied by a confidence in the dollar, which led to some very real gains in asset prices, stocks and commodities (that are priced in US dollars). But in real terms using the gold standard, stocks have been significantly hurt by the falling greenback, thanks to a nearly 85% drop in the value of the buck compared to gold. Next let's look at how stocks fared in gold terms.

Figure 2 shows that the Dow, priced in gold, peaked in mid-1999-almost a year before the index peaked in nominal terms and a big part of the more than 80% drop in real stock prices due to dollar weakness. Stocks have been doing well lately in the face of a weakening dollar, but this has had an overall net negative effect in real terms.

Figure 2 - Weekly chart of the Dow Jones Industrial Average priced in gold. Chart

Stocks in a Euro and Canadian Dollar Perspective
The next two charts show the Dow priced in Euros and Canadian dollars to provide a different value perspective. As we see, the Dow peak in 2007. It was well below its 2000 peak and remains more than 50% depressed from a European investor's point of reference. This may explain why dollar denominated assets held by foreigners (as well as the interest in Treasuries) has fallen in the past few years.

Figure 3 - Weekly chart of the Dow Jones Industrial Average priced in Euros. Chart

Figure 4 - Weekly chart of the Dow Jones Industrial Average priced in Canadian dollars. Chart

Stocks and Commodities
Do you think gold has rallied based on hype and speculation, not real demand? To test this idea, let's examine how stocks have fared compared to commodity prices.  As we see, compared to a basket of 17 commodities, the Dow Jones Industrial Average is down nearly 65% from its commodity-adjusted price peak in 1999.

Figure 5 - Weekly chart showing the Dow priced in commodities as represented by the CRB Index. Chart

Are Valuations Justified?

Now that we have a more global perspective on how stocks have fared in the new millennium, where are stock valuations in nominal US dollar terms? If they are historically cheap, they will become more attractive to investors looking for long-term value who believe that stocks have the potential to appreciate in real terms, even if the dollar continues to weaken. This of course assumes that economic growth from here will be sustained and that the dollar does not collapse in value compared to other major currencies.

In late October, performed an interesting comparison between stock values (S&P500), after stocks rallied 60% between the March lows and October highs, with the 60% rallies that occurred in 1972, 1976, 1983, 1994, 2006. As the following table shows, the numbers were interesting. Based on these metrics, stocks are anything but cheap!

Here is a summary of the 10 indicators following past 60% rallies compared to this one.

  1. Year-over-year retail sales: 9.3% average in prior 60% rallies versus -5.3% currently
  2. Consumer Confidence Index: 95.5 average; 53.1 now
  3. Capacity utilization: 79.9% average; 66.6% now
  4. Year-over-year industrial production: 4.1% average; -10.7% now
  5. Institute of Supply Management (manufacturing) : 53.9 average; 52.6 now
  6. Payroll employment gains over period: 2.2% average; -2.0% now
  7. Decline in continued unemployment claims from cycle peak: -26.3 average; -11.6% now
  8. Year-over-year growth in total credit market debt: 9.3% average; 3.0% now
  9. Year-over-year growth in household debt: 8.8% average; -0.1% now
  10. P/E multiple (trailing 10-year earnings): 16.8x average; 20.0x now

Figure 6 - Weekly chart showing prices, average P/E (blue line) and earnings growth (GRT) for 7,995 U.S. stocks tracked by VectorVest. As the chart shows, the average P/E for the broad range of publicly trading companies entered uncharted territory in 2009 and is still well above any previous year's high. Chart

But what happens when we examine valuations for a much broader basket of US stocks, like 8000 (see Figure 6) instead of the cherry-picked, and constantly modified, S&P500 or Dow Jones Industrial Average? The results of this exercise were equally interesting.

On June 5, 2009 the average price-to-earnings ratio for the 8,011 US stocks of the VectorVest Composite Index (VVC) hit an all-time high of 155.58, thanks to rising prices, but no increase in average earnings. Earnings had fallen to their lowest level since the VVC was initiated in 1995 of $0.13/share.  But then earnings for a broad range of companies began to show their first real signs of improvement since March 2007, rising from $0.13 to $0.15 per share. P/Es have continued to fall, albeit slowly, to just over 100 on October 30, 2009 as earnings rose. 

The same can't be said about earnings growth (GRT). After peaking in May 2005 at 11%, earnings growth (GRT) continued to deteriorate falling to 10% in 2006. By the second week in October, earnings growth had fallen to 0% and the average EPS for the roughly 8000 companies had grown to just $0.22/share, still well below their new millennium peak of $1.04/share in January 2007. 

How do these numbers compare to the last recovery? As the rally was getting underway in March and April 2003, earning growth (GRT in red) was a much healthier 8%, and earnings growth had begun improving nearly a year before hitting a low of 3%. Within two months of the bottom in stock prices and the beginning of a 56-month bull market, VVC P/Es peaked at 60.51 (May 2003). Looking even further back to the lofty prices in March 2000, we see the P/E, although high, was a much more benign-32 times and earnings growth was running at 11%. 

The Mother of All Carry Trades

Since late 2006, the financial world has become all-too-familiar with the carry trade (selling a low-yield currency to buy assets in high-yield currencies). Then, the Japanese yen was the fuel of choice, thanks to basement costs of borrowing. But with the credit crisis and rapid collapse in the values of high-yield currencies, like the Icelandic krona with commensurate losses, the carry trade appeared to go the way of the dodo bird-extinct.

However, the very factors discussed above have given global investors with a penchant for risk a new carry trade target - that's right, the USD. As Figure 3 shows, one popular currency pair, the New Zealand dollar and US dollar (NZD-USD) has helped fuel the recent stock rally. It means that global investors can borrow dollars at record-low rates, sell them to buy New Zealand dollar denominated bonds and other assets, and reap the interest rate difference as profit. A further weakening dollar/strengthening NZD is a bonus. Their major risk is the possibility of a rapid USD appreciation/NZD depreciation.

As Figure 3 shows, this carry trade was somewhat popular before the credit crisis began in late 2007, but has recently surpassed its 2007 peak popularity, as investors sell USD to buy NZD. Currently, the correlation between the two is nearly 0.94 (a correlation of 1 is perfect correlation). 

Figure 7 - Weekly chart of the New Zealand dollar - US dollar currency pair in the upper sub-graph, the S&P500 in the mid-subgraph and the 20-week correlation between the two (red).

As the economist known as Dr. Doom, Nouriel Roubini, pointed out in an article last week, the conditions that have driven the USD carry trade have created what he believes is the "mother of all carry trades."

Here is how he outlined the power behind the key risks that this trade presents in his Financial Times article, "Mother of All Carry Trades Faces an Inevitable Bust."

"So what is behind this massive [stock/commodity] rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates - as low as negative 10 or 20 per cent annualized - as the fall in the US dollar leads to massive capital gains on short dollar positions." 

These conditions, "a zero Fed funds rate, quantitative easing and massive purchase [monetizing] of long-term debt instruments is seemingly making the world safe - for now - for the mother of all carry trades and mother of all highly leveraged global assets."

If Roubini is right (and let's face it, his track record in calling the market leading up to and through this crisis so far is impressive), investors are surfing a global cash tsunami which could still be some time from reaching its zenith. However, any potential for gain is offset by the reality that the bigger this bubble gets, the more destructive its ultimate collapse will be, so caution is a requisite.

But even Dr. Doom is careful about calling the end of the financial world as we know it in his final paragraph.

"This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall."

Market Summary

I will be the first to admit that one of the biggest challenges in the current credit crisis and apparent recovery has been estimating the impact of various policy decisions by the Fed and other central bankers around the globe. Few, including yours truly, appreciated just how powerful this stimulus could be in the face of massive debt. In my defense, job one is to protect principle, and debt creates serious risk, especially when it gets as big as it is today.

As history has taught us, bubbles generally build longer than expected, with the biggest gains coming nearer the end than the beginning. Enter too late or exit too early and you underperform your less risk-averse peers.

We at ProfitScore will continue to take a cautious approach to this market and trade it with great care, with both eyes on money management. We will continue to take profits out of the markets without putting serious capital at risk.  This is certainly not a market for the weak of heart!

Based on current economic reality, the U.S. still has some time to go before it can follow nations like Australia and be weaned from the punch bowl. And as long as the punch bowl offers libation, there will be money to be made, as long as one doesn't imbibe to the point of losing an appreciation for what happens when the punch is gone.

Interesting Reading:

International Monetary Fund - Principles for Stimulus Exit

Detail IMF document - Global Economic Prospects and Principles for Policy Exit

Why Some Countries Are Stopping Their Stimulus,8599,1936585,00.html

The American Economy in One Chart

Mother of All Carry Trades Faces Inevitable Bust - Roubini

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.  Commentary found in this newsletter is for informational purposes only and does not effect how our portfolios are traded.   

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

Based on our internal valuation estimates, fair value on the S&P 500 is approximately 850.  Our long-term dismal GDP growth calculations over the next five years, combined with the fact that equities are currently 30% overvalued, have our five year forecast on the S&P 500 as a negative return.  I have had only limited success forecasting equity markets based on fundamentals because investors simply don't care.  Fear and greed drive the markets and they always will.  Due to volatility contraction and P/E expansion into nose bleed territory, we remain vigilant in our efforts to carefully manage risk. 

Our equity trading accuracy remains above 50%, but our average losing positions during October were larger than our average winning trades, producing small negative returns for equities in October.  MTD November, we are currently showing small gains for equities across the board.  Interest rate sensitive allocations continue their upward march higher.      

Index Advantage:

Trading accuracy has stabilized north of 50%, after our low in July.  Large monthly moves seem to find us on the wrong side of trades, which causes us to fight back to pull our returns back into positive territory.  November is showing small gains for the month.  Managing risk in a hard-charging market can be a difficult job.        

For the month, this pillar gained -1.28.  

Strategic Balance:

We continue to tread water in this allocation, as our risk-adverse traders patiently wait for higher probability trades to materialize.        

For the month, this pillar earned -0.67.      

Dynamic Income:

Our interest rate sensitive strategies combined to once again produce positive returns for what is now the 7th-winning month in a row.  Given the over-extended positions in asset classes traded in this allocation, we are growing more cautious about changing dynamics and increasing volatility.  If the economy once again falters, I fully expect the government to once again manipulate the long and short end of the yield curve, making our job managing these positions almost impossible.  Until then, we plan to make hay while the sun is still shining!

For the month, this pillar earned .98.

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. 

Can I Do It This Year?

As I mentioned this spring, I entered a 12-month weight-loss competition with three of my friends.  Once every four months, we go the Boise State University and jump in a hydrostatic tank to officially weigh in and measure fat loss.  Money and pride are on the line, so my competition has been tough.  My fellow fat friend, Rich Davila, beat me by a smidgen in the last weigh-in, but it appears I may take home the gold in our upcoming December weigh-in.  That is, if I can make it through the toughest 60-day stretch of the year.

Every year I tell myself that I am not going to gain weight over the holidays.  I have never once achieved my goal.  Not one time!  I can attest that surrounding yourself by great southern cooking (my wife is a wonderful cook) during the holidays is not good for your waistline. This year is going to be different - I hope.

I seem to do okay fighting back the temptations here in Idaho, but every year we travel back to Tennessee for Christmas.  Not gaining weight during a Tennessee Christmas holiday vacation is practically impossible.  The temptations are about the same as a teenage boy faces during a spring break in Florida. 

Like war, I have a battle plan, but once the first deserts are served, my knees get weak and I gorge myself like a pig going to slaughter.  If anyone has any suggestions for me to fend off the upcoming food attack, I would love to know your secrets.    

Working to grow your wealth,

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

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

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

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

Posted 11-20-2009 8:19 AM by John M. McClure