Would Someone Please Press The "Easy Button"?

Our Monthly Performance Update
My Decision on Buying My Next House
Cocaine, Profits & Your Brain
Top Ten List of Risks to Watch Out For
Interesting Stories
Portfolio Performance Analysis
Basketball, Dancing and Mom's Scavenger Hunt

In this letter, I have produced my top 10 list of risks I see in the immediate future.  Several months ago, Greece would have been lower on my list.  However, economic conditions are very fluid and seem to be changing at increasing speeds.  I will also discuss my decision on when I plan to buy my next house.  For those not familiar with my housing saga, I sold my house in May, 2006 because I fortunately saw this housing crisis approaching.  I have been renting a home since then, and now my rental contract is due for renewal in March, so I need to decide whether to buy a house or continue to rent.  I'll outline my research on this decision.

There is some fascinating research on investing and your brain.  This research removes all doubt on the importance of controlling your emotions when making investment decisions.  Since most Americans are on a cocaine-induced investment high from 2009 gains, it may be time to carefully plan out your next investment steps so your emotions don't destroy the gains from such an impressive year. 

It has been about two months since my last letter.  Recent investment research projects have had me working 60-plus hour weeks and I simply haven't had time to update you on my thoughts.  As a money management firm, my priorities must always be focused on making money for our clients..  To help shoulder some of the research responsibilities, I have recently retained a PHD who is extremely capable and battle-hardened, with over 20 years of quantitative system development expertise.

Our portfolios will soon benefit from this research.  I can honestly say that I have never been more optimistic about our ability to produce consistent, absolute returns for our clients.  In 2010, we will be launching stock and ETF portfolios to compliment our current offerings.    

A disproportionate share of ProfitScore's budget is spent on research and development.  The world is constantly changing, and thus, asset flows are in a state of flux to adjust to these changes.  Many in my industry would argue that 2009 was a government-manipulated flux, but a flux nonetheless.  Since the launch of our multi-manger portfolios in March of 2007, we have remained in the top deciles of our manager peer groups.  Staying at the top of our game takes considerable effort and expense, as we chase down many dead end rabbit trails in our never ending pursuit of alpha.  Our bounty looks rewarding for our investors in 2010!

Here is probably my all time favorite quote:

"Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited."
George Soros

Our Monthly Performance Update

U.S. equity markets have seen increased volatility since the first of the year.  This probably has to do with the fact that volatility is being produce from outside the United States and is more or less out of our government's manipulating hands.  Troubles in Euro land promises to keep the risk of flash point events high for the remainder of 2010.  YTD, we are showing green across the board for our equity portfolios and a small loss for our fixed income focused strategy. 

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

Jan 08 to









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: http://profitscore.com/insight.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.

My Decision on Buying My Next House

As long-term ProfitScore subscribers may remember, I sold my house in Boise in May 2006 once I realized that the hot market was simply not sustainable. In retrospect it was the right decision - home and property prices in my area have been cut in half since then.

My original plan was to get back into the market this year but I have re-evaluated that decision. Let me share with you my reasons why I don't believe this is the time to buy. 

Without a doubt, the huge foreclosure number is the 800-pound gorilla dominating the market right now - another 315,716 were reported in January. Although this is a decrease of nearly 10% from December, it is still 15% above the level reported in 2009 according to RealtyTrac.

As this next chart shows, mortgagors who are 90 or more days behind on mortgage payments soared over the last year. History tells us that these folks have a better than 90% chance of defaulting so this is a good leading foreclosure indicator. As long as foreclosures are increasing, there will be continued downward pressure on real estate prices. Increasing layoffs and weak employment number (discussed above) certainly don't help.

According to RealtyTrac CEO James Saccacio, "January foreclosure numbers are exhibiting a pattern very similar to a year ago: a double-digit percentage jump in December foreclosure activity followed by a 10 percent drop in January. If history repeats itself we will see a surge in the numbers over the next few months as lenders foreclose on delinquent loans where neither the existing loan modification programs or the new short sale and deed-in-lieu of foreclosure alternatives works."

Like any other market dominated by the laws of supply and demand, prices rarely appreciate in the face of increasing supply and falling demand. And the greatest risk to putting off buying as I see it is increasing mortgage rates but here is the dilemma.

Sure, mortgage rates could be quite a bit higher in 2011 or 2012. But if rates rise, it will be another lead weight on real estate prices. There is an old adage in real estate - for every 100 basis-point rise (1%) in interest rates, roughly 10% of the buyers get knocked out of the market. And the lower the interest rates, the greater this negative impact (since a 1% rise from 3 to 4% interest rates translates to a 33% increase in payments all things being equal). 

Currently the average price of an higher end home in my area is $300,000, down from $600,000 three years ago. Assuming prices drop to $200,000 but rates rise from 5 to 10%, my payments will still be a higher (at least until rates come back down again) but the principle will be a lot lower. On the flip side, if I buy at $300,000 and prices fall to $200,000 that means I will have to come up with another $100k (plus commission and expenses) when I want to move!

Thanks but no thanks. It is just not a risk I am prepared to take. And while we are on the topic if risk and reward, I wanted to mention a very interesting book I read recently that I think you will find fascinating.

Cocaine, Profits and Your Brain

"The neural activity of someone whose investments are making money is indistinguishable from that of someone who is high on cocaine or morphine... Financial losses are processed in the same areas of the brain that respond to mortal danger." - Your Money and Your Brain by Jason Zweig

Why are most of us so challenged when it comes to investing? In his 2007 book, Jason Zweig delves into the science of neuroeconomics to explain how smart people can become stupid when it comes to markets.

Take Sir Isaac Newton, who postulated the three laws of motion (every action has an equal an opposite reaction) and is credited with discovering the law of gravity. In 1790, he was wiped out in a stock market crash. How could a genius like him make such a classic mistake? One can have the best laid plans but when it comes to the practice of investing, the vast majority of us including the likes of Newton are unable to follow through on the theory.

In his book, Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, Zweig proffers some ideas regarding why investors go astray when it comes to applying their investment plans. Here is the problem according to Zweig. "The neural activity of someone whose investments are making money is indistinguishable from that of someone who is high on cocaine or morphine," which makes greed such a powerful motivator. On the other side of the psychological ledger is fear causing investors to become equally illogical when losses occur. According to Zweig, "financial losses are processed in the same areas of the brain that respond to mortal danger."  

In other words, the emotions of fear and greed can and usually do override the most carefully developed investment plans.

The challenge for most of us is separating the evolutionary factors, like gorging when food was plentiful and running from a predatory animal during our caveman days, are counterproductive when it comes to investing. Those, like Warren Buffett who are ultimately successful, only do so because they are able to control these powerful emotions and let logic dictate their investment decisions.

The other option is to find a professional money manager to handle this challenging task for you...


Top Ten List of Risks to Watch Out For

Here is our top-ten list of risks today, both short and long-term, as we see them in 2010 and beyond.

1.)  Ballooning debt (and deficits) - This is our most discussed challenge that currently faces stocks (and our economy), which has been the case for a number of years. But unlike past recessions which served to reduce debt levels, this time around debt has soared.  Debt was at the heart of the credit meltdown that was in a large part caused by the housing market collapse and the biggest reason for the stock drop between October 2007 and March 2009.

For more on this please see last month's ProfitScore IQ at:  http://www.profitscore.com/display.aspx?articleid=YroVUlgCkd8=
In a nutshell, total credit debt is now well above $50 trillion, or more than 370% of  estimated 2009 US GDP. Throw in unfunded liabilities from such programs as Medicare, Medicaid and Social Security and the total rises to more than $115 trillion, or more than $1 million per US household. This risk takes us immediately to the next biggest challenge.

2.) Rising interest rates - As debt levels rise, interest rates become increasingly important.  As we discussed in our last newsletter, the fact that interest rates haven't risen faster is somewhat surprising. But it will only continue as long as bond investors continue to accept real losses in exchange for the perceived safety of US dollar-denominated assets like US Treasuries. As past crises have taught us, once investors begin to lose faith in a currency, interest rates soar and that creates a whole new set of economic challenges. This risk is currently exemplified by growing sovereign debt risk in such countries as Iceland, Ireland, Spain and former Eastern block countries like Latvia, Lithuania and Estonia. And who seriously expected sovereign defaults in oil-rich Dubai? These risks will expand rapidly as interest rates rise. 

The European Union will either bail out Greece or its economy, and government will fail within the next 6 months causing systemic risk around the world.  Germany would argue against bailing out Greece because they are only 2.7% of the EU and then systemic risk can be controlled.  As a point of reference, Bear Stearns was less than 2% of the US banking assets and look at what happened to our banking system and the rest of the world when they failed.  Given the EU differences of opinion and Europe's history of getting along, I project that Greece has a greater than 50% chance of falling into a deep depression that will take them decades to recover. 

3.) Aggressive central bank quantitative easing (QE) - Another name for this risk could be "Misguided Monetary Policy." Put simply, quantitative easing is an attempt by central banks, led by the Federal Reserve, to reverse popping asset bubbles. But what policy makers are doing in effect is more of what got us into this mess in the first place. The idea that we can create more debt to cure our debt dependency is absurd, at best. At worst, it is the penultimate definition of insanity - doing the same thing, while expecting a different result.  Unfortunately, the public and policy makers are unwilling to do what is necessary - let a correction rid the system of the excesses that have built up over the decades through bankruptcies, debt defaults and foreclosures.

The unfortunate side-effect is that the longer this painful but necessary catharsis is in coming, the more severe and protracted it will be. As the lessons from Japan have taught us, there are two ways of curing economic excesses-denial or quantitative easing.  The way they dealt with it was by denying the severity of the problem, which only compounded it, along with the pain of the ultimate cure. Quantitative easing efforts in the U.S. too closely mimic the Japanese solution for my liking, but somehow too many believe that this time will be different. More likely it will serve to lengthen the time it takes for full, sustainable recovery. (See next point.) 

4.) Government bailouts - There is little doubt that government stimulus programs and policies have catapulted stocks higher - so much so that some analysts have leveled charges of market manipulation (see article TrimTabs, suggests government manipulated stocks). These programs have the same goal as quantitative easing. This is accomplished by throwing more money at the problem in an effort to repair popping bubbles. And even if quantitative easing were to end tomorrow, government programs could continue indefinitely or until either bond holders or taxpayers finally rebel, since the former must finance on the hopes they will be paid back and the latter ultimately pays for such efforts.

Like quantitative easing efforts, government bailout programs could eventually prove counterproductive and while they may lessen the short-term pain, ultimately extending the time it takes for full recovery. (See the October 28 ProfitScore IQ http://www.profitscore.com/display.aspx?articleid=gB2mbJnjm0o= ). As President Gerald Ford declared to a joint session of Congress, "A government big enough to supply you with everything you need, is a government big enough to take away everything that you have..." Unfortunately, this outcome does not come due to deliberate malicious intent, but is the unfortunate aftermath of policy decisions.

5.) Housing effect - As Mr. Bernanke (and everyone else who followed his lead) learned the hard way, ignoring the importance of the housing market can throw a real wrench into anyone's plans for continued economic success. But true underlying residential real estate health has been obscured by government bailout programs such as TARP (Troubled Asset Relief Program), HAMP (Home Affordable Modification Program) and a continuous supply of cash to troubled lenders Fannie Mae and Freddie Mac, resulting in an apparent improvement in the housing market. In our December 17, 2009 ProfitScore IQ ( http://www.profitscore.com/display.aspx?articleid=YroVUlgCkd8= ), we discuss the troubling gap between new and existing home sales.  Here is an updated chart showing that the gap is still widening, thanks in large part to expanding government and Fed programs to stimulate home sales. Unfortunately, it has not worked very well for new home sales.  And what happens to both when these programs finally run out?

Chart - http://www.calculatedriskblog.com/ 

6.) Commercial real estate - So far, the Obama administration has committed trillions to try to fix the residential housing market. The most expensive of these fixes is the purchase of approximately $1.25 trillion in residential mortgage-backed securities issued by Fannie Mae and Freddie Mac. Then there was the $8,000 first-time home buyers' rebate that was not only extended but expanded to include prior home buyers (with a smaller rebate).  There have been no such stimulus or bailout programs for commercial real estate, nor should we expect this. Therefore, commercial real estate (CRE) will provide a true insight into real estate demand in the future which is why it is important to follow. The article entitled, "Ugly CRE Charts" says it all...go to http://blogs.reuters.com/rolfe-winkler/2010/01/06/ugly-cre-charts/

Below, we include a chart comparing residential and commercial prices. As we see, while residential home prices appear to have begun to respond to government programs with prices bouncing off bottom in March and April, commercial property prices continue to drop. Other troubling CRE trends include rising commercial defaults, falling prices and rising vacancy rates in everything from strip malls to office space (see articles in  Commercial Real Estate links section).

Chart - http://www.calculatedriskblog.com/

7.) History of recoveries - In economic circles, David Rosenberg has become a household name. Never one to get caught up in irrational exuberance, he has been providing sobering commentaries for years. But his approach has caused many, especially the bulls, to discount what he has to say and this was a fatal oversight leading up to the October 2007 market collapse. Rosenberg was in the small minority of economists who saw it coming (see Economists Explain Why Hints of the Economic Crisis Eluded Them below).

Since stocks bottomed in March 2009, Rosenberg has continually pointed out the risks in this recovery and the observations in his first client newsletter of the year (including the second quote of the month) are no exception.  Below is the chart demonstrating his point. As we see, in all past recoveries GDP growth was nothing short of exceptional, that is with the exception of the current one triggering the logical question, in spite of trillions in stimulus spent and the most aggressive quantitative easing program in history, why has economic growth been the weakest since at least 1950?  Although the answer to that question will take some time to answer, it demonstrates that efforts so far to inflate the bubbles have proven disappointing.   A 32% surge in personal bankruptcies isn't helping (see article Personal Bankruptcies... below).

Chart - http://www.gluskinsheff.com/

8.) Jobless decade - This next chart appeared in a January 1, 2010 Washington Post article entitled, "The Lost Decade for the Economy" (see link below) and compares job growth in the previous seven decades. As we see, the latest decade was by far the worst with zero job growth. If we are to see any measurable improvement in our economy, job growth is pivotal, especially considering that about 70% of economic growth is dependent on consumer spending, begging the obvious question: If consumers aren't confident about job prospects, why would they increase spending?

Chart - http://www.washingtonpost.com/

9.) Stock valuations - This has been another favorite topic discussed in the ProfitScore IQ. Both bulls and bears cite valuations to support their case - the bulls say  they are attractive and bears tell us they are too high. So who is right? In recoveries, expectation leads to reality - investors have purchased stocks on the expectations that earnings will rise, hoping that they will be proven correct. At the beginning of the 2003 recovery, the Price/Earnings ratio for the nearly 8000 stocks tracked by VectorVest soared to more than 60 times earnings (see first blue arrow in next chart). Bulls were eventually proven to be correct as earnings caught up in 2004.

In March 2009, the average PE for the roughly 8000 stocks in the VectorVest index soared to an unprecedented 155 (see second blue arrow in next chart). Will the bulls again be proven correct or do the bears really have a point that this time expectation is running much too rich to pan out? By year-end 2009, the PE for the nearly 8000 stocks of the VectorVest index had returned to a more normal number at 40, as the next chart shows. But even after a large decline, the PE is still high by historic standards. There is a risk that stocks have gotten too far ahead of themselves and although earnings have recovered from their March 2009 lows, they are still anemic in historic terms. This premise is further supported by long-term PEs published by Robert Shiller, who has shown that on a trailing ten year basis, PEs are still high at 20. In past recessions, long-term PEs have generally dropped below 10 before a sustained recovery occurred.  As discussed above, the big difference between past and present recoveries is government stimulus and no one knows for sure what comes next.

Chart - http://www.vectorvest.com/

10.) The "this time is different" mentality - This is not so much a challenge as it is a curse. There is no clearer example of this thinking than from our government and banking leaders, who throughout this malaise, have adhered to the belief that doing more of what got us into this problem will solve it. As long as the majority believes that the problems that presents us will have a different outcome than in the past, look out.  In their latest book, This Time is Different, economists Ken Rogoff and Carmen Reinhart trace financial folly back eight centuries and clearly show that this belief has dominated each economic catastrophe, but each time it was eventually proven false, usually with tragic results. Unfortunately the error in this assumption was only realized after the population had endured considerable pain through a series of false bear market rallies and ensuing economic and market retrenchments.

If you are a serious student of markets and the economy, the book published by John Wiley & Sons in 2009 is an essential read. This list of portfolio risks is by no means complete. Will markets continue to scale the wall of worry and when will the next correction strike? These are the $64 million questions today.

As one gets closer to retirement, the more conservative and risk-phobic a portfolio should be. But a portfolio for someone in their 50s has traditionally included government and bonds deemed low risk. But if the government is in reality treading the path to financial calamity, bonds become a questionable choice, especially if rising yields and inflation are in the cards longer-term. 

If there was ever a time for help in keeping your eye on your financial goals and sticking to your plan, this is it!

Interesting Reading

I Know What Keeps Obama Awake at Night

TrimTabs Suggests Government Manipulated Stocks

Timothy Geithner Meets Vladimir Lenin - John Hussman

A Testing Year - Buttonwood

Housing Animal Spirits to Be Banished by Prime Foreclosures

U.S. Growth Prospects Bleak in New Decade, Government Bailouts Create Illusion of Profitability

Economists Explain Why Hints of the Economic Crisis Eluded Them        

U.S. Loan Effort Is Seen as Adding to Housing Woes

Sprott - Is It All Just a Giant Ponzi Scheme?

Personal Bankruptcies Surge 32% in 2009

The Lost Decade for the Economy

Commercial Real Estate links
Ugly CRE Charts

Commercial Real Estate Poses Risk to U.S. Recovery, Ryding Says

Strip Mall Vacancy Rate Hits 10.6%

US Apartment Vacancy Rate Hits 23-Year High-Report

Moody's: CRE Prices Off 1.5% in October

Moody's: CRE Prices Off 41 Percent from Peak, Off 3% in August

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.

2009 was a bumper year for just about every asset class that got destroyed in 2008.  As I have mentioned before, there have only been 2 other rallies in the history of the US stock market that have increased 50% or more in 24 weeks - both happened during the Great Depression and both ended in tears.  It will be interesting to see if history repeats itself or at least rhymes.  To help you visualize how seldom powerful rallies like 2009 occur, below is a graph from http://dshort.com/ to give you a point of reference.

Our quantitative investment style is based on taking higher probability trades.  If probabilities are low, we will invest against them occurring.  If they are high, we position assets accordingly.  Twenty-four-week rallies increasing 50% or more happen so rarely, they are practically impossible to anticipate.  In my world, these events are considered a statistical outlier, or a fat-tailed event, because they fall outside the normal distribution curve.  Historically, these events have been followed by increased volatility, which usually, but not always, means declining markets.  Since fair value on the S&P is around 850, the edge is to the downside.    

Part of our research recently has been to help us determine when events like this are occurring.  They are very difficult to anticipate, but when they are occurring, we have uncovered an edge that will help us identify these abnormal markets and adjust our positions accordingly.  In our research discussions, we describe these markets as when the train is on the tracks, because positioning assets against them is like standing in front of a train.  Our recent findings should help us step out of the way the next time our indicators here this powerful whistle blowing. 

Index Advantage:

2010 is off to a good start.  Our long/short equity traders have capitalized on recent volatility.  The biggest change in our profits is due to the fact that markets seem to have normalized, so short positions are once again equally contributing to trading gains.            

YTD this pillar gained 1.98. 

Strategic Balance:

Trading activity has picked up as these very risk adverse traders have begun to increase the frequency and size of there trading positions.  We will be adding allocations to this important pillar in 2010.            

YTD this pillar earned .53.      

Dynamic Income:

2009's powerful rally compressed high yield spreads reducing the opportunity to make profits in high yielding assets.  I anticipate that the majority of our profits in 2010 for this investment pillar will be produced by our government bond and currency traders.  If markets accelerate to the downside, there could once again be opportunities to harvest high-yielding profits later in the year.     

YTD this pillar earned -.24.

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. 

Girls Basketball, Dancing and Mom's Scavenger Hunt

My daughters have developed a love for the game of basketball.  As their coach, I get to spend quality time, sharing a game which we both love to play.  Coaching has helped me become a better dad, because it pulls me away from the office and focuses my attention on the family.  The experience has taught me how to be a better coach and them to be better basketball players.  You might say we are teaching each other.  This year, both Sarah (10) and Annabelle (7) are the leaders on their team.  Annabelle's team is undefeated and Sarah's team has lost only one game by one point. 

This past Sunday was Valentine's Day and with two daughters and a wife, it has become an increasingly important holiday around the McClure household.  On Friday, the girls and I celebrated by attending their school's Daddy Daughter Valentine's Dance.  It has become an annual tradition that I hope I get to enjoy until they are 18.  Since Annabelle has grown too big to hold in one arm and dance with Sarah in the other, the girls have had to start taking turns dancing with Dad on the slow songs.  It is fun to watch them fuss about who gets to dance with Dad next. 

On Saturday night we created a scavenger hunt for their mom, hiding 10 gifts around the house with clues for finding the next gift.  Mom didn't expect a thing until we sprung it on her during my famous, big Sunday morning breakfast.  Mom had a blast trying to find all the gifts.  Annabelle was so excited to help Mom that she would give her a few extra hints on where the next present might be.  Sarah was not too happy with Annabelle's extra hints.  I am truly blessed to have such a wonderful family. 

Best of wishes to you for a happy, healthy, prosperous and risk-aware 2010!

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: http://profitscore.com/insight.aspx 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 @ profitscore.com.

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

Posted 02-17-2010 7:50 PM by John M. McClure
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