Managing Uncertainty

Now that some of the dust has cleared from the international markets, it is a good time to assess the real impact of Japan’s triple disaster on your actual portfolio.

Why? Because it is sometimes important to look back and recognize that for most investors, the damage was in the 2%-4% range. It may seem cruel that financial markets can rebound so quickly after a massive earthquake, a tsunami and partial core meltdowns but, except for Japanese fund managers and the people who are suffering in the affected areas, the news cycle is about to leave the story behind.

The urge to “Do Something”

When we invest, we bring all the skills we have acquired in the non-investment world, especially those which have worked so well for us.

One of those skills is the ability to quickly react to stimulus. Our ability to survive in the world depends on quick reactions. Whether driving, walking, making decisions at work or social situations, our ability to react to our environment is critical to success. We actively seek to hone our reaction skills through education, training and experience. Some of our reactions are “hardwired” and so quick that when we put our hand on something red hot, our nervous system reacts even before sending the message to the brain. By the time the brain becomes aware of the incident, the hand has already jerked away from the hot surface.

What works well in the physical world does not always work as well when it comes to investing. For the short term professional trader, lightning fast reflexes may be important. But for the rest of us, letting the new information get all the way to the brain where it can be judged against the existing investment strategy is the way forward because trading, while cheap these days, is not cost free.

As the markets regain their pre-triple disaster pose, it is clear that “doing something” just for the sake of reacting to the news is not the best investment posture to strike. As the Nuclear plants are brought under control, we should see iodine and salt prices returning to normal, even in Mainland China.

What does Japan mean to the Global Economy?

Most observers reckon that Japan was either in or about to enter its next recession even before the triple disasters struck. That means the 4%-4.8% global growth rate that many economists are looking for this year did not rely heavily on a strong Japanese contribution.

What about Japan?

Although our initial reaction was that Japan’s financial prospects have not changed significantly as a result of the triple disaster, there has been one movement which bears further observation: the Yen.

The world’s Central Bankers are coordinating efforts to clamp down on the surge in the Yen that occurred in the aftermath of the quake (82.9 on March 10th to 76.25 on March 17th) as Japanese firms and individuals scrambled to bring money back onshore. Given Japan’s high level of indebtedness, one might expect the Yen to weaken as the scope of the disaster became clear. But, that would ignore the investment situation from the local perspective. Japanese individuals and institutions have spent the last two decades funneling money offshore to capture more promising returns than were available onshore. With a massive rebuilding program on the horizon, it would appear that investors are voting with their offshore accounts that there will be some attractive opportunities in the not too distant future. Japan has often only undertaken comprehensive restructuring as a result of Gaiatsu (outside pressure). Although usually a term reserved for foreign political pressure, the triple disaster comes at a time when Japan has largely exhausted its biggest source of finance (individuals saving through Japan Post Bank). That pile of savings is still very large but is more likely to be drawn down than grow given the aging of the population. Whether the rebuilding effort will be large enough to spur the economy out of its “Lost Decades” is something to watch for over the coming months. To succeed, a certain amount of intestinal fortitude on the political side will be required to allow for economic restructuring in addition to just reconstruction. The dramatic movement of the Yen suggests that the possibility exists.

So, how do we manage in such uncertain times?

There is no “System” that will predict an earthquake (large or small) or any other “Black Swan” event that might trip up the financial markets. Fortunately, the financial markets are more resilient than the 24/7 cable talking heads suggest. The problem with Black Swan events arises when one invests without a plan. Because, without a plan, all one is left with is panic and reaction. Unfortunately, with High Frequency Trading systems trading 50-70% of the daily volume in the US on timescales that are a tenth to a hundredth of the time it takes to blink, the reaction game is one in which an individual investor has no competitive edge.

The trick is to change the parameters of the game to play to your strengths. By taking a longer viewpoint, most of the market noise (intraday and intraweek volatility) cancels itself out. The remaining movement can be analyzed in terms of shifts in economic or financial fundamentals or investor perceptions of the same. This is an area where astute observations and an eye towards risk control can help one capture returns that will build wealth in the long term.

Whether you use the Fund King System or another investment discipline, it is important to keep a level head and make the important decisions (what to invest in, when to buy and when to sell) well before the markets inundate you with conflicting data. Not all of your trades will be winners but having solid parameters for judging winners and losers before the market starts reacting to the day’s events will leave you in a much better position to make astute investment decisions.

Or you can load up on iodine tablets…

What looks good this week?

Across the portfolios, we are seeing a deceleration in the small caps which performed in the first few months of the year. An interesting sector to watch is financials which may be poised for a big jump in top line growth if confidence in the US economic recovery grows. Banks in particular have been in balance sheet repair mode since the Global Financial Crisis started. If the focus switches to market share and revenue growth, we could see a big surge in financial shares in the US. XLF is currently ranking #2 in the US ETF Sectors Portfolio.

Silver (SLV) still looks solid both in the longer term portfolios and in the short term commodity portfolio. Energy looks good both in US terms (XLE) and Globally (IXC) and while events in Libya may influence prices in the short term, the longer term driver is increased demand from G8 economies that are still in the early stages of an economic recovery from the Global Financial Crisis.

The Seeking Alpha Portfolio

This week, we bid farewell to Taiwan (EWT) which has been nudged out of third place by the S&P 500 (SPY).

As noted in the past, the tech sector has shown signs of weakness that suggest either that economic growth for 2011 has been overestimated or that the tech sector is not going to benefit to the same degree as it has at similar stages in economic recoveries of the past. The fact that most of the tech innovation is actually taking place in software rather than hardware (apps vs. a new tablet; software as a service rather than installed applications) may be part of the puzzle as corporate budgets are spent on IT projects that deliver more efficiency rather than just building in new capacity. The system may be signaling that the pricing power lies with the corporate IT departments rather than the tech firms that will be supplying them.

Oil, Food and US Big Caps

With SPY nudging out EWT, we should be on the lookout for signs that confirm or contradict the idea that the US will grow at a solid 4% plus rate. Unemployment will continue to draw headlines as the Republican presidential candidates start to turn Political Action Committees into formal campaigns in the coming few months. However, it is important to keep two things in mind.
1) Unemployment is a lagging indicator of economic growth in the best of statistical times. And
2) US statistical methods tend to understate new employment in recoveries and overstate the situation in downturns.
So, with a double lag effect, investors should not put much weight on payroll releases. By the time they flash “green”, most of the recovery may be finished.

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