Dr. Copper Is a Quack

10/14/2011 7:00 am EST

Focus: MARKETS

This widely followed professor of economics has lost his tenure thanks to Dean Lumber, wood being a commodity that Lee Munson says is a much better economic indicator these days. He also explains why he believes our markets have changed too much for conventional asset-allocation strategies to work.

Kate Stalter: I am on the phone today with Lee Munson. He is the founder of asset management firm Portfolio. He’s also a regular commentator on CNBC.

Lee, you have an upcoming book, which as I understand covers the premise that for retail investors, allocating across the range of asset classes may be an outdated principle. So tell us a little bit about that before we get your view of the current market.

Lee Munson: Well, it all goes back to when we looked at the 1950s and we started understanding modern portfolio theory. It was a very basic premise that if you diversified with different asset classes that didn’t move with each other, that you could achieve a type of diversification that would lead you to higher return for less risk.

This is something that Wall Street really grabbed hold of in the 1980s and 90s. The problem: just like the Dogs of the Dow or the January Effect, it’s really called the Trader’s Effect. Once so many people do it, it loses its power. It loses its magic.

In that same idea, we started seeing in the early 90s where international indexes like the EAFE started to have a strong correlation to the broad US market indexes. Now, we don’t know why, but I would probably say that the ETF explosion and the type of electronic trading that we see today has made things like small-cap, mid-cap, large-cap, and even some commodities to some extent, start moving with, let’s say, the S&P 500.

So, I don’t think that in today’s world, it’s necessarily valuable for an individual investor or institutional investor to own a little bit of every single asset class, especially if many of them are moving together. What we need to focus in on is the risk each of those asset classes is kicking off.

Kate Stalter: So, as market conditions do change—and obviously there’s been so much volatility recently—how should retail investors view the right asset allocation mix? Because, you and I probably both hear the questions from retail investors about what they should be doing right now.

Lee Munson: First of all, they need to have a long-term risk budget, not a long-term pie chart. Pie charts are lies. Pie charts basically say you should have 60% in different stock classes and 40% in different bond classes.

What we want to do is we want to say, long term, how much risk do you want to take? You can do that by measuring risk over long periods of time. When it comes to actually executing that strategy, that’s when you have to put the stats down and start looking at a fundamental view of the world.

I’ll give you a perfect example: Europe. Since January 2010, our firm has been out of anything involving the EAFE or international indexes.

It’s not because we’re brilliant. It’s not because we know that there’s going to be imminent danger. I knew that Dubai was falling apart in November of 2009, and I knew that Greece was becoming a problem. Because of those fundamentals, I just simply said, “I don’t want to be part of or participate in Europe.”

To further help me with that decision, I noticed that the international index had a .9 or 90% correlation to the S&P 500. So, why have higher expenses? Why have more stuff in your portfolio and deteriorating fundamentals in Europe when that investment on a daily basis, monthly basis, is mainly going to track the S&P 500?

Now, that’s the theory. Now, how has that worked over the past two years? Well, it’s been very profitable. You know, the EAFE has very much underperformed the S&P 500, and our clients have done better by not seeking that extra diversification.

I think we have to take that step beyond. It’s not about underweighting or overweighting. I think that that’s an overused idea. You’re directional. You’re either in Europe, or you’re not.

For us, we’re out of Europe, and I would say one should stay out of that until they solve their problems, not just making a great press release about Germany and France are going to force a default, not force a default. This is a long-term problem, and for me, I’m long-term out of the area.

Kate Stalter: Let me just ask you a little bit about Europe, then, to follow up on that. As you know, I want to get to some of your specific investment ideas.

Lee Munson: Sure.

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Kate Stalter: Before we get there, you had talked recently in a TV appearance about waiting out some of this European uncertainty and the volatility in the market. What’s your take on that? There obviously was a little bit of a rally after Merkel and Sarkozy announced a plan to make a plan, but what’s your take on Europe these days?

Lee Munson: Well, you know, my take is that there will be periods of time that we’ve experienced, especially in August and September of this year, where there is contagion, and the volatility of fear and uncertainty in Europe does flow over. Just like that 90% correlation I talked about. It will start to pour over into US domestic markets.

If you have euro traders, they’re trading US markets no differently than they’re trading European markets. I think the plan for a plan, what we really want to see is when France and Germany come out and say, “We’re going to do something good.” We want to see the market react positively to that.

It’s no different than if earnings are good. What do we do? We see, does the market sell off that news, or buy into that news?

In August and September of this year, no matter what the heads of state said, no matter what the ECB said, the market had a negative reaction to it. They could have said, “Greece will be fine and all is forgiven,” and the market would have dropped.

So, what we’re starting to see in October is a sentiment shift. The problems in Europe have been around all year. Nothing today is going to change the problems in Greece, or Portugal, or anyplace else. The only thing that’s going to change is how the market, meaning the collective traders in us all, react when these heads of state open their mouth.

About two or three weeks ago, I thought we were starting to hit bottom on the US markets when there was a press announcement by Obama, and the market didn’t immediately start selling off the first moment he opened his mouth. That’s what we’re looking for, because all that information about what is the plan, what is going to happen—it’s meaningless.

The individual investor, and even most retail investors, really will never understand the full picture of Europe. They will never understand the opaque balance sheets of those European banks. But we can take a pulse of the market, and see how are we collectively reacting when somebody says something.

Kate Stalter: Let’s segue from there into some of your actionable ideas you have to flourish in this particular market scenario.

Lee Munson: Well, number one, I think that we can’t leave the industrials out to die. Some of the areas that we continue to be long, even though we budget for risk: US master limited partnerships.

We tend to like to purchase exchange traded notes for the liquidity, for the ease of tracking, and I think if an investor wants to do some more due diligence, they can certainly seek information from us or go look at the information that’s available on the Internet. I’ve written a few things on Seeking Alpha about it.

The long story short, we have poor energy infrastructure in our country here in America. There’s going to be continued investment. There’s going to be continued subsidies by the government. They are a special interest, a bipartisan special interest.

So, I think that if you can seek out an area like the Master Limited Partnership arena, where there are a lot of distributions from their earnings and also available money to reinvest, that’s a winning combination.

I also think that people should really focus on those industrials if they’re looking for individual stocks. You know, the Caterpillars (CAT) of the world, I think, are an actionable thing.

The defensive plays, your drug companies—that’s not where I would start heading right now. Even some of the energy companies. We like Occidental Petroleum (OXY). Those are some of the areas that we like in particular.

I can tell you why. Just look at the price of lumber today. If you’re not into futures and looking at that, that’s okay. If the individual investor looks at the price of lumber today versus the futures price going one year from now, you’ll see there’s serious contango.

Now, what does this mean in plain English? People who need lumber are willing to pay 30% more to secure that lumber a year from now, than what the price is today.

Now in the old days, we used to look at copper as a leading indicator. Well, people trade copper all the time. Everybody—hedge-fund managers, everybody is talking about copper, copper, copper.

You know what happens? Copper now tracks the market. It goes up and down with the market. It doesn’t tell us anything.

But the price of lumber is very complicated. It tells us about shipping costs. It tells us about transportation costs. It tells us about the demand, and it tells us about the buyers. And it’s not just about building homes; it’s about people who need something are trying to calculate how much things are going to cost a year out.

You know what? They’re saying they’re willing to pay a 30% increase. We don’t have to worry, “Well, is that from the oil or is that from labor costs?” They’re thinking across the board, at a 30% increase, just everything is very expensive.

So, I think that that leads us to continue to look at the cyclical industrials. If we don’t get the double dip, you’re not going to want to be left holding a bunch of Coca-Cola (KO) and Pfizer (PFE). That’s not where the action is going to be. Quite frankly, you can end up being sorry for it.

Kate Stalter: Well, Lee, thank you so much for these ideas today. You’ve given us some interesting new topics to think about.

Lee Munson: Hey, it’s a pleasure to talk to you. If anything, just remember, keep risk constant. If you’re really interested, you can read my book. It’s coming out from Wiley in December called Rigged Money, where I’m really going to rail against these ideas of pie charts, over diversification, and some of the more unsavory parts of my industry.

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