Why I'm Being Cautious

06/04/2013 7:45 am EST

Focus: STRATEGIES

Stephen McKee

Editor and Publisher, No-Load Mutual Fund Selections & Timing

Stephen McKee of No-Load Mutual Fund Selections and Timing is beginning to stockpile cash just in case, and here he explains the reasons behind his strategy.

Nancy Zambell: My guest today is Stephen McKee, the editor of the No-Load Mutual Fund Selections and Timing newsletter, as well as a couple of others. Welcome, and thanks for joining me, Steve.

Stephen McKee: It's good to be here. I appreciate it.

Nancy Zambell: The MoneyShow last week in Las Vegas was pretty successful for you, right?

Stephen McKee: It was fantastic. The MoneyShow does a great job of attracting some quality investors and some great participants. We did put on a couple of workshops and had a tremendous turnout.

They also had us on the webcast, with the mutual fund presentation, and we were also on the presentation on ETFs. We're very pleased with how it went.

Nancy Zambell: That's great. Now tell me, what did you think of investor sentiment as you were talking to folks at the show?

Stephen McKee: You know, it's very interesting. I'm not sure if I've seen such a divergence between the professionals—the advisors who are getting paid—versus the investing public.

The advisors are pretty much as bullish as can be. The institutions are bullish. I believe Barron's came out a few weeks ago saying they've had the highest number of bullish advisors.

Investor sentiment is way bullish, but yet you look at the individuals and we're still a little but muted, a little bit neutral. Maybe they have some invested, but they're certainly not riding the train of the bull market higher over the past couple of months. It's very interesting that again, you have these bullish advisors, but a pretty neutral public.

Nancy Zambell: Yes, I found the same thing when I was doing my interviews. What do you actually think of this market? We're having a pullback the last couple of days.

I think Bernanke confused people yesterday saying we're going to continue buying bonds, and then we're going to start pulling back. Then of course Japan didn't like that. The China numbers were not too good. They look like they're not too bullish there. So what's your take on all of this?

Stephen McKee: Bernanke was fairly confusing. I think you're right. Over the last couple of months, he's definitely been signaling we have to get the unemployment rate down to 6.5%. It's nowhere near that.

Then all of a sudden he starts coming out with, "we have to start winding down this buying program." I guess it's something we all know is going to happen eventually, but I don't think anyone expected it as soon as June for the buying program to slow down, if not stop.

I think we've had a fairly good reversal day yesterday, for what that's worth. Occasionally, those reversal days work where it was up strong—100 points, 200 points, or 150 points—and then down.

The lows were below the lows from the previous day on both the industrials and the transports. It could be very interesting going forward. We certainly had a huge run, and we are more than due for something more than a 1%, 2%, or 3% pullback.

Nancy Zambell: Do you think we're going to get an 8% or 10% pullback, or do you think that we could actually crash?

Stephen McKee: That's another interesting question. Part of it sort of depends on if we have left the secular bear market that started in 2000...has it ended?

Because if it has, the nature of pullbacks—or bear markets in a secular bull market—is totally different than how they act in a secular bear market. Think of 1987. That was a waterfall decline, but it was over. In fairly short order. Sharp, short, painful, scary.

Nancy Zambell: All of the above.

Stephen McKee: Yes. Think of 1990—short, sharp, and scary, but it was over in six months. Then fast forward to 2000. It was a long, drawn out, three-year bear market, 2007, 2008 into the first quarter of 2009, before it finally hit bottom. It was a long, drawn out affair.

It's a good question. What's going to be the nature of any sort of a pullback that we get? Is it just going to be a normal pullback, and then kind of rally on from there?

I'm sort of leaning toward the waterfall decline. I think we've had a lot of participants, a lot of chasing of the market. And the question is really are there any buyers underneath left, or has everybody got in?

If everybody is in, then you have these vacuums that form, and you do have these sharp, short pullbacks: 10%, 15%, even 20%.

Nancy Zambell: What are you advising your subscribers to do?

Stephen McKee: We've got some cash in the portfolio. We tend to be fairly risk-averse. We do try to sidestep these things, and we're actually thinking of raising some cash here.

In the ETF model portfolio, it's fully invested. We're watching very closely. We have some fairly close stops in there, and we try to let the market tell us what it's doing. If it rolls over, we'll zoom back out to cash. Then if it starts heading, we'll get back in.

We try not to anticipate. We try not to tell the market what it's going to do. We try to let it tell us.

Nancy Zambell: You're using mostly technical factors in your model, is that correct?

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Stephen McKee: Yes. We do monitor the fundamentals and the leading indicators, housing, consumer sentiment, the GDP, what's the Fed doing, what are interest rates doing. We look at the world inputs. Then we use also trends and divergences, fairly normal technical indicators. That's kind of our timing process.

Then in our selection process, we use a risk-adjusted model, and that's kind of the key that sets us apart from everybody else. We adjust the fund's performance for the risk they've taken. We use a risk-adjusted relative to performance. Some people say that's just momentum.

So if something is up and down 10% every month, if they made me 100% after three months, I guess that's OK because their performance has outperformed. If they are up and down 10% and they end the year at zero, obviously that's way too volatile for the returns, and we wouldn't be in it. Even though the momentum might be there, we wouldn't be there, because we adjusted for the risk.

Nancy Zambell: Do you have any favorite sectors right now?

Stephen McKee: That kind of goes back to that question earlier, about are we in a secular bull market? Has the bear of the last 13 years changed?

One of the interesting things is the participation is really across the board. You have the value stuff going up. You have mid cap, large cap, small cap.

We track about 800 funds, and we select the top 5%. That's our buy list. Then we hold them as long as they're in the top 20%, so that's the top 5% and then the next 15%. Then you have the mass of the 60%, the worst—or the next bottom 15%, and then the worst 5%. You never want your money in those. No, if you're taking the risk, you may as well be with someone who is leading.

It's very interesting that there is such participation. The one area that had been kind of not participating was the internationals, but when Japan loosened up, they kind of shot into the top. It's very interesting at least domestically you have wide participation.

Nancy Zambell: Yes. It seems like you said, whether you're looking at small-, mid-cap, whatever, and that's just not always the case with the market. That kind of rings a warning bell in my mind.

Stephen McKee: Well, it could be a warning bell. Yes, I mean you sure don't want to confuse brains in a bull market. People do that.

Nancy Zambell: I know they do. People get caught because they're right one time, and they're going to be right the next time, and that rarely happens.

Stephen McKee: Absolutely. I've been doing this for 15 years. Mark Hulbert came out with an interesting article. He tracks our newsletters and gives us a great ranking. We're number one over the last 20 years for risk-adjusted performance.

He wrote an article about evaluating your manager—is it luck or is it skill? He said you have to have 15 to 20 years to tell. Yes, don't confuse brains in a bull market. Just because it's been up five months, that doesn't mean it never changes.

Nancy Zambell: What do you think about the metals? Are you buying any of the gold ETFs or silver or anything?

Stephen McKee: No, those are what I call comets, instead of stars. The comets come into and out of prominence; stars are more or less fixed. We want to be with the leaders. Gold and the precious metals—those are all one comet.

I think it's another very good question, and I think what happened was that people were anticipating. We were flooding the world with money. Japan is onboard with flooding the world, so everybody is expecting inflation to take off, and the gold market is acting like major deflation.

I think a lot of people really had this concept in mind, and I'm not sure you have to use stops. Just admit you're wrong and move on. To answer your question, no, we don't have any precious metals.

Nancy Zambell: OK, what would be your favorite mutual fund right now if you had to say you had a favorite—if you had new money to invest?

Stephen McKee: I think there are probably six or eight different mutual funds in our portfolio. In the ETF portfolio, we have the five big ones. At any point, we're either all in or all out. We are going to be expanding that to about eight.

A couple of names as far as ETFs, for example, iShares Dow Jones Select Dividend Index (DVY) has been doing fantastic. The Vanguard Wellesley (VWINX). There's a layer of balance; those are a couple of hybrid funds that look attractive.

There is Barron Partners...that one has been doing good, the iShares Russell Mid Cap Value (IWS). We may own one or two of those in the portfolio, and then you know three months, six months, a year from now, that's definitely going to turn over.

I'll also say we've been taking long-term capital gains. It's been a fantastic past few years.

Nancy Zambell: Yes, it sure has. A big relief after what happened just prior to that, but that's what makes the world go round. Right? We're in it for the dips and the good times too.

Stephen McKee: Yes. Bernanke, I would assume, is a student of history, and that definitely helps. He definitely loosened up, and said we're going to avoid what happened in the 30s. And he really has.

The housing numbers have come around. The car manufacturers have come around. The unemployment is kind of lagging. But the consumer discretionary ETFs have just been doing gangbusters the last couple of years. It's like another one of those anomalies where you have this concept in mind, but the reality is a little bit different. It's interesting.

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