Ramblings of a Portfolio Manager 11-30-2009

Ramblings of a Portfolio Manager or Insomnia Can Be Detrimental To Your Investment Portfolio

Why do we Americans assume someone with a foreign accent is inherently more intelligent? Such an ethno-reverent attitude has probably caused more Americans to become victims of scams, swindles and frauds than avarice and naiveté combined. Now, lest you rush to label us xenophobes, remember that Charles Ponzi leveraged his suave Italian accent and consider how much US investor money is now being thrown at heretofore unknown but quite charming Christian Baha, who not only sports an quaint accent but has made it the cornerstone of his funds’ television marketing program. We wonder how many investors even understand what Baha is hawking with that brogue let alone know his track record.

We don’t recommend it but anyone tuning in to CNBC’s Worldwide Exchange at 4am EST will hear daily an distinguished looking, unsmiling white haired portfolio strategist (who would look more comfortable at the bar at Claridge’s than in front of a Bloomberg terminal), smugly proclaiming in upper-crust English, stilted French or broken Hoch Deutsche intonations that the US will suffer a double-dip recession and that our equity markets are going nowhere (or down). In our humble opinion, this euro-centric investment philosophy is a projection of the insipid investment opportunities of their own no-growth economies on ours. It’s a dour analysis that they’ve been promulgating all year and it’s been dead wrong. Yet US investors continue to pour money into the funds of these offshore masterminds and they are regularly extolled as market mavens by the business press. So it was with a wry smile that we listened to the TV talking heads inform the American investing public over the last two weeks that the “smart money” foreigners (China and India) are buying gold and, therefore, so too should we.

We’ve seen this movie before. Remember the “brilliant” Japanese investors and their investments in big-ticket US real estate in the 80’s, right at the top? How did they fare? Well, for starters there was the $2 billion lost on Rockefeller Center and $841 million on Pebble Beach (twice), deals which were lauded by the press at the time. How about the British, seen as savvy fellow anglo investors, who also had their share of bad investments from homebuilders (Beazer) to advertising agencies (J Walter Thomson, Ogilvy and Mather), retailers (Brooks Brothers) and scores of New England banks—all purchased at market peaks? Saudi Prince Al-Waleed, praised as an investment genius by the press, at least tried to buy on dips but still lost big on Citigroup—twice--and his neighbors in Abu Dhabi thought $30/share was a good price for the same company, now trading just north of $4. All of the above were all poorly timed investments made by supposedly sophisticated private parties and many American investors rushed to join in where they could. Of course Sovereign entities are not exempt from bad decisions and let us not forget the blunders of Iceland, which went from fishing village to financial center and back in the period of several years and, more recently, Dubai, a tiny Arab Emirate with no oil but which bet heavily on development at that commodity’s peak (oh boy, leveraged real estate speculation based on oil speculation!) and is now in danger of defaulting on $59 billion of debt. Again, in both cases domestic investors piled on, following the “smart money.”

Our point here is that while Americans don’t have a monopoly on investment talent, neither do foreign investors. So if you happen to have a sleepless night and tune into the financial new channels early morning, remember two things: 1. that the opinions of the smart-sounding foreigners are both situationally based and biased and 2. governments (not just our own) are slow, ponderous decision-making bodies and by they time they recognize and act on an opportunity, not only is the barn door open, the horse is usually already at the Alpo plant. Personally, we’ll leave the US market investing to US-based portfolio managers and the gold buying to jewelers.

Ramblings of a Portfolio Manager 11-23-2009

Ramblings of a Portfolio Manager or News Flash: Picking Stocks Long Term Can Impair Memory

Yet another portfolio manager appeared on CNBC arguing that the market, as expressed by the price-to-earnings multiple on the S&P500, is way overvalued. His argument was, “if you use the unrealistically optimistic $60 in earnings per share for the S&P for 2009, the market is trading at a P/E in excess of 18x.” We can do that math too but what gave us pause is that this particularly money manager seemed to have quite a bit of experience in investing. If that is true, then perhaps his long-term memory is impaired (or he slept though Finance 101 in Business School) so we offer for him a little primer on how markets tend to work:

1. Price-to-earnings ratios (P/E) always peak at economic troughs and trough at economic peaks. This is simply because markets are discounting mechanisms and when economies, and thus earnings, are at their lowest point (small E), markets are already looking ahead for the recovery (larger than expected P). Conversely, at economic peaks, the E becomes very large while the P tends to remain flat, as investors look ahead to the next downturn (can’t get any better than this!) resulting in a “peak” P/E that is lower than one would see at a trough.
2. As “unrealistic” as he views 2009’s earnings expectations, they are already running at or ahead of his gloomy forecast of $60/shre. Next year’s expected EPS (2010), which the market is already discounting, are $71, an 18% growth rate over his “optimistic” number and rising fast. If we place the “normal” P/E of 15x, which he espouses, on that number, we are right about at fair value on the S&P now. However, we point out that the forecast for next year is rising and might likely come in much higher by year end 2010. So an 18% return may be conservative and if we get any kind of multiple expansion (investors willing to pay a higher P/E) as the market looks out to 2011, the return could be even higher.
3. Stock prices tend to obey the dividend discount theory that the current value of a stock is merely the present value of all the future expected cash flows (e.g. dividends) from holding that stock. Mathematically discounting those cash flows requires an interest rate assumption in the denominator so with rates effectively at zero we could, in theory, have an infinite stock market multiple. That the multiple on forward earnings is back to its recent historical average of 15x, says to us that a ratchet up in rates is already baked into market forecasts.
4. Our friend believes the “extreme overvaluation” can be corrected with a 5% pullback in the markets. Again, our math may not rival his but we calculate that a 5% drop in P, holding E constant, results in a 5% drop in the P/E. If that makes stocks more attractive to him, then we have issue with his use of the adjective “extreme.” We are inviting him in to watch us trade our portfolio, where 5% is a modest spread between the bid and ask market quotes on a good number of our holdings!

Reviewing our retort, we can acknowledge arguments for fair value and, thus, a period of consolidation in the markets. But we just can’t undo our years of finance theory education and practical experience to declare the market “overvalued” at the present time. And we note that the valuation pendulum almost always swings too far to either side (as it did to the upside in 1999 and to the downside last November). So, hating to sound like momentum investors (which we are not) we are holding onto the pendulum (albeit with a loosing grip) while it’s still on the upswing.

Ramblings of a Portfolio Manager 11-16-2009

Ramblings of a Portfolio Manager or Where have all the Doctors and Auto Mechanics gone? Have they been replaced by English Teachers, Biology Majors and Soda Jerks?

Another market week, another bevy of market analogies from economic bears. Everyone wants to be Yogi Berra (no pun intended) it seems. From the “Soda Jerks” we get talk of “sugar highs” and “double dips”, implying that the economy is only showing signs of energy due to a temporary and fleeting injection of “carbs” (fiscal and monetary stimulus), which, when removed, will cause a “sugar crash” i.e. a “double dip” back into recession. The “English Teachers” continue with the tried and true Us, Ws, etc. without any valid explanation of why we will get economic growth charts with patterns tracking those capital letters. The “Biologists” remind us that stimulating a dead frog gives an immediate reaction and then the frog returns to its dormant state--you get where they are going with that one. All these camps are trying to find a catchy sound-bite to describe either why the world economy looks better than they have been predicting all year, or why it will sink back into the level that they originally, incorrectly, predicted. Yogi Berra just sought to entertain, not depress. Perhaps these economists need to work on their delivery.

In our humble opinion, rather than comedian school, all these folks should take a quick refresher course at ITT Tech or, perhaps, a decent Caribbean medical school. Any guy named Skeeter down to the Standard station will tell you that once you jump start a car, it will keep running after you remove the cables (stimulus) because the alternator takes over and runs things. In the US, as well as the major capitalist economies around the world, profit motive is the alternator. Once the “jump start” gets the economic engine running, smart business people take over and start hiring and restocking ahead of higher expected future sales. And this behavior becomes self-perpetuating, thus driving the economy ahead in the absence of further external stimulus, just like a well functioning alternator will do for your car. Of course the ITT dropouts in DC are trying hard to throw a monkey wrench into our alternator but so far have only succeeded in slowing, not disconnecting it.

In the same vein (pun intended), any 3rd year Med Student will inform you that a good jolt from an AED will revive a patient whose heart has stopped (technically dead) so long as it is properly applied and the patient hasn’t been in cardiac arrest for a prolonged period. We argue that the “Biologists” are incorrect in their assertion that this patient is long dead with rigor mortis already set it. We may concede that our AED is being applied by 1st year Med Students (those handling policy in DC) so some risk remains, however, we also believe that the patient’s heart never really stopped, just slowed down. Despite the early credit-taking for the “Obama Miracle” we firmly believe that the normal business cycle has much more to do with the recovery we are seeing and that a little CPR might have been all that was needed (instead of the major open-heart surgery we are now getting) once the Fed applied the paddles last year.

It’s early Monday morning and, for the second week in a row, we have a world-wide stock market rally with the US futures pointing to a much stronger open. If the Markets here close up today, it will be only the second time we have had back-to-back positive Mondays this year. What does that mean? Heck if we know but some technician somewhere will find it to be a sign that the money flow or reverse oscillating Bernoulli Bands or some such thing are positive and that we are due for more gains (or losses) ahead. Personally, we believe in looking at astronomical indicators. In our case, we analyze stars rather than planetary alignment, and note that the waning power of one particular star, our President, has significantly reduced the weekend headline risk that used to cause weekly Black Mondays. The trend is your friend until it isn’t so, always looking for an inflection point, we may just rethink the day on which we price our picks for Ramblings going forward. Of course, before we do we will consider all the sugar, volts, amps and dead frogs out there.

Ramblings of a Portfolio Manager 11-9-2009

Ramblings of a Portfolio Manager or Hello Goldilocks?

It’s generally a sign that a writer has made the mainstream when his/her material appears on bathroom floors across America. We won’t be so conceited as to think that Ramblings would ever achieve that kind of pulp fiction status, however, we were more than a little amused to watch Jim Cramer prance about the sound stage last week holding a stuffed teddy, proclaiming “you just can’t win with a bear.” His blather went on to sound increasingly similar to the theme of last week’s Ramblings. Now, we don’t in any way mean to imply that Mr. Cramer found a copy of our weekly on the tiles of the CNBC executive washroom or, for that matter, would give it any credence if he had, which causes us to be a little scared that we actually may independently, at times, think likewise to the self-proclaimed “TV Madman.” By the way, Cramer turned bearish to bullish to bearish and then back to bullish on the markets all in the space of the last 6 trading days (we hope you were able to profitably trade on that good advice). He has yet to retract his statement that “we’ve seen the highs of the year in the markets and you can short just about anything…” Another 350 Dow points to the upside and we shall see about that. In the meantime, if we find ourselves in-line philosophically again with Mr. C. look for Ramblings to morph into a children’s pop-up book.

So far, the results for earnings season, and the market’s reaction, have generally fallen along the lines of our expectations. Technology stocks and others that have had good runs and for whom bullish sentiment and whisper numbers have re-emerged (high expectation stocks), generally fared poorly unless they were able to significantly “beat the Street.” Lower-expectation stocks did much better even on bad news and by the end of the last week we had seen a genuine shift in market sentiment, resulting in a sector rotation out of cyclical winners and into defensive laggards. October, once again, evaded its popular reputation and proved itself as the month in which markets typically “turn,” rather than “tank.” This fact was illustrated by a Dow that did virtually nothing for the month while the heretofore better-performing NASDAQ and Russell Small Cap indexes took a hit.

Now that an earnings season highlighted by markets that ignored both good news and bad is winding down, what can we expect for the remainder of the year? Perhaps mating the market’s behavior during earnings season with its performance last week can generate a prediction. As you recall, a better-than-expected ISM gave the markets a nice rally last week. We believe, however, that a good deal of that rally was based on simultaneous significant democratic gubernatorial losses around the country, which foreshadowed coming results of the 2010 mid-term congressional elections. Political gridlock is good for the markets and last week’s elections signaled to some that we may indeed get a Congress a year from now under which nothing will get done. The elections also signaled a waning of Obama’s rock star status, which encouraged bulls to believe his healthcare bill may be in peril or, at the least, due for significant revision. The House slim 5 vote margin over the weekend certainly indicated the diminution of Mr. Obama’s ability to lead via star power and the bill is expected to face greater challenges in the Senate later this year. By the end of last week, Friday’s weaker than expected employment data failed to sink the market—in fact the Dow eked out a small gain for the day. Synthesizing all this, we see a market that is more focused on next year than the last twelve months, and which is anticipating the removal of uncertainty. Markets hate uncertainty—so much so that we believe the market will rise whether Obama’s healthcare plan is passed or defeated and, later this year, whether Cap and Trade succeeds or fails. With the uncertainty of multiple policy risks behind us, regardless of outcome, companies may well begin to hire again and the market is beginning to see that. So with earnings season in the rear view mirror, political uncertainty beginning to wane, we may see further gains in this market. And if unemployment indeed begins to come down, we just might hear talk, as we did in the 90’s, of a Goldilocks economy—one that is neither too hot nor too cold.

Ramblings of a Portfolio Manager 11-2-2009

Ramblings of a Portfolio Manager or “Beam Me Up Scotty!”

For those non-Trekkies, Kobayashi Maru describes a fictional test taken by cadets at Starfleet Academy--one with no possible winning scenario. The pyrrhic exam was only defeated once, by Captain James T. Kirk (then cadet), who reprogrammed the computer to allow a positive outcome. It is meant as a test of character rather than of skill or military acumen. It also describes current U.S. market sentiment toward the US economic recovery.

Wednesday afternoon, the market experienced a strong sell-off, primarily on the news that the well-known Fed Insider, Government, er Goldman Sachs, had lowered its projections for third quarter GDP expectations to +2.7% from the prior Street expectations of +3.0%. If Goldman said it, then, well, it must be true since they are the smartest guys in the room and, of course, have the “inside line.” Just like it was with their $150/bbl oil prediction in 2007 and $25/bbl prediction in early 2009. On Thursday, US third quarter GDP came out at +3.5%. Well, one of three ain’t bad… Goldman’s miss and the economy’s beat immediately spurred a round of short-covering and some genuine buying in the US equity markets, with the Dow ending the day up nearly 200pts on Thursday. Immediately, technicians who saw all sorts of chart breakdowns on Wednesday evening tripped over one-another to find bullish themes in Thursday’s market actions. The economist crowd, however, were not so sanguine.

Having been 50% correct all year (at a much greater cost than the quarter one could just as well flip), the PhDs found no cheer in the 3^rd quarter economic report. They were quick to point out that, ex-cash for clunkers, the real number was probably +2.7% (which would still be the best quarterly advance since the third quarter of 2007). Missing from their dour analysis was that consumption as a whole added 2.36% to growth with inventory restocking adding nearly 1% and residential construction adding 0.53 percentage points, its first positive contribution since the fourth quarter of 2005! Actually, many viewed the consumption component as a bad thing as it is seen as “volatile.” Gee, our math says that in an economy 70% driving by the consumer we are right on track (3.5%x.70%=2.45%), but then again we don’t have PdDs in economics or higher mathematics. The economists divided into two camps: the “skeptics” saw the data as bad, claiming that the economy is only being supported by the Obama stimulus package. Ignoring that fact that only 17% of the package has been spent on what most of their brethren argue are non growth-producing projects, they claim the only way the US experienced GDP growth in the third quarter was through government spending; i.e. growth was spurious and without the stimulus, we would still be in recession. Therefore, they argue, the market is ahead of itself. Of this camp we ask, what was the point of the stimulus package if not to produce this exact result? The second camp, the “believers,” were more forward looking. In their view, the growth data was bad as it was real and signaled that the Federal Reserve may withdraw liquidity ahead of current expectations. They argue that the market is not discounting a rate hike as early as they now predict and, therefore, is ahead of itself. All this “no way out” arguing helped the Dow to more than erase Thursday’s gains on Friday. Japanese sailing vessel analogies aside, we term this the “damned if you do and damned if you don’t” scenario. Just remember that it was a group of PhDs in economics who almost sunk the world economy in the last great financial crisis (with leverage) in 1998 with the last “too big to fail” bailout--Long Term Capital.

As we write this Sunday evening, news comes across that the Chinese PMI rose to a better-than-expected 55.2, the highest level in 18 months, signaling continuing expansion of manufacturing in that country. Chinese GDP is now expected to grow in excess of 9.5% this year—a number of which we should be envious…at least we think. What do our economists say? Well, we’ve yet to hear them try to convince anyone that growth in China is bad for a multitude of conflicting reasons, as they are attempting to do with growth here. In fact, no one questions that Chinese growth is stimulus-induced--as it should be--and that their Central Government will soon be tightening monetary policy. Instead, economists have been telling us just not to believe the numbers—that the Chinese Government is lying. Perhaps, but such “lies” can only continue for so long before a little dog exposes the man behind the curtain. By the way, the Shanghai Composite ended the day up 2.7%. Well, enough of the movie analogies. Our whole point in this Ramblings is to suggest that a lot of very highly educated folks can take the same data and arrive at the same market predictions for wholly opposite reasons if they have a prior bias. By the same token of course, many highly educated folks can take the same data and arrive at polar opposite market forecasts, also depending upon their priors. That demonstrates the pitfalls of giving credence to economists as market prognosticators. Our question is, who will be the Jim Kirk to reprogram some of these geniuses? Obama? Geithner? Bernanke? Our bet is on Mr. Market. In any case, whomever he/she is will rely on psychology rather than programming to resolve this intellectual no-win scenario.