“Dude, you’ll need a different board to catch a phat ride without a rad curve!”
It’s been nearly two weeks since the Federal Reserve last met and made the historic pronouncement of their intent to start purchasing long-dated treasuries with the runoff from their maturing MBS portfolio. Since that decision the Dow and S&P500 have fallen roughly 5% each. Harder hit, however, have been the bank stocks, which have fallen 8% as expressed by the Keefe Bruyette Bank Index, and small cap stocks with the financial-heavy Russell 2000 Index also down 8%. Thanks guys!
We opined last week on the reasons for the market’s ill take on the Fed’s decision so we won’t repeat it. Rather, we question whether the market is “getting it” in its negative view on bank stocks in particular and by extension, equities in general. The conventional wisdom of the portfolio manager is that the flattening of the treasury yield curve from the Fed’s actions will crimp bank earnings—particularly in the current environment in which most banks have been “surfing the curve” by using their near zero cost of funding (from Fed Funds, negative real rates on time deposits after fees and pitiful CD rates) to reinvest in long-dated, risk-free treasuries. We don’t disagree--with a steep yield curve, the banks were literally printing money with little risk given the Fed’s promise to hold short-term rates low for a very, very long time. Now, however, that little game seems to be over and with the other arm of the Government rushing to “help” with the Financial Reform bill, estimates are that earnings of banks and other financial institutions will fall significantly (25% or more by some estimates). Where we disagree is with the extension of the conventional wisdom to encompass the belief that this will dampen the incentive to lend, thus weakening the economy. We lost count of how many PMs appeared on TV over the last two weeks with a statement to the effect of “the market cannot recover without the banks leading the way.”
It’s been too short a time to analyze bank balance sheets to determine whether the Fed’s decision has made any substantial change in Management behavior and it could take up to a quarter or so for the information to work its way into financial statements. In the short-term, however, we can see the immediate effect on consumer behavior and at the end of the day, that’s what we all care about anyhow. Last week, mortgage refinancings were up 16%--an immediate reaction attributable to the rapid drop in long term rates. That little blip alone should put substantially more money in the pocket of the beleaguered consumer, more than whatever new fees the banks might extract thanks to Fin Reg. That’s a net positive to the economy. But what about those banks? Will a flat curve hurt them? We believe the Fed’s actions were designed to do just the opposite. By flattening the yield curve, the Fed did two things, both of which were intentional: First, it brought down mortgage rates, a shot in the arm to the ailing housing market. Secondly, it sent a message to the banks that the risk-free surfing is over and that’s a good thing. If bank Management wants to stay employed and appease shareholders, they’re going to have to find new sources of revenue. One, as we mentioned, will be to raise fees to depositors, but we feel the lower long-rate environment will more than make up for that in consumer wallets. The other is to boost net interest margin by reaching for yield—that is, by taking some risks like making loans or even buying MBSs themselves. In the latter case, the banks would be taking over the Fed’s recent job (the market didn’t like the Fed’s decision to stop MBS purchases), driving mortgage rates even lower, and in the former they would actually be spurring on economic growth. Either action would be good for the housing market, the overall economy and, ultimately, for the equity markets. We just need the Obama Administration to get out of the way and let the banks do what they do best.
Monday, August 23, 2010
Monday, August 16, 2010
Ramblings of a Portfolio Manager
Bullard vs. Buffett
The Federal Reserve held its monthly meeting last week and since then the equity markets have churned lower daily. By the end of the week all the major equity indices were down following the decision with the S&P 500 and Dow dropping 4% respectively and the Russell 2000 index of small cap stocks plunging 8%, all within three trading days. The reaction was as dramatic as it was unexpected and left all major US equity indices back in the red for the year. The Ten Year Treasury Bond yield, meanwhile, hit a 16 year low and is now below the dividend yield on the S&P 500, something that almost never happens. The pundits ascribed the market’s response to the Fed’s downgrade of expected GDP growth-- which is interesting as that was something that was widely expected--and its decision to maintain its balance sheet at current levels, essentially halting its earlier ongoing withdrawal of liquidity from the markets. The Fed also reiterated its intent to keep rates at the same level for an extended period (also expected) and to reinvest the proceeds of maturing Mortgage Backed Securities into Long Maturity Treasuries.
Forget the pundits, why did we get such a dramatic negative reaction? Typically, continued easy money policy would be seen as a positive. The simple answer is based on the Fed’s signaling. Historically, a good portion of the efficacy of the Federal Reserve has been not so much its actions as its pronouncements—that is, simple declarations of intent to proceed in one direction or another have been sufficient to achieve the desired economic results, rather than actual direct monetary intervention. Of course, the Fed tries very hard to send signals that guide the markets and economic participants to the desired behavior…and such was the case this time around. The problem is, like any type of guidance, the outcome depends upon the expectations of those that are guided. In the case of the equity markets, a recent round of strong economic data got many participants (us included) into the belief that the economy is stronger that the economic data suggest and that the Fed was of the same belief. Their downgrade of economic growth, though expected, paired with additional quantitative easing, quashed that belief for many. Had they done nothing, the markets would doubtless be much higher today.
The second issue we see with the Fed’s actions is the decision to allow short term MBS securities to roll off and to use the proceeds to buy long-dated US Treasuries. We believe the market had hoped for more open market purchases of MBS securities thereby bolstering the housing market, a weak link in our current economic recovery, with continued low mortgage rates. The current plan would simply flatten the yield curve, which for many is seen as a net negative. We disagree. First of all, mortgages are priced off the 10-30 year Treasuries so with the Fed driving down the yield on these instruments mortgage rates will fall any how. Secondly, we believe that flattening the yield curve is going to get some of the big banks off their collective conservative butts to stop “surfing” the Treasury yield curve. That is, borrowing short term at essentially zero and plowing it into risk free Treasuries at a 4% yield, free money so long as the yield curve doesn’t invert. Now, with 30 year Treasuries heading toward the 3% range, many banks will face the prospect of below historical net interest margins. How to boost them? Make loans, of course. That is what the economy really needs (other than certainty out of Washington but that’s tantamount to expecting a $1mm check from the tooth fairy) and we believe that is what the Fed had in mind with its strategy. Obviously, the market does not see it our way.
The other outcome of the Fed’s move was renewed talk of deflation. St. Louis Federal Reserve Member James Bullard has been doing the speaking circuit with his prediction that the US is heading toward a Japanese-style deflationary economy based on the Fed’s continuing zero-interest rate policy, which he believes is putting the U.S. economy at risk of falling into a Japanese-style deflationary cycle that could keep the economy weak for several years. Now, when a Fed governor speaks, the Markets listen and the current weakening expansion certainly lends credence to his beliefs. The interesting tidbit to consider is that his predictions fly in the face of the predictions of a very famous market participant, Warren Buffett. Reports have Buffett , link to report, shortening the duration of his bond holdings after warning that deficit spending could force inflation higher. Twenty-one percent of his holdings including Treasuries, municipal debt, foreign-government securities and corporate bonds were due in one year or less as of June 30, Berkshire said in a filing Aug. 6. That compares with 18 percent on March 31, and 16 percent at the end of last year’s second quarter. As Buffett was quoted as saying “The United States is spewing a potentially damaging substance into our economy -- greenback emissions. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt.” Clearly, his opinion of the outcome of the Fed’s monetary policy is 180 degrees from Bullard’s.
So who to believe? We tend to follow the guys with the real world experience rather than the academics. Furthermore, based on the earnings conference calls we have sat in on we continue to hear that companies are bumping up against the limits of their productivity growth or capacity utilization. At some point, like flood water behind a dam, that has to push through in a great rush of additional hiring and plant expansion. That, we believe, will give us the growth and employment this economy needs and, ultimately inflation rather than deflation.
The Federal Reserve held its monthly meeting last week and since then the equity markets have churned lower daily. By the end of the week all the major equity indices were down following the decision with the S&P 500 and Dow dropping 4% respectively and the Russell 2000 index of small cap stocks plunging 8%, all within three trading days. The reaction was as dramatic as it was unexpected and left all major US equity indices back in the red for the year. The Ten Year Treasury Bond yield, meanwhile, hit a 16 year low and is now below the dividend yield on the S&P 500, something that almost never happens. The pundits ascribed the market’s response to the Fed’s downgrade of expected GDP growth-- which is interesting as that was something that was widely expected--and its decision to maintain its balance sheet at current levels, essentially halting its earlier ongoing withdrawal of liquidity from the markets. The Fed also reiterated its intent to keep rates at the same level for an extended period (also expected) and to reinvest the proceeds of maturing Mortgage Backed Securities into Long Maturity Treasuries.
Forget the pundits, why did we get such a dramatic negative reaction? Typically, continued easy money policy would be seen as a positive. The simple answer is based on the Fed’s signaling. Historically, a good portion of the efficacy of the Federal Reserve has been not so much its actions as its pronouncements—that is, simple declarations of intent to proceed in one direction or another have been sufficient to achieve the desired economic results, rather than actual direct monetary intervention. Of course, the Fed tries very hard to send signals that guide the markets and economic participants to the desired behavior…and such was the case this time around. The problem is, like any type of guidance, the outcome depends upon the expectations of those that are guided. In the case of the equity markets, a recent round of strong economic data got many participants (us included) into the belief that the economy is stronger that the economic data suggest and that the Fed was of the same belief. Their downgrade of economic growth, though expected, paired with additional quantitative easing, quashed that belief for many. Had they done nothing, the markets would doubtless be much higher today.
The second issue we see with the Fed’s actions is the decision to allow short term MBS securities to roll off and to use the proceeds to buy long-dated US Treasuries. We believe the market had hoped for more open market purchases of MBS securities thereby bolstering the housing market, a weak link in our current economic recovery, with continued low mortgage rates. The current plan would simply flatten the yield curve, which for many is seen as a net negative. We disagree. First of all, mortgages are priced off the 10-30 year Treasuries so with the Fed driving down the yield on these instruments mortgage rates will fall any how. Secondly, we believe that flattening the yield curve is going to get some of the big banks off their collective conservative butts to stop “surfing” the Treasury yield curve. That is, borrowing short term at essentially zero and plowing it into risk free Treasuries at a 4% yield, free money so long as the yield curve doesn’t invert. Now, with 30 year Treasuries heading toward the 3% range, many banks will face the prospect of below historical net interest margins. How to boost them? Make loans, of course. That is what the economy really needs (other than certainty out of Washington but that’s tantamount to expecting a $1mm check from the tooth fairy) and we believe that is what the Fed had in mind with its strategy. Obviously, the market does not see it our way.
The other outcome of the Fed’s move was renewed talk of deflation. St. Louis Federal Reserve Member James Bullard has been doing the speaking circuit with his prediction that the US is heading toward a Japanese-style deflationary economy based on the Fed’s continuing zero-interest rate policy, which he believes is putting the U.S. economy at risk of falling into a Japanese-style deflationary cycle that could keep the economy weak for several years. Now, when a Fed governor speaks, the Markets listen and the current weakening expansion certainly lends credence to his beliefs. The interesting tidbit to consider is that his predictions fly in the face of the predictions of a very famous market participant, Warren Buffett. Reports have Buffett , link to report, shortening the duration of his bond holdings after warning that deficit spending could force inflation higher. Twenty-one percent of his holdings including Treasuries, municipal debt, foreign-government securities and corporate bonds were due in one year or less as of June 30, Berkshire said in a filing Aug. 6. That compares with 18 percent on March 31, and 16 percent at the end of last year’s second quarter. As Buffett was quoted as saying “The United States is spewing a potentially damaging substance into our economy -- greenback emissions. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt.” Clearly, his opinion of the outcome of the Fed’s monetary policy is 180 degrees from Bullard’s.
So who to believe? We tend to follow the guys with the real world experience rather than the academics. Furthermore, based on the earnings conference calls we have sat in on we continue to hear that companies are bumping up against the limits of their productivity growth or capacity utilization. At some point, like flood water behind a dam, that has to push through in a great rush of additional hiring and plant expansion. That, we believe, will give us the growth and employment this economy needs and, ultimately inflation rather than deflation.
Monday, August 2, 2010
Ramblings of a Portfolio Manager
Mr. Peabody’s Apples
The dog days of summer are upon us so we’ll spare you a lengthy treatise on some arcane aspect of finance. Instead we’d like to talk about a little children’s story, written by Madonna of all people, that we used to read to our kids. It’s based on an old Eastern European folk tale of a woman who spread a false rumor and the village wise man who challenged her to shred a feather pillow into the wind and then try to recapture all the loose down, the moral being that once out false rumors and gossip are almost impossible to recall. Sound like the internet? Sounds a lot like CNBC to us as well.
OK, confession: what we really want to do is give you a quick report card on the current earnings season to date. So far approximately 1/3rd of S&P 500--and by extension all US--companies have reported their second quarter earnings. Going into this reporting season the general consensus among the Wall Street sell side and financial media was that the second quarter reports would be good, but not great, and that management guidance would be terrible, given the turmoil in Europe and engineered slowdown in Asia. How did that consensus belief come into being? Cynically, we suspect that it originated from a Wall Street sell side analyst who was unable to update his Q3 and 2011 earnings models because the managements of companies he followed refused to spoon feed him the correct numbers. In any case, however it began, the financial media picked up the story and repeated it ad naseum, without any attempt at corroboration or even sanity test, until it became an accepted fact—it all just made so much sense (to them, anyhow).
Fast forward a month and where are we? Well, by our calculations, 78% of the companies reporting so far have beaten Wall Street earnings estimates with EPS up 42% year-over-year versus initial expectations of 27%--i.e. 15% better than forecasts. That’s almost 10% higher than the average “beat” rate since 1998. As for guidance, at least 10% of companies that have reported so far have raised guidance, 2% have lowered it with the rest maintaining their outlook for the rest of the year and into 2011. Doing the tough math, that’s 98% of reporting companies NOT seeing the future in the same way as the sell side or financial media. By the way, according to Bespoke Investment Group (whose numbers differ very slightly from ours), that’s the highest percentage spread of up vs. down guidance since 2001 and the fifth consecutive quarter where positive guidance has outnumbered lower, the longest streak since 2001. And how are the analysts and media reacting to this reality? Well, some of the feathers are back in the pillow, but the perception remains and the talking heads still manage an ominous “What will management say about the future?” at least once a day when mentioning companies due to report. In addition, beaten but not out, financial reporters, who obviously haven’t read the Mr. Peabody parable (do they even read?) have started yet another rumor: this one goes something like “While the earnings have come in better than expected and guidance has been strong, most companies have missed or not beaten on the top line.” This amounts to an admission of “Well, we may have been wrong about the first rumor but, surely, two pillows will need not be restuffed…?”
So with all the hand-wringing about the top line, what does the data say? Stuff it Baby! According to our data and others, revenues have largely followed earnings with 73% of reporting companies beating top line expectations to date, a number also well above the historical average. In fact Reuters just last week raised its year-over-year revenue growth expectations from 9% to 9.5%. While the percentage “beat” has not been as great on the top as the bottom line (5% vs 15% for EPS), the data is still in direct conflict with what we hear daily in the media. Yup, the financial media’s reaction to this fact has been to throw out the pillow entirely--to simply ignore facts and continue with the mantra of “Revenues just aren’t living up to expectations.” We suppose it makes for better headlines than “We Was Wrong!” So, in answer to our question above, no, financial reporters don’t read…or at the least they can’t read earnings reports. It’s a good thing your first grade teacher wasn’t also a financial reporter—with their ability to analyze report cards, you’d still be repeating that grade.
This morning the brains on CNBC are reporting that 1/3rd of S&P 500 companies are left to report. It appears that retailers, on a one-month lagged fiscal year, no longer count in Medialand. We wonder if any attempt will be made to return these feathers. Doubtful. As we tell our kids while they watch cartoons, “don’t believe everything you see on TV…except, for course for Spongebob.”
On next week’s installment of Misconception Becomes Mantra : How 50.6% of the stimulus package having been spent so far amounts to “almost all of it” when it hits the airwaves.
The dog days of summer are upon us so we’ll spare you a lengthy treatise on some arcane aspect of finance. Instead we’d like to talk about a little children’s story, written by Madonna of all people, that we used to read to our kids. It’s based on an old Eastern European folk tale of a woman who spread a false rumor and the village wise man who challenged her to shred a feather pillow into the wind and then try to recapture all the loose down, the moral being that once out false rumors and gossip are almost impossible to recall. Sound like the internet? Sounds a lot like CNBC to us as well.
OK, confession: what we really want to do is give you a quick report card on the current earnings season to date. So far approximately 1/3rd of S&P 500--and by extension all US--companies have reported their second quarter earnings. Going into this reporting season the general consensus among the Wall Street sell side and financial media was that the second quarter reports would be good, but not great, and that management guidance would be terrible, given the turmoil in Europe and engineered slowdown in Asia. How did that consensus belief come into being? Cynically, we suspect that it originated from a Wall Street sell side analyst who was unable to update his Q3 and 2011 earnings models because the managements of companies he followed refused to spoon feed him the correct numbers. In any case, however it began, the financial media picked up the story and repeated it ad naseum, without any attempt at corroboration or even sanity test, until it became an accepted fact—it all just made so much sense (to them, anyhow).
Fast forward a month and where are we? Well, by our calculations, 78% of the companies reporting so far have beaten Wall Street earnings estimates with EPS up 42% year-over-year versus initial expectations of 27%--i.e. 15% better than forecasts. That’s almost 10% higher than the average “beat” rate since 1998. As for guidance, at least 10% of companies that have reported so far have raised guidance, 2% have lowered it with the rest maintaining their outlook for the rest of the year and into 2011. Doing the tough math, that’s 98% of reporting companies NOT seeing the future in the same way as the sell side or financial media. By the way, according to Bespoke Investment Group (whose numbers differ very slightly from ours), that’s the highest percentage spread of up vs. down guidance since 2001 and the fifth consecutive quarter where positive guidance has outnumbered lower, the longest streak since 2001. And how are the analysts and media reacting to this reality? Well, some of the feathers are back in the pillow, but the perception remains and the talking heads still manage an ominous “What will management say about the future?” at least once a day when mentioning companies due to report. In addition, beaten but not out, financial reporters, who obviously haven’t read the Mr. Peabody parable (do they even read?) have started yet another rumor: this one goes something like “While the earnings have come in better than expected and guidance has been strong, most companies have missed or not beaten on the top line.” This amounts to an admission of “Well, we may have been wrong about the first rumor but, surely, two pillows will need not be restuffed…?”
So with all the hand-wringing about the top line, what does the data say? Stuff it Baby! According to our data and others, revenues have largely followed earnings with 73% of reporting companies beating top line expectations to date, a number also well above the historical average. In fact Reuters just last week raised its year-over-year revenue growth expectations from 9% to 9.5%. While the percentage “beat” has not been as great on the top as the bottom line (5% vs 15% for EPS), the data is still in direct conflict with what we hear daily in the media. Yup, the financial media’s reaction to this fact has been to throw out the pillow entirely--to simply ignore facts and continue with the mantra of “Revenues just aren’t living up to expectations.” We suppose it makes for better headlines than “We Was Wrong!” So, in answer to our question above, no, financial reporters don’t read…or at the least they can’t read earnings reports. It’s a good thing your first grade teacher wasn’t also a financial reporter—with their ability to analyze report cards, you’d still be repeating that grade.
This morning the brains on CNBC are reporting that 1/3rd of S&P 500 companies are left to report. It appears that retailers, on a one-month lagged fiscal year, no longer count in Medialand. We wonder if any attempt will be made to return these feathers. Doubtful. As we tell our kids while they watch cartoons, “don’t believe everything you see on TV…except, for course for Spongebob.”
On next week’s installment of Misconception Becomes Mantra : How 50.6% of the stimulus package having been spent so far amounts to “almost all of it” when it hits the airwaves.
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