Kettle Creek - Ramblings of a Portfolio Manager

Ramblings of a Portfolio Manager

2011-11-07T07:05:00.001-08:00

Ramblings of a Portfolio Manager--The Perfect Trifecta?

It should be no news to investors that, since July, the US capital markets have been held hostage by political and economic events unfolding in Europe. One cannot pick up a publication above a child’s pop-up book without reading about the political machinations in Greece and Italy and the struggles of French and German ministers, along with the ECB and IMF, to staunch the tide of debt defaults and ensuing continental recession. And our markets seem to move dramatically on every utterance by any European “official” however minor. For nearly 4 months now, the US capital markets have been the dog wagged by the Euro-tail. In fact, a recent study showed a 70+% correlation between US and European equities, nearly twice the long-run average. Should this be and how long can the trend continue? We see three reasons why the trend may be soon to end.

We are now at the tail end of earnings season in the US. Remember, this was a very low expectations season as many analysts had factored in the “Euro effect” into their numbers. Estimates were that 2011 S&P earnings could drop by as much as 25%, especially given that the depths of the European crisis occurred largely in the third quarter. Instead, US companies continued their long run of beating estimates with over 75% of companies doing so, right in line with the trend for the last eight quarters. S&P earnings estimates for the year barely budged. And as far as forward guidance from Management, it was not so robust as in past quarters, given the uncertainty in Europe, however 2012 S&P earnings have been revised down less than 3%. Hardly the stuff of economic Armageddon that has been predicted. In fact, the S&P500 is now trading at over 3 multiple points below its long run average. Yet this past season was the least talked about earnings reporting period probably in history as the financial press focused all their attention on Europe. Had Europe not existed, equity markets in this country would surely be much higher just on the back of earnings alone.

Also largely ignored by the talking heads was China. For over a year now economists have been wringing their hands over China’s monetary tightening policy, aimed at curtailing the real estate boom in that country. The fear was that China could not engineer a soft landing in the broader economy and would slip into recession, dragging the rest of the world with it. In the last few weeks, however, we’ve received data out of China that their braking efforts have been effective with inflation slowing while the economy continued expansion at a fairly robust pace. In fact, the Chinese have now stopped their string of interest rate and reserve hikes, signaling an end to their tightening policy and there is now talk of reducing the reserve requirements on banks, clearly an easing move. In fact, data shows that Chinese bank lending has risen substantially over the last two months, a sign that banks, at least, believe that the tightening cycle is at an end and a period of easing may lie ahead. Of course, that would good for world economies and, by proxy, world equity markets.

Finally, though the doomsayers may posit otherwise, the Europeans are, in fact, moving aggressively to fix their problems. No, with 17 sovereign entities to work in harmony, they cannot implement changes as fast as we did TARP in this country but it is clear that France and Germany are taking the lead to move things ahead. Does anyone doubt that Merkel and Sarkozy pulled a Luca Brazi on the Greek Prime Minister over the referendum? You can bet they will do that with Berlusconi as well if needed. While the issues in Europe will be worked out over months if not years, eventually they will fade from the front pages. That factor, along with China easing and record low interest rates and P/Es in this country, could just be the perfect trifecta for a significant market rally.

Ramblings of a Portfolio Manager

2011-08-22T07:09:00.000-07:00

What to Expect From Jackson Hole
This Friday Chairman Ben Bernanke will speak at the Federal Reserve’s annual symposium in Jackson Hole, Wyoming.
Last year, Bernanke hinted that the Fed might embark on a second round of asset purchases to bolster the recovery, dubbed QE2. That speech kicked off a 28 percent rally in the Standard & Poor’s 500 Index of stocks that ended in a three-year high on April 29th.
At the last Fed meeting policy makers pledged to keep their benchmark interest rate near zero until at least mid-2013 and also said they “discussed the range of policy tools” available, giving hope that they may add to their record stimulus. That signaled that a QE3 might be on the table.
The whole world will be watching Bernanke’s speech, so if he chooses not to say very much, the global markets are sure to be disappointed. Though many market observers deny we will get a QE3, still there is hope among many that one will be forthcoming in some form.
Predictions are that Bernanke will suggest that the central bank will lengthen the average maturity for its $2.86 trillion of assets, which would help bring down long-term interest rates. The yield on the benchmark 10-year Treasury note dropped as low as 2.062 percent on Aug. 19 in New York, according to Bloomberg Bond Trader prices. Yields have fallen to record lows since the Fed announced its rate pledge on Aug. 9.
At the Fed’s last meeting Federal Reserve Bank presidents Charles Plosser of Philadelphia, Richard Fisher of Dallas and Narayana Kocherlakota of Minneapolis all voted against the Fed’s decision to keep the target for the federal funds rate at zero to 0.25 percent until at least mid-2013. Plosser and Fisher both said last week the pledge won’t help spur growth. The last time three policy makers dissented was in November 1992.
The central bank has kept the rate on overnight loans among banks near zero since December 2008. It also purchased $1.7 trillion of Treasury and mortgage debt between December 2008 and March 2010, and the $600 billion of Treasuries from November through June. The result was a temporary rise in risk assets but economic growth and job creation remains moribund.
Despite what many market watchers believe, the Fed is not out of bullets yet. Bernanke told Congress on July 13 the Fed does have stimulus options; these include buying additional securities, increasing the average maturity of its bond portfolio, lowering the interest rate on excess reserves and pledging to keep its balance sheet near a record high for a longer period of time.
When he foreshadowed the Federal Open Market Committee’s Aug. 9 decision to hold interest rates near record lows, the S&P 500 Index climbed 7.6 percent between Aug. 8 and Aug. 15. Unfortunately, it has since fallen 6.7 percent since amid concerns that U.S and global economic growth are faltering. Still, the Fed got a pretty good response to its decision, so they may deploy one or more of their remaining tricks.
The bond market seems to be already is pricing in an expectation that the Fed will announce new purchases of $500 billion to $600 billion, and investors looking for confirmation in Bernanke’s Jackson Hole speech may be disappointed.
The cost of living in the U.S. accelerated at an annual pace of 1.8 percent in July, excluding food and energy costs, which are typically more volatile. The gain was the largest in more than a year, according to Labor Department data released Aug. 18. That signals that, at least, QE2 was successful in staving off deflation.
However, the economy grew at a weaker-than-projected 1.3 percent annual pace in the second quarter, the Commerce Department said July 29, and growth in the prior quarter slowed to 0.4 percent, the weakest three-month period since the recovery began June 2009, suggesting that QE2 did little for the economy.
Morgan Stanley analysts have cut their estimate for expansion worldwide this year to 3.9 percent from a previous prediction of 4.2 percent. Part of the reason was “the drama” around lifting the U.S. debt ceiling, which helped depress financial markets and erode business and consumer confidence, the analysts said in a report last week.
Bernanke would have to overcome internal opposition to additional measures after his rate pledge led to the three dissents. There is less agreement this year among FOMC members that further easing is needed than there was a year ago when Bernanke spoke out. That suggests that the Fed chairman won’t hint at additional measures in Jackson Hole.
Still, Bernanke’s has shown he is willing to swim against the tide of dissent among the Governors in his decision to pursue the rate pledge with or without the full support of his fellow policy makers. So we the markets may get some, even if little comfort, this week.

Ramblings of a Portfolio Manager

2011-08-15T06:48:00.000-07:00

Ramblings of a Portfolio Manager—This is NOT 2008!

It feels awful out there…trust us, we know. We’ve cancelled all summer plans to remain in the office to mind this market even though with 500 point Dow swings it is difficult to know exactly what to do, if anything (we wonder why Obama and the EU leaders haven’t done the same, instead choosing to put lotion on each others’ backs in some exotic warm locale). With volatility like this it is easy to make a mistake so we monitor, take advantage of dislocations and try to understand where things are headed. For many investors, however, it's easy to draw parallels between this market and 2008 and there from comes the volatility we are seeing. We don’t believe this period in the worlds’ economies or markets is anything like 2008 (or 1974 for that matter) and there are a number of indicators that tell us otherwise.

For example, if we look at the 2Yr USD Swap Spread chart below Courtesy of Bloomberg (a measure of fear over the financial health of banks)– it is clear that professionals in the global credit markets (as opposed to the retail investor in the US Treasury markets) do not believe this is 2008 all over again. The current 2 year USD Swap Spread, which ballooned to nearly 170 bps in the fall 2008, still hovers at a slightly elevated 29bps—it’s hardly a blip in the chart. We aren’t even where we were at the end of 2010 in terms of fear regarding the financial system. Remember, 2008 was all about the fear of every US Financial Institution being insolvent and/or under-capitalized. And we did have real defaults... remember CIT? That was true credit risk.

At the moment what it appears is that we are dealing with is a global sovereign/currency crisis, which requires large-scale solutions: Eurozone fiscal unity; Chinese participation in the EFSF, etc. Of course, some economists are talking about the possibility of breaking up the Euro, however, even the Germans (who get almost 40% of their GDP from exports) are vitally aware of the implications of operating once again under the Deutsche Mark. If we do some overly simple math we see that Germany can easily lose as much as €300Bln in exports every year if that were to happen. Compare that to their current peripheral contribution to Europe? It makes it look like peanuts. In any case, if Greece, Portugal and Spain collapse; then Germany is already on the hook. And the there are the German, French, Italian banks -- no one wants to see this happen and they aren’t going to let it.

We hear rumors daily—for example, on Thursday some small unknown Chinese bank supposedly stopped doing business with SocGen—it was false and certainly benefitted the rumor monger as it dropped the futures 200 points alone in just 10 minutes (of course the futures recovered and we had a nice day—hope he/she lost his/her shirt)—but most of these are just plain false. Yet while many of these fears/rumors are unfounded, the volatility they create is not helping to improve trading liquidity. Furthermore, the liquidity that the Central Banks are pumping into the markets is losing its benefits as investors take it for granted. It is clear that the global economy is slowing, and risk is being re-priced. But that doesn’t mean one cannot make money in stocks. In fact, as we have all seen over the last 3 years, the pendulum can over swing both ways until sanity prevails. At the moment, we believe risk is being overpriced and will return to normal slowly but in short order.

The good news is that right now our markets are functioning: $10Bln in new corporate bonds priced last week alone as companies took advantage of negative real interest rates to clean up their balance sheets. That's an important data point. It means that investors still have cash to put to work and issuers can still come to market. It also means that Corporate America is getting healthier and while dislocations such as negative real rates can persist for a time, the bond markets and, most likely the equity markets, have overreacted and we are due for a reversal. This morning Japan reported much better than expected GDP. And we have only seen upward revisions to S&P 500 earnings projections since earnings season. No, this is not 2008 although it may feel like it. We suggest you turn off the financial news, enjoy your summer vacation and let the capital markets quiet down and sort themselves out. They always do—even post 2008.

Ramblings of a Portfolio Manager

2011-08-08T06:37:00.000-07:00

Dear Investor:

After Last week’s market turmoil you no doubt are scared and rethinking what crazed decision ever lead you to invest in stocks in the first place. That’s only natural. You’re also probably going to be watching all the Financial TV pundits over the weekend, from Nouriel Roubini, telling us Armageddon is just around the corner to Warren Buffett, waving his little American flag singing “buy buy buy.” How can you make sense of all this rhetoric and jargon? Where were these geniuses’ 2000 Dow points higher?

We thought long and hard about what to write this week but in doing so we ran across this week’s Barron’s piece on the week gone by. Now, we all know Barron’s can be a fairly bearish publication but we found a surprising amount of bullishness in what they had to say. So rather than cobble together something on our own, we reprint here, in part, an article from that publication we thought accurately paralleled our thoughts. Full credit to Barron’s and the author for the piece, we take no credit other than finding it online at midnight last night and seeing that the article is both sober and balanced.

Barron's(8/8) Attention, Shoppers. It's Time To Buy

12:10 AM Eastern Daylight Time Aug 06, 2011
(From BARRON'S)
By Andrew Bary
After the recent plunge in major global markets, U.S. stocks look attractive. The benchmark Standard & Poor's 500 index trades for little more than 12 times projected 2011 profits, one of the lowest price/earnings ratios in a generation. The Dow Jones Industrial Average has a similar P/E -- 11.6 times this year's estimated earnings. Its dividend yield of 2.62% exceeds the depressed 2.56% yield on the 10-year Treasury note, another rare occurrence. This isn't the1970s, when P/E ratios were low but inflation and interest rates were high. Investors are worried about different problems: a weakening domestic economy, Europe's debt mess, political dysfunction in Washington and a massive and seemingly intractable federal budget deficit. Yet American corporations rarely have been in better shape, with generally robust profits and balance sheets flush with more than $1 trillion in cash. Analysts are loath to predict when the sell-off, which began July 22, might end, but many say they see stocks ending the year higher. If the S&P 500 merely gets back to its 2011 peak, set in April, the index would rise 14%. "The economy is doing well enough to keep earnings rising and bring some bullishness back to the stock market," says Jim Paulsen, investment strategist at Wells Capital Management.
Investors have been rattled by the swift pace of the sell-off, in which the S&P 500 fell more than 10% in 10 trading sessions. This marks only the fourth such decline in a bull market since the end of World War II. The other three 10% drops occurred in late 1974, October 1997 (during the Asian crisis) and August 1998 (after the collapse of the hedge fund Long-Term Capital Management). The good news is that the market rallied an average of 18% in the ensuing three months after each of those three setbacks, according to J.P. Morgan strategist Thomas Lee. Stocks might be near a bottom after a week of selling. The Dow finished Friday at 11,444.61, up 60.93 points in a volatile session but down 5.8% for the week. Most of the damage occurred Thursday, when the average fell 512 points, or 4.3%, its biggest point drop since late 2008. The industrials are down 1.2% for the year; they were up 10.7% at their April peak. The S&P 500 ended the week at 1,199.38, off 7.2% for the five days and 4.6% for the year. The situation is worse overseas, as the table nearby shows. The Euro Stoxx 50 index is down 15% this year, Japan's Nikkei is off 9% and formerly once-hot Brazilian stocks are down 24%. Every major European market except Switzerland has a P/E below 10, and European stocks yield an average of 4%. Closer to home, the top 50 U.S. banks trade on average at around book value. They have been cheaper only twice in the past 25 years-during the deep recession of 1990 and the 2009 financial crisis. Both those times were major buying opportunities, and today, notes RBC Capital Markets analyst Gerard Cassidy, the industry's fundamentals are improving. At 37.60 a share, J.P. Morgan Chase (ticker: JPM) trades below book value and for under eight times projected 2011 profits. The stock yields 2.7%, which is likely is going higher. Citigroup (C), at 33.44, is down 29% this year and trades for less than 75% of book value of $48.75. Tangible book is a conservative measure of shareholder equity that excludes goodwill and other intangible assets stemming from acquisitions. Goldman Sachs (GS), at 125.18, trades just above tangible book, and Morgan Stanley (MS), at 20.02, changes hands below tangible book of $26.97. A wobbly global economy poses risks for big financials, but the industry's capital levels are appreciably higher than in 2008 and leverage is lower. It will be tough for most big financial companies to earn 15%-plus returns on equity in the coming years-a performance that was common before 2008-given higher mandated capital levels. But the stocks are priced for single-digit returns or worse. Drug stocks, normally defensive, haven't done a lot to protect investors lately. Pfizer (PFE), at 17.49, trades for around eight times estimated 2011 profits, while Merck (MRK), at 31.71, has a similar P/E ratio. Both yield more than 4.5%.Government pressure on drug-cost reimbursements could escalate around the world, but that concern seems captured in drug stocks' low valuations. Technology companies have more exposure to Europe than other stock-market sectors, but they also have excellent balance sheets and low price/earnings multiples. Microsoft (MSFT), at 25.68, trades for nine times estimated earnings for the fiscal year ending next June. Its P/E, excluding net cash and investments of $6 a share, is under eight. Intel (INTC), at 20.79, trades for nine times projected 2011 profits and yields 4%, while Hewlett-Packard (HPQ), at 32.63 fetches less than seven times current-year profits. Apple (AAPL) the market's premier mega-cap growth stock, at 373.62, trades for 14 times what it is likely to earn in the fiscal year ending September. Excluding $80 a share in cash and investments, its P/E is closer to 10. In the energy sector, many investors prefer exploration plays and oil-service stocks, but the best value could lie in industry giants like ExxonMobil (XOM) and Chevron (CVX). At 74.82, Exxon trades for under nine times projected 2011 profits and yields 2.5%, while Chevron, at 97.61, has a P/E of just seven based on estimated 2011 net. It yields 3.2%. The recent drop in U.S. oil prices to $87 a barrel from $100 could pressure profits, but the stocks look to be discounting far lower oil and gas prices. The prospect of cuts in the Pentagon budget has crunched defense stocks. Northrop Grumman (NOC), for instance, now trades at 55.49, down from 70 in early July, and sports a P/E of eight. It yields 3.6%. Lockheed Martin (LMT), another major contractor, trades for 72.82, or 9.7 times earnings, and yields 4%. Gold has been a bright spot, rising $36 an ounce last week to $1,663.80. The metal is up 17% so far this year. Gold is shining because investors fear that the U.S. government will continue to pursue policies-notably zero-percent rates and massive fiscal deficits-that will further debase the dollar and spark inflation. Gold remains an "underowned" asset class with few individuals and institutions with a sizable weighting, which could mean more buying. While gold has gained, major producers have lagged. The leading miner, Barrick Gold (ABX), is down 14% this year to 45.86, and trades for just 10 times estimated 2011 profits. Gold bugs weren't happy that Barrick paid up to buy a major copper miner earlier this year, diluting its exposure to gold. There is rumored to have been heavy selling of Barrick by some institutional investors in recent months. Even so, Barrick has rarely had such a low P/E and its profits have a lot of leverage to gold prices. Berkshire Hathaway (BRKA) is a financial Fort Knox, with one of the strongest balance sheets among huge companies. Its shares have been no safe haven, falling11% this year to $107,300, or just 1.1 times book value. Berkshire looks inexpensive with a price/book ratio that has rarely been lower in recent decades. Its earnings power has never been better. Berkshire CEO Warren Buffett has been cool to stock buybacks -- the company has repurchased virtually no stock since he took over in 1965 -- but he ought to consider a buyback rather than paying cash for another major acquisition, given Berkshire's low valuation. Stocks had a tough summer in 2010 as the S&P 500 dropped 15% from its spring high to a low of about 1,050 in late August. That proved to be a buying opportunity as Federal Reserve Chairman Ben Bernanke came to the rescue with a new credit-easing program, known as QE2. By the end of 2010, stocks had risen 20% from their August lows. While the Fed is more reluctant to begin a fresh asset-buying plan this year, stocks look even cheaper than they were last summer. Historically, it has been good to buy the stock market when its trades around 10 times earnings. Barring global financial mayhem, investors with a modicum of patience should do well. Stocks could be the best asset class in the world.

Ramblings of a Portfolio Manager

2011-07-19T06:30:00.000-07:00

Will We Get a Budget Deal and What Will Be Left of the Economy When We Do?

We don’t have to bring everyone up to speed on the current status of the budget/debt ceiling negotiations going on in Washington. Suffice to say that each side remains intractable on their respective positions with Obama shuttling back and forth proposing noble but clearly unpassable “deals” in order to save face for the elections next year. Meanwhile, our Treasury Secretary and Federal Reserve Chairman alike continue to warn the parties not to play a game of Chicken with our debt rating and, ultimately our economy, backed up by rating agencies who, though discredited over the past few years, still carry weight when it comes to existing contracts and indentures and, ultimately, the interest rate paid by the entities they rate.

While all of this makes for a good side show and the current yield on the long bonds suggests that the markets expect a deal to be done to avoid default before the August 2nd deadline, missing from the popular headlines is what the negotiations themselves may be doing to the economy, in a sense making any “deal” moot by the time it becomes passed. Few noticed that several small rating agencies have actually become proactive and have already dropped our debt rating one notch. Moody’s and S&P, however, are the 800 lb. gorillas to whom everyone pays attention and whose ratings are written into bond indentures across corporate America. Still, what those smaller firms say and said are telling. Being proactive, they looked at whatever a potential deal might be and what the ongoing negations have been doing to corporate behavior in the months leading up to that deal. What they arrived at makes total sense and is a good basis for their downgrades. Corporate heads watch CNBC too and the growing sense that the “deal” will come to the wire and be much less than is what is really needed to get this Country on the right track for the next decade, let alone to the next election, is, once again, causing great uncertainty. In fact, this Administration’s legacy will be the uncertainty they have caused with business given all their regulations, policy shifts and new spending programs. That uncertainty has hampered hiring since Obama took office and, just as it looked as though, perhaps, Companies were about to try to forge ahead no matter, around comes another bout of uncertainty—the outcome of the budget talks.

What CEO, who’s debt is tied to LIBOR, Prime or, gasp, Treasuries, is going to make capital spending and hiring plans not knowing what rates he/she will be paying on that debt in 3 weeks? To do anything, frankly, would be irresponsible. Everyone was shocked at the poor employment numbers released in early July but they made total sense—Corporate America is frozen in its expansion plans pending the outcome of the “great deal.” And this time, we cant just blame the Obama administration—the Republicans are as much at fault for the deadlock and the uncertainty it is causing. Now everyone is looking toward the August release. We can almost guarantee they will be as bad if not worse than those released in July, as company’s sat on the sidelines in wait and see mode. Meanwhile, many municipalities , who’s debt payments are tied to the rate on US Treasuries, are making contingency plans should the negotiations go past August 2nd or should the promised downgrades occur. Geithner and Bernanke were’t kidding when they said the outcome of a default will be disasterous. Our 9.2% unemployment rate will balloon as Federal, State and Municipal employees are let go in droves after a default. Bottom line, those little rating agencies looked ahead and saw the damage the current gridlock is already doing to the economy and, knowing a weakened economy cannot pay its debts as well as a strong one, did the right thing and did their downgrades.

So what to do? Frankly, we do expect a deal and a very small one at that, one that cuts spending over a lengthy period of time. Will such a deal be good enough for the rating agencies? We hope so. If that deal is accepted by Moody’s and S&P and we retain our rating, then we expect a nice market rally. Why? Because such a deal is yet more can kicking and preserves current spending and tax levels, items deemed important in helping the US get back on its feet. As for rates, well they may even rise on hopes of a future recovery. Still, we wonder what might be if the dolts who we elected actually get together and come up with some meaningful cuts. The markets are willing to assign higher multiples to unleveraged companies and the same holds true for the economy as a whole. A $4-$6trillion cut might provide the leverage reduction the markets seek and produce an even bigger rally. We doubt we’ll ever see such a deal but for now a deal, any deal, that raises the debt ceiling and staves off the rating agencies, will be good for the equity markets. We hope the markets are clever enough to see the poor employment numbers we will see in August are a direct result of the uncertainty factor. If they can get past that fact, we may rally right to year end. Just expect many more Mylanta days, as we have been seeing, before that occurs.

Ramblings of a Portfolio Manager

2011-07-11T06:28:00.000-07:00

Here We Go Again?

We awoke early this morning to find futures for markets around the world, including our own, sharply lower, while many Asian markets had already closed deeply in the red. The cause: a trifecta of yet another Southern European debt-laden country nearing a crisis—in this case Italy, the apparent breakdown in debt reduction talks between Obama and the US Congress over the weekend, and, most likely, some carry over from the poor jobs report in the US on Friday. US bond yields, which were heading higher after the strong PMI numbers we received here last week, are back below 3% for the 10-year Treasuries. In short, just about everything that made the markets rally off their bottom in late June—the resolution of the crisis in Greek debt, optimism over a debt deal in the US and a promising ADP jobs report, seem to have been undone since last Friday morning. This, of course, begs the question, are we going right back to our June lows this time quicker than the sickening 6 week slide that got us there? We don’t think so.

Let’s look rationally at each piece of news, one at a time. First, as for Italy, this is no Greece. Yes, it is a much larger market but it is also much different in its behavior toward austerity. We note that the Italians have already put in place some severe austerity programs voluntarily and have already taken steps to reduce their sovereign debt. The IMF has already agreed to backstop Italy and there will be no anxiety-riddled days of waiting on a vote from the Italian Government on a vote to accept the aid and the conditions that go with it. In addition, the situation in Italy is not new news but that doesn’t seem to matter these days. Any weakness on the “Italian Affair” will most likely be a buying opportunity.

As for the spending and debt reduction talks here at home, it did indeed look like Obama had struck a promising $4trillion deal with Congress last week and the markets liked that. Over the weekend, however, old biases crept back in from each side with the republicans backing away over tax hikes for the “wealthy” and our good friend Nancy Pelosi backtracking on any kind of cuts in entitlements. Both of these items were part of each side’s give and take that would have made a $4trillion deal work. Obama has yet to give up on his ambition plan, as it would have been somewhat of an election-enhancing coupe for him, however it looks more likely that a plan with cuts have the size will be what we get. In any case, both sides have made noise about contingency plans on raising the debt ceiling so that should not be a concern, even if they do bring it down to the wire. Furthermore, sad as it may be, a $2trillion deal would actually be better for the US economy as it would include smaller tax and spending cuts. Yes, it does kick the can further down the road but it would be a good start and one that hopefully keeps rates at home and the value of the dollar low, both of which will only continue to benefit the US economy.

Finally, we can’t discount the lousy jobs report we got Friday morning. There was little in that report that was encouraging for employment prospects in the US. We do note, however, that the Monster Employment Index, released the same day, was +3.5%, its best showing since early 2008, prior to the financial crises. Unlike the Government’s data, which is backward looking, this index is real-time data from employers regarding their intent to take on more employees. The ADP report, which is being ridiculed of late do to its apparent “inaccuracy”, is also real-time from a broad swath of employers. In many ways, it is more up to date and accurate than the government’s data. Remember, if the economists are correct about the idea of a temporary slowdown thanks to Japan and oil, that fact would have been captured in the June data, which it apparently was. In sum, we believe the July employment data will be much better, but we will have to wait for that to see. One thing is for sure, with such weak data, there is now more pressure on the Fed to implement a QE3 style program. Look for a softening tone from some of the Fed governors and certainly no talk of liquidity withdrawal for the conceivable future.

So, should we be concerned or is this a buying opportunity. Ultimately, we believe all three issues will be resolved or seen for what they are—temporary—but despite the recent rally the markets are nervous so we may see some weakness over the next few days. The key will be what companies say during their conference calls. So far, the few that have reported have “beat and raised” meaning they see the current slowdown as temporary. Bellwether Alcoa reports tonight and that may well set the tone for what we hear going forward. With its costs falling and prices for its products rising, we think that report will be good and, perhaps, just what this nervous market needs to hear.

Ramblings of a Portfolio Manager

2011-06-27T05:28:00.001-07:00

Is QE2 Really Dead?

With Greece back in the headlines—and we’ve said quite enough on that subject--we thought we’d take the opportunity to talk a little about one of the other of the myriad concerns the US equity markets have been focused upon over the last two months—the coming end to QE2. Very few government actions have been so well telegraphed to the markets yet the equity, currency and bond markets have been roiling over the last two months as they fight to determine what, if anything, will be the exact effect of the end of the Federal Reserve’s program to support bond prices and keep interest rates and the dollar low with the purchase of US Treasuries.

QE2’s goal was to support asset prices through the purchase of $600 billion of US Government debt issues. The hope was that higher asset (equity, bond) prices would lead to the wealth effect among consumers and businesses alike, spurring spending and, eventually, production and hiring. Whether the program was a success or not remains to be seen. Of late we have received some fairly weak economic data from the US, including employment, which has called into doubt the efficacy of the program. Our thesis is that the effects of QE2 have a lag and that the full impact of higher asset prices and easy money has yet to kick in and be seen in US economic data. In the meantime, economic data, as it always is coming out of a recession, has been lumpy causing many to declare the program a failure. We choose to wait and see. In the meantime, while economists fret over the pending end to QE2 and the apparent lack of a successor, they ignore one very important artifact of the program from the outset—the Fed, now the largest owner of US Treasuries, is earning some decent interest rates on its purchases. In fact, the Fed’s balance sheet now stands at close to $2.9 trillion. With Fed Chairman Ben Bernanke declaring that it will be some time before the Federal Reserve begins to unload its considerable holdings in Treasuries, some pretty sizable interest payments will be hitting the Fed’s income statement. What will they do with all that money?

On June 22 the Fed concluded its monthly Open Market Committee meeting and Bernanke gave a rare press interview shortly thereafter. The takeaway for the markets, as we saw in equity price actions that day and the next, was that there would be no QE3, something many traders and economists alike were hoping for to continue to support asset prices. What was largely ignored, however, is that the Fed said on June 22 that it will continue to buy Treasuries with proceeds from the maturing debt it currently owns. Given the size of its balance sheet, that could mean purchases (reinvestment) of as much as $300 billion of government debt over the next 12 months without adding any additional money to the financial system. That means that the central bank will continue buying Treasuries to keep market rates down as the economy slows. And those purchases will continue to support demand at bond auctions while Obama and Republicans in Congress struggle to close the gap between federal spending and income by between $2 trillion and $4 trillion. So not only is the Fed maintaining its accommodative stance, it is, in effect, launching into an unofficial QE2.5—something the markets have yet to focus upon.
Of the Fed’s bond holdings, a total of $112.1 billion will mature in the next 12 months, 7 percent of the $1.59 trillion in Treasuries held in its system open market account. Just replacing those securities will require the Fed to buy an average of $9.4 billion of Treasuries a month through June 2012. The Fed also holds $914.4 billion of mortgage-backed debt and $118.4 billion of debentures, the debt of government sponsored enterprises Fannie Mae and Freddie Mac. Estimates are that $10 billion to $16 billion will mature each month, depending on the pace of prepayments. That is yet more liquidity that will be reinvested into the system if the Fed decides to keep its balance sheet size the same, as it has openly declared.
Helping the Fed with its low interest rate policy has been the flight to quality by investors in the face of European debt concerns. Treasury 10-year yields fell to the lowest since Dec. 1 last week, down from this year’s high of 3.77 percent on Feb. 9. On June 24, the two-year yield came within one basis point of the record low, set November 2010, reaching 0.32 percent. And so far there’s been no lack of demand for government securities even as US Treasury debt has grown to $9.26 trillion from $4.5 trillion at the start of the financial crisis in August 2007, and $5.75 trillion when Obama took office in January 2009.
Most economists don’t expect that the Fed will raise its zero to 0.25 percent interest target rate for overnight loans between banks until the first quarter of next year. At his June 22 conference, Bernanke declared that the inflationary pressures we saw earlier this year are abating, in his opinion, and yields on 10-year Treasury Inflation Protected Securities show bond traders project an average 2.2 percentage point inflation, up only modestly from the 1.5 percentage points the way back in August 2010, when Bernanke first indicated the central bank might resume debt purchases to fight deflation. That suggests the first interest rate hike may be well into next year—beyond Q1
Bottom line: the asset purchases the Fed must make, even if they occur on a smaller scale, over the next year still continues the strategy that the Fed was trying to accomplish in the first place. That means that even with the end of QE2, the liquidity flow and its fundamental impact will remain intact for some time to come. So even though the market is going through a correction in anticipation of QE2’s demise, we may very well see the resumption of the liquidity driven rally.

Ramblings of a Portfolio Manager

2011-06-20T08:34:00.000-07:00

If Everyone is so Bearish, Who is Left to Sell?

The Dow managed to avoid 7 straight weeks of declines on Friday but just by the skin of its teeth. Rising 30bps, about the amount it needed to stay in the positive for the week, most of the “rally” came on hopes of a weekend bailout package for Greece—something similar to a European version of the Lehman weekend we all experienced back in October of 2008. Unfortunately, investors didn’t get their wish and the futures look ugly this morning.

Most readers know we aren’t big proponents of technical analysis and even less convinced Greece is meaningful but in a time where investors throw out fundamentals based on macro fears, we do concede that technicals have a role, if only for the reason that people do look at them. So we decided to take our own look at some of the more popular indicators to get an updated idea of sentiment and where it might be pointing in terms of where the markets might be heading over the next few months, regardless of what the fundamentals may be.

Ok, this is a lot of data and its’ not clear to the casual observer what to make of it. We have two takeaways. First, the trend is consistently down—i.e. negative. So anyone who tells you there is too much bullishness in this market is probably full of it himself. Secondly, the most reliable indicator we have back tested, the CBOE Equity Put/Call ratio, is getting close to its high from October of 2008 (extremely bearish), when the world was thought to be falling apart, and coincidentally, right now sits just atop of where it was on March 2009, the market’s bottom.

Reading this data, our sense is that we are getting close to a bottom on investor sentiment. Since 2008 we have had over 10 5% pullbacks, a record and one which is based on still fresh memories of 2008. Now, bottoming sentiment doesn’t necessarily mean that stocks will rebound but it’s a good clue that they probably will stop going down. Then, given the huge short interest ratio, if we are correct in our assumption that economic data will come in higher than expected in the third and fourth quarter and pairing it with the bottoms up fundamental data we keep hearing from our companies (beating estimates, raising forecasts) and valuations, we may have a recipe for a decent rally in stocks by year end.

We hope everyone had a great Father’s Day

Ramblings of a Portfolio Manager

2011-06-06T05:54:00.000-07:00

Double Dip Talk Again?

How fickle the equity markets can be. One to two data points and the markets can change their tone on a dime. Case in point—not so long ago as mid-April many economists were talking hyper inflation, large interest rate hikes and a soaring dollar. Several weak data points later, including Friday’s miserable jobs report, and Treasury yields are back at nearly an all time low, the Euro is closing back in on $1.49 and those same pundits are now exploring a double dip recessionary scenario. The equity markets, of course, have followed in sync. With little political will for a QE3 so far, one must ask did we hit a soft patch or is the economy in Q1 or is the economy just in the process of transforming itself from stimulus-based growth to a self-sustaining engine? Just a reminder: economies NEVER move in a straight line.

A few encouraging points were missed last week. The Non-Manufacturing ISM, released on Friday as well, is still in expansion mode. Over the last 12 months the ISM non-manufacturing index has averaged 55.4 and May came in at 54.6 suggesting that this sector of the economy is still on track for an expansion. Continued gains here suggest continued gains in core retail sales and therefore consumer spending and the economy. That would mean no double-dip although it hardly suggests an accelerating economy. A few takeaways from the Non-Manufacturing ISM: Overall business activity rose in 14 industries, including real estate (interesting), construction, finance & insurance, healthcare and information. That these gains are so broad is reassuring as is the overall size of the gains. Orders were up in May with gains in 15 Industries and new orders came in at 56.8 in May compared to 52.7 in April. Among the 15 industries signaling growth were professional services, transportation, finance & insurance, healthcare and information. Since the current recover began, these sectors have exhibited job gains and an expansion in their sales. The current outlook of the US. Economy is for continued growth in these service sectors as the share of total consumer spending on services continues to grow over time. Another take away is that export orders grew in sectors such as art, entertainment & recreation, professional services, accommodation and
food services—all sectors where a strong, historical orientation to consumer service provides American suppliers with a comparative advantage.

Another oft talked about but seemingly ignored fact is prices paid, a measure of costs to the consumer. The ISM showed that prices paid increased in May again, but the index dropped to 69.6 from 70.1 in April. Seventeen industries reported an increase in prices paid, including real estate (a positive sign), accommodation & food (certainly no surprise), healthcare and professional services. Now, this may be a double-edged sword as rising prices paid suggest that many firms are getting squeezed at the bottom line in the short term and many retailers proved that it is likely that companies are having difficulty passing on input costs to their final customers given the problems faced by many consumers. However, though many commodities are up in price for non-manufacturing companies including airfares, copper, cotton, diesel fuel, gasoline and many oil derivative products these prices are expected to come down, particularly if our Chinese and Indian trading partners are successful in engineering soft landings in their respective economies (some economists are coming around to the view that these two countries are nearing the end of their tightening.. The market’s obvious fear, in the short term, is that these rising prices will crimp margins and thus earnings. However, we just came through earnings seasons for most industrial companies affected by rising input costs (retailers are still reporting) and few, if any industries, complained about their inability to pass on higher prices. True, retailers had difficulties but with a record cotton crop going into the ground the spring, that issue may also be alleviated in the fall. Gasoline is falling, which also benefits the consumer.

Of course, the Non Manufacturing ISM is but one data point but are not the markets reacting to every headline these days. Also overlooked is the fact that Greece finally, actually, really may have a resolution to their issues. That would put further downward pressure on the dollar, benefiting our exporters. Now, no country every devalued its way to prosperity, however, in the short-term, a continued weak dollar should help our exporters, bolster commodity prices and support the US markets. None of this suggests a double dip is on the horizon. And, while hope is never a good investment philosophy, there is little doubt that the Obama administration is running scared with the upcoming Presidential elections (anyone see him blame China and Europe for our woes last week? Incredible). So don’t discount some last ditch effort to create jobs (an effort that would have to begin soon to produce the desired effect by election time) as well as pressure for the Fed to keep all that liquidity in the markets for much longer than expected. So while QE3 remains off the table, liquidity will remain high and the recent sell-off on its demise seems quite overdone.

Ramblings of a Portfolio Manager

2011-05-28T05:58:00.000-07:00

Markets and Economy Got You Confused? Join the Crowd.

It was random and coincidental that we chose to take a hiatus from Ramblings the last two weeks—two weeks, which turned out to be some of most confusing and volatile in the US equity markets in the last few years. Frankly, we had gotten tired of constantly addressing the Euro-debt crisis (what more can one say?--Greece is still tiny last we looked and China and the IMF are still poised to help the rest of the Eurozone with a bailout), the fact that the end of QE2 has been fully discounted by the US equity markets (or so we believed), that China would not sink the global economy with its monetary tightness and may soon take its foot off the economic brakes and, finally, that US corporate earnings were due to come in strong, making this equity market cheap-really cheap when one considers the low debt and strong earnings growth sported by Corporate America amidst record low interest rates. Shame on us. Just like the markets mysteriously operate to make just about all investors and economists look as stupid as possible so too did they act similarly with those of us who write about them. Vacation over.

So what has happened since we last published Ramblings? Well, just about the opposite of what we and it seems most US market participants believed would occur. On May 1st the markets opened to the news that Osama Bin Laden had finally been expunged from this world. The news that, perhaps, the World had become a less risky place was initially greeted with a strong market surge—strength which lasted all of about one hour. Instead of the usual strong start of the month, as investors plow more idle cash into the strong equity markets, we got a quick surge followed by a fairly strong sell-off. The markets have been down every week since. What’s going on? Well, if one is to believe the pundits, investors, seeing the end of QE2 and its liquidity stream (which must have just come up as a total surprise), began to rotate out of cyclical and commodity stocks and into defensive, “growth stocks,” which presumably would outperform in a post-QE2 world. Of course the fact that rising rates, higher commodity prices and hyper-inflation had been widely predicted, all of which would have further crimped the earnings of these companies was irrelevant (did any one read the earnings reports from the likes of P&G, Kellogg, Proctor & Gamble? Not so hot given their rising input costs and inability to pass on price hikes). The consensus was that this “unexpected” end of QE2 was going to slow the economy (remember now, no-one ever believed that QE2 was going to help the economy in the first place) and that was enough to spur a flight to safety. The really perverse outcome of this line of thinking is that US Treasuries actually surged to new one year highs. Was not the end of QE2 supposed to produce a rise in rates and a corresponding fall in bonds? Many portfolio managers were poised for just such an event. Nope, the new prevailing market view was QE2’s eventual demise was going to slow the economy (again, not that anyone thought it was going to speed up the economy)--not good for stocks--and that outcome (along with this new-fangled thing called a Euro debt crisis and some real tangible evidence that China’s policies were achieving the desired soft landing—again totally unexpected) sent everyone running to the safety of US bonds. It didn’t help that Bill Gross, who has appeared on TV multiple times to tell all the world that he was short the US Treasury, was “exposed”after being proven wrong on the direction of the yield curve, and confessed that he was really only “underweighted” in those securities, not short. Even the smart, rich and powerful can be disingenuous.

Adding fuel to the fire of the last two weeks has been a slew of weak economic data coming out of the US. It started with first quarter GDP, which came in at 1.8%, roughly half of what the prior annual growth rate had been but was expected. Many reasons were cited for the slowdown but the deceleration in real GDP in the first quarter primarily reflected a sharp upturn in imports, a deceleration in PCE, a larger decrease in federal government spending, and a deceleration in nonresidential fixed investment. This was followed up by continued weak housing data, less than expected industrial production and employment numbers that, while better than prior months, failed to impress. Suddenly, it seems, investors got the idea that the end of QE2, still a month out, was already producing a slowdown in the economy and that it was time to sell stocks and/or get defensive. The term “double dip” even began to be thrown around again. Investor sentiment dropped along with cyclicals, money flowed out of equity funds and back into Treasuries, resulting in their dramatic rise and, worst of all, the dollar surged (at least temporarily) as concerned investors around the world sought the safety of our richly priced government debt—something that didn’t help commodities and may produce a self-fulfilling prophecy down the road should it persist. The data bears this out. Investor sentiment, thanks to AAII, dropped to a recent low in May:
Bullish 25.6%, down 1.1
Neutral 33.0%, up 0.9
Bearish 41.4%, up 0.1

Change from prior week:
Bullish: -1.1
Neutral: +0.9
Bearish: +0.1

Long-Term Average:
Bullish: 39%
Neutral: 31%
Bearish: 30%

Even the outflow from municipal bonds slowed and turned positive as investors either tired of selling or re-acquainted themselves with the “safety” and tax efficiency of these securities. The result: falling stocks, a rising dollar and soaring US Treasuries. The current yield on a 1-year Treasury security is now down to 18 basis points—that’s right, put your money into the “safety” of a debt instrument on the verge of a credit downgrade and, essentially, you’ll supposedly get just the same amount back in 12 months. Obviously, investors do not feel the same about equities.

So, from our perspective, that’s what happened in the first two-thirds of the month. The last week, however, operated somewhat differently. Even though the US equity markets were down on the week, a subtle shift in sentiment could be felt. Bad economic data (GDP, Philly Fed, Existing Home Sales) didn’t produce a sell-off in the equity markets nor a rally in bonds. In fact, somewhat of the opposite proved true in the last few trading days. What happened? Did investors come to their senses? Did they read something in the data the rest of us did not? Or did they decide to become long-term investors once again? We think all of the above. First, we remind everyone that the 1.8% first quarter GDP growth is only now being felt in the weekly economic data due to the lag effect. So it’s no surprise that the recent data stream has been less than robust following that report. Secondly, we believe, investors have begun to realize that the effects of QE2 (which is less than a year old) are lagging and probably wont even show up until Q3 or Q4 of this year. This latter attitude is producing what is not being called the “See over trade,” which is a term describing how investors are now beginning to look beyond the current economic weakness to either await the eventual impact of QE2 or, possibly, the introduction of some sort of QE3 or QE2.5 based on the recent data. Also included in the “see over” trade have been a number of pronouncements from Fed officials (remember all the way back to April 27th when Bernanke said the same thing) that liquidity was not going to be withdrawn quickly or, for that matter, any time soon and in the meantime the Fed is going to reinvest the proceeds of its bond sales back into the markets, essentially a reverse-sterilization process that would mitigate any impact of the end of QE2.

In the last week many major investment houses have reduced their GDP estimates for the US for the rest of the year. This has set investors on edge, however if one parses the data, one can read that the reduction in GDP is less than the prior full-year estimate less the reduction in Q1---so, essentially, the rest of the year is supposed to rise from prior forecasts. Add to that is a bump up in estimates for US GDP for 2012. The coming election year has been cited (no-one has ever been re-elected with 9% unemployment) for that rise but also there is a growing feeling (actually enunciated by our socialist Euro-counterparts) that the global economy has become self-sustaining and no longer needs external stimulus. If this theory is correct, then the recovery not only becomes self sustaining but will accelerate as strong growth leads to further strong growth and, gasp, hiring (excluding any dumb tightening moves by the Fed). We believe we are at that point now. The economy is transitioning from one of stimulus-driven growth to one which is self-sustaining. And, like any inflection point, this period is giving us mixed economic signals. In the next 6 months, however, these signals should all begin to align and point in the same direction—up—especially if the folks on Capitol Hill pull some last minute rabbits out of the hat to stay in office, something we strongly believe will happen.

So don’t get discouraged, hang on to those stocks and have a very, happy Memorial Day.

Ramblings of a Portfolio Manager

2011-05-09T04:07:00.001-07:00

Sit on it or Rotate?

What the heck happened last week? “ What?” You Say? From most investors’ perspective it was a relative calm week. Though May didn’t start off with a big rise, as we have seen in prior months, a look at the indices shows that all, on the surface, was fairly calm. The Dow pulled back a modest 1.3% but the S&P 500 fell a more severe 2.1% and the Russell 2000 dropped 3.7%. Profit taking? “Sell in May and Go Away?” Some “de risking” ahead of the halt of the Fed liquidity stream? Europe again? Yes.

Actually, the raw index data belies the real underlying damage that was done to many sectors and their constituent stocks. Of the 10 S&P sectors, only one rose during the week, and that was Healthcare, up a modest 0.03%. Selected sectors, particularly ones that have done well this year, were taken to the woodshed with Energy down 7.3%, Materials down 4.5% and Industrials down 2.5%. Financials and Technology also took it on the chin, down 2% respectively. And these are the S&P sectors, composed of large cap stocks. The movements at the small-cap end of the spectrum were even more severe—almost double across the board. Is this the long awaited “major” pullback that strategists have been espousing for months now or something more subtle yet, in its own right, more severe? We think the latter.

The week/month actually started on a high note. Over the weekend we received news that our arch enemy, Osama Bin Laden, had been killed in Pakistan and much valuable Intel had been gleaned from his computers and records. That news alone sent the morning futures into triple digits. However, by the end of Monday, all major indices were in the red with the Russell 2000 taking the biggest hit, down over 1% on the day. The Dow, which held strong for most of the day, succumbed at the end and posted a modest loss. So was this “sell in May.” Well, there was selling for sure but there was also some buying—it depended upon what sector one looks at. With Energy, Materials and Industrials taking the brunt of the hit, one could point a finger squarely at the dollar. After all, the key to these sectors all year has been a weaker dollar. In fact, the dollar did rise for most of the week and the equity markets responded with their expected inverse relationship. The temptation would be to simply dismiss the action as investors’ attempt to get ahead of the Fed’s inevitable withdrawal of liquidity from the system slated, in Ben Bernanke’s words, for several months from now. We remind investors that a simple halt to QE2 does not mean an instant withdrawal of liquidity—we, like Japan, can sit for months, years, with low rates and lots of liquidity in the system. And in some ways, the actions of certain asset classes last week bore this theory out—bonds actually rose during the week, something most portfolio managers would expect to happen in reverse once the Fed stopped buying. So what was going on last week? Did simple patriotism cause a flight to the dollar and US bonds?

From our perspective last week was a sector rotation, plain and simple, but a strong one at that. Consumer growth companies and health care, the old fall backs in a weakening economy, far outperformed the cyclical sectors of energy and materials. The fact that we got some weak data during the week (weak GDP, ADP, Service Sector PMI) only reinforces this viewpoint. Fears of Fed tightening had little to do with this—in fact, the Fed factored in little except that Bernanke made it clear we would not have a QE3 and that, combined with weak economic data, scared many investors into thoughts that that the economy couldn’t stand on its own—i.e. that we would be headed toward a double dip once QE2 came to an end. That thinking explained much. Flight to the safe haven of Treasuries and the Dollar seem to be the rule when things look weak here (confirming that the Dollar remains the world’s reserve currency) and the rotation into less cyclical sectors confirmed the trend. By the end of the week, we saw somewhat of a reversal of trend but rumors of Greece pulling out of the EU stoked more headline risk and the rebound rally lost most of its steam.

So are we headed for a double dip or, at the least, a weakening economy? As we write Goldman Sachs is cutting its GDP forecast for the rest of the year by 0.50%. Not the stuff of a double dip but not heading in the right direction either. The worrisome part is that our foreign trading partners are still struggling to reign in their own economies, something that, if they are successful, will dampen foreign demand for our exports. Again, not something good for robust GDP at home. While we still believe that QE3 is not yet on the table, the Obama administration is up for reelection in 2010 and 9% unemployment just isn’t going to get him reelected. Then again, throwing us back into recession with squabbling over debt ceilings and Social Security cuts isn’t going to retain that republican majority either. So there is impetus on Capitol Hill to get things moving. In the end, we think the Fed will once again come to the rescue and hold off on any liquidity withdrawal until at least next year. And if the data continues to come through weak, then we may see loose monetary policy deep into 2012 or later. Maybe even QE3. Are we in Japan, you ask? It’s beginning to look like it.

Ramblings of a Portfolio Manager

2011-04-25T04:16:00.001-07:00

Standard & Poors Just Issued a Warning on US Government Debt. What a Great Time to Buy US Government Debt!

Last Monday was a harrowing and confusing day in the US capital markets—a day that demonstrated the perverse, sometimes conflicting, nature of investing in financial assets: assets whose prices are determined not by any particular standardized underlying valuation metric but by the supply and demand dynamics of a wide range of investors, from the Ivory Tower PhD quants down to the trailer park chat-room day traders.

US investors awoke Monday to find the US equity market futures already deep in the red. Once again Europe’s debt woes (particularly Greece) had been thrust into the front of the headlines, with more rhetoric about default and further restructurings amid a tanking economy thanks to austerity measures. Like many, we assumed the day would play out as it had for the entire year—weaker hands would be shaken out of US stocks and into Treasuries in the morning, only for the reverse to happen later in the day when the “smart money” took advantage of what was essentially old news to do some bargain hunting. After all, “every” smart investor know that QE2 will be ending soon, producing an outflow from Treasuries, presumably into the next best alternative, US equities. It wasn’t to be. Late in the morning, before the US markets opened, the futures tanked even more and the news hit the wires that Standard & Poors, that Gold Standard, leading edge credit rating agency, which had given AAA rating status to most of the Credit Default Swaps and esoteric real-estate derivative products that almost sunk the world’s financial markets in 2008, had just put the entire outstanding balance of United States Treasuries (and future issuances) on a “negative” from “stable” outlook. For S&P, it was the first step in a 3 step process toward a full downgrade of US debt from its exalted AAA status, a distinction it has held for nearly 80 years, and signaled that years of profligate spending and mounting debt with nothing but political rhetoric and no solutions to the issue, had finally caught up with the world’s largest economy. The outcrop—if the US did not address its deficit and ballooning debt problem, S&P would most likely downgrade the country’s debt from its AAA status within 2 years.

Of course, the rational investor, trained in Friedman, Keynes, Malkiel and Samuelson, to name a few, expected that the bond market would tank that day and though money might not flow directly from Treasuries to stocks, at least the expectation was that the reaction in the equity markets would be “tame.” In fact, the rational investor, including us, was once again taken aback by the perverse nature of the capital markets of late. Financial instruments have never moved exactly as predicted by the text books and that relationship has broken down over time but seldom do we see a complete 180 turn from what would logically be expected. Last Monday, we saw that with the Dow trading down as much as 240 points on heavy volume, while the longer Treasury maturities, after a brief dip, beginning to climb. Huh? If the US were to lose its AAA status, would not it have to pay higher interest rates and, given the relationship between rates and bond prices, would not bonds sink? One would think so but, as we mentioned, the opposite happened, although stocks did recover some of their initial losses over the course of the day.

What happened? The brain trust of economists are still scratching their heads and fiddling with their models replete with Greek symbols, crunching them on Cray’s latest supercomputer. Meanwhile, the rest of us have cobbled together a more homespun explanation for what happened. First of all, some sort of action by the rating agencies was most likely expected by the bond market (heck if we know what the equity markets were expecting-remember influence of the trailer park day traders) and the one we got was the mildest of the moves S&P could make; in fact, it wasn’t even the step before a downgrade: we still have to go on “credit watch negative” before a downgrade is imminent. Secondly, S&P gave us a 33% chance of a downgrade in 2 years. That’s better than even money and extends beyond the next election when we hope (as we always do) that a more fiscally responsible group of politicians will take office. Thirdly and relatedly, the move was seen as indeed political, with S&P basing its decision more on the gridlock it sees in the current Congress than any deeper economic weakness of structural problem in the economy. Fourth, Moody’s ever the politician itself, quickly reassured the markets (and big brother) that it had no intention of following suit with a negative rating of its own. Finally, many in the markets saw the move as a call to action to the politicians—the proverbial straw that would break the camel’s back of gridlock and rhetoric and get those sound bite hogs in DC focused on the real matter at hand—cutting the deficit and reducing our outstanding debt load. It is interesting to note that the dollar fell on that day, as would initially be expected, but stayed low even as bonds rallied. Anyone think the Fed stepped in under QE2 to mitigate the fallout?

That’s a long-winded explanation of why bonds probably didn’t sell off, but why did the equity markets tank and why did bonds actually end up on the day? The answer here is probably more subtle and complex. Compared to what we said about bond market participants above, equity market players are less thoughtful, more reactive and just don’t do as much homework. To them, the reverse was true—S&P’s warning shot might cause Congress to overreact, following the UK and implementing austerity measures before the economy has fully recovered—maybe even canceling the QE3 through 15 that some expected. In addition, failing a resolution, a full downgrade of the US (2 years out at the least) would affect US corporations as well, raising the cost of their borrowings, which are now at an all time low. That would also serve to put the brakes on the fledgling recovery. Finally, the move was seen as changing Bernanke’s Wednesday Q&A on QE2, from something benign to something more hawkish. All of this would be bad for the economy and bad, ultimately, for corporate earnings and thus stocks. So why did US Treasuries rise on the day? Well, as we all know, when the US (or global) economy is seen as potentially having negative issues, investors “de risk” (someone please explain that term to us and how it is done in an hour on trillions of dollars) and flee to quality; the only perceived quality investment left (barring Switzerland and gold) is, you guessed it, US Treasuries. Gold was up on the day, as was Silver. This phenomenon has been seen many times in other countries—during a debt downgrade, it is equities that take the brunt of the downgrade. The funny thing is, following the news, a spate of strong US corporate earnings came out, pushing the yields (and prices) higher, signaling a stronger economy ahead and negating much of the flight to quality (but Gold and Silver still rose, this time on inflation fears—go figure).

Oh, and our 2 cents (less than 0.01 Swiss Franc now) is that Bernanke now comes out even more dovish than expected on April 27th. What simpler and politically more palatable way to avoid a debt crisis than to continue to deflate our currency, paying back our debt faster with worthless dollars, thus simultaneously stimulating our economy further and collecting more taxes at the same nominal rate and avoiding economic or political repercussions of a tax hike or austerity. Anyone see supply side economics in here anywhere? We think this would successfully avoid a downgrade (a growing economy, shrinking debt and higher taxes would keep the ratings fools at bay despite the devalued currency). QE3, we think, just got more probable so we would avoid the Dollar. We’re still not sure what to do about Treasuries, although we certainly wouldn’t hold them here. We just hope the Chinese don’t start voting with their feet (or Bloombergs to be precise). Welcome to the Bizarro Land of investing.

Ramblings of a Portfolio Manager

2011-04-18T07:14:00.000-07:00

Which Asylum is Being Run by the Inmates?

Over the weekend the Chinese Central Bank ordered the State’s banks to set aside more cash reserves in an effort to curb lending and escalating inflation. This is the 4th such reserve increase this year alone and China’s largest banks will now have to hold 20.5% of their capital in cash reserves. The move comes on the back of the Bank’s April 6th benchmark interest rate hike, the 4th since the beginning of 2010, and was in response to Friday’s report that the Chinese economy had grown 9.7% year over year, higher than the projected 9.5%. Since the PBOC began its efforts to slow the Chinese economy in 2010, through a series of rate and reserve hikes, the economy has shown little to no signs of easing its rapid growth. The one sector of the economy that has shown some response is the Chinese property market, which was ostensibly the PBOC’s initial primary target. Since the tightening cycle began, the Chinese property market has cooled from its torrid pace of 2009-2010 yet it is still growing. The latest report shows residential property values up 6% so far in 2011, less than the 7% annual growth of 2010, and that number is expected to decline further into 2012.

One would expect, with such restrictive monetary policy, the Chinese equity markets, along with their Asian counterparts, would be heading south daily in anticipation of much weaker economic news ahead. Instead, the Shanghai Composite was up 22bps overnight and most other Asian markets were essentially flat. European markets, however, are down over 1% and US equity futures are pointing to a much lower opening. In fact, this is a pattern that has been repeated since late January and since that time the Shanghai Composite is up nearly 14%, besting both Europe and the US, all while China has been applying the brakes. Now, to the astute US equity investor, this might seem perverse. Surely, from past experience, we know that rising interest rates in the US are almost always associated with a decline in the stock market so why is the same not happening in China? In fact, a larger question is why are rate hikes in China having more of an effect on European and US markets than on its own?

There are several answers to this conundrum (we use this word purposefully). First, looking back at history, even in the US an initial round of rate hikes does little to bring down the equity markets. There are many explanations for this phenomenon but the reason is probably a combination of several factors: first, most rate hikes in the US are well telegraphed so the first few hikes are never a surprise; second is investors’ initial belief that that rate hikes will be modest and short in duration (remember “one and done?”); third is the inevitable initial cash flow out of fixed income securities and into equities, which serves to prop up the stock market in the short term; finally is the belief among many investors that the Federal Reserve is often late and can do little to effectively apply the brakes once the economy has begun to run—the old “Genie out of the bottle” analogy. Much of these same reasons may well apply to the current Chinese market. Surely, the PBOC’s tightening has come as no surprise and even though there is no Chinese Treasury money to flow into stocks, the currency has appreciated less than rates, keeping the export economy relatively strong and that, of course, feeds into the belief that the rate hikes will be ineffective in slowing economic growth. And even if the tightening is effective, what will be the new growth rate-- 8%? Still not bad given the valuations of Chinese equities. Chinese investors, as well, may not recall the PBOC’s last tightening cycle, which went overboard, throwing the economy into a recession, and so continue to doubt the efficacy of the Bank’s policies.

The ultimate question, of course, is why are the monetary policies of China having more of an affect of US markets (at least in the short run) than they are on Asian equities? We see this every time the Chinese Central Bank makes a move—miners, mineral and capital equipment stocks in the US get hard hit on fears that China will stop buying while Korean, Hong Kong, Japanese and Chinese equities often charge ahead. Are US portfolio managers the inmates running the great casino, er, asylum that is the US market? Or do they know something Asian investors do not? Probably a little of both. China is growing at nearly 10%; we are barely eking out 2% and much of that growth is thanks to Asia and other emerging markets. Should China successfully put the brakes on to a 7-8% growth rate, the economy in the US may well stall or even contract. Just think about where the miners, commodity and industrial companies have been getting their earnings growth of late—most of it has been in the Pacific Rim, not here. So we are tied to the hip with China but they are wearing a flotation vest while we still have a brick (called the National Debt) tied to our feet. If the PBOC is successful in curbing inflation, China may well keep its head above water but we could find ourselves drowning nevertheless. The lesson here is twofold: first, we had better hope that the Chinese are successful in engineering a soft landing and secondly, we should not extrapolate the behavior of the Chinese market during its tightening cycle with what might happen to our own once the Fed decides it is time to put on the brakes—remember, the drop from 10% to 8% is a lot less both in terms of percentage and economic impact than that from 3.5% to 2%.

Ramblings of a Portfolio Manager

2011-04-11T08:01:00.000-07:00

Extra! Extra! Commodity Prices to Derail the Economy!

So say the popular financial news media, each and every day since oil broke $100 per barrel back in February on Mid East and African tensions. Scores of “analysts” have appeared on TV to tell us that $100, $110, $120, $125/bbl…well, you get it, is the “tipping point” (annoying resurrected economist slang for the straw that broke the camel’s back), which will send the US economy spiraling back into economic recession. A host of others have also appeared to tell us that copper, steel, corn, cotton and grain will pose a similar threat. We even had Saudi Arabia posit a $350-$300/bbl number should they face Libya’s fate (read, we want US forces and ordnance). Combined with the idiot politicians, who cannot come to terms on budget “cuts” (actually less of an increase but still an increase) that amount to 0.30% of this year’s annual budget and continued troubles in Japan, the “double dip” camp has reemerged as a potent voice on the airwaves. This time, however, they don’t have their stories well coordinated. The Commodity chickens fear commodity-induced inflation will crimp corporate margins, slowing hiring and killing the consumer, thus reducing earnings and throwing us back into recession. The Budget and Japan watchers (in league with the Euro-contagion conspiracists) argue that Japan’s weakness, European austerity and a Government shutdown will simply shave GDP growth estimates back to a point where job loss, rather that creation, will ensue. The outcome of either camp’s dire prediction is that our economy will slow, falling back into recession. Just recently Goldman Sachs trimmed their 2011 GDP forecast by a full percentage point, to 2.5%, a level inconsistent with job growth, based on all of the above fears—no sense in angering any one of the camps, all of whom cold be a potential client for Goldman’s next custom crafted special purpose vehicle. Are all these really bright folks correct? Has anyone ever done a real follow-up on Goldman’s stock-specific or economic calls? We have, they stink. So much for the “smartest guys in the room.”

Let’s throw out a few basic statistics. First of all, US inflation is 70% based on wages. 20% is commodity pricing. The rest is miscellaneous paper transfers and non-commodity spending. As many have lamented over the years, we don’t make anything anymore over here but lawyers and bankers. And right now those paper-pushers aren’t doing as well as the popular press would have you believe. There is still actually deflation in financial services with the continued surfeit of workers. Add in nation-wide U7, which is still above 15% and there is an overhang of people ready to enter the workforce but whom haven’t gotten “the call.” True, that overhang could hit like a Tsunami at any time, should US industry find productivity gains are no longer low hanging fruit, but for that to occur, GDP growth would have to be several percentage points higher than it is now—and that would signal a very, very strong economy, flying in the faces of the doomsayer scenarios we described above. We just aren’t there yet and capacity utilization (save for the Airlines who are desperately cutting back flights in the face of rising energy prices) is still just below a level that would signal additional hiring and capital investment.

Secondly, as we have often heard, consumer spending comprises a nice round number, also about, 70% of our GDP. For true economic weakness and a double dip to occur, we have to damage that consumer. Quick to respond, the Commodity guys point out that higher oil prices mean higher gasoline prices, which will slow consumer traffic. As a double whammy, when “she” gets to the mall, the consumer will find higher goods prices as the result of climbing cotton and other raw material inputs into the products purchased. In fact, there is already some evidence of “demand destruction,” the reduction of energy usage as a direct result of higher energy costs. Miles driven are down 3% year-over-year, according to AAA, and that can almost be directly related to higher energy prices. FedEx and UPS are raising shipping rates, hurting online sales as well (or at least the margins of the online retailers). But the argument that finished goods prices are rising is specious at best. Retailers are cutting, not raising prices for a host of goods from apparel to automobiles and amid those price reductions they are reporting record margins—why? Because the greatest input into manufacturing those products is labor, not commodities and labor in this country is highly flexible (still high usage of temps) and gaining no traction in pricing and manufacturers have learned flexible manufacturing techniques over the years, able to quickly move production to the lowest cost producing countries world-wide. The tech companies, hit with supply disruptions resulting from the Japan quake, are a prime example of this move to flexible manufacturing. Small wonder the Korean stock market has done so well of late—which stable, cheap labor country do you think benefits most?

Do we think the US will experience inflation over the next 2-3 years? Yes, of course. But not the hyper-inflation for which so many experts have been clamoring. QE2 will end and we just don’t see enough political resolve for a QE3. Prices will have to stand on their own after June and then we shall see. With no more downward pressure on the dollar, we would expect prices for commodities to fall. The offset is that US manufacturers will become less competitive world wide with the stronger currency but, as we have pointed out, the rest of the world (27% of S&P 500 earnings) is doing better than we are. So, perhaps, exporting our inflation (and higher margins) abroad will save corporate margins here. Next week we will start to see US corporations reporting Q1 earnings. We expect little or no impact on Q1 from either oil, Europe or the earthquake, which occurred late in the Quarter. Guidance and forward looking statements will be key to where the market heads over the next 6 months. However, as of last week, Corporate manager optimism was still at a recent high. Given all that has occurred over the world in the last two months, for that level of optimism to stand, we would expect guidance to be much better than expected and the market to move higher

Ramblings of a Portfolio Manager

2011-03-21T05:39:00.001-07:00

Bombs are Good for the Market?

“Sell on the trumpets, buy on the cannons” is an old Wall Street expression suggesting how to invest during armed conflict. It’s a reverse offshoot of the overly used “buy on the rumor, sell on the news” maxim and, despite its now trite status, the recommended behavioral anomaly seems to persist in the equity markets. It worked during Iraq’s invasion of Kuwait, during the US invasions of Afghanistan and Iraq, after Clinton used cruise missiles to kill a few camels and burn some Sudanese tents and an Aspirin factory and, given the status of market futures this morning, seems to be holding once again after allied missile strikes and bombing broke out in Libya over the weekend. The theory, as best we can define it, is that the reality of war is never so bad as the fear, fog and rumor leading up to it. In light of the above examples and Libya, that theory probably holds true especially given the asymmetrical powers of the opposing forces in all these recent cases.

Interesting, there is a lot more operating on the markets this morning than just hitting Libya with a few bombs. Japan seems to have stabilized their runaway reactors over the weekend, connecting power to drive water pumps and cool the core. That’s good news on the long road to resolving their ongoing post-quake reactor crisis and most likely is lightening some of the nuclear discount under which the markets have been trading of late. However, missed by the popular press was a statement issued by Japanese Prime Minister Kan, pledging to rebuild quickly and aiming to compile a relief and reconstruction package as soon as next month. Estimates for the cost of rebuilding effort run as high as $100 billion. That would also be good news not only for the Japanese people but for infrastructure companies both in Japan and abroad, a fact we pointed out last week. Not so well publicized was Saudi Arabia’s pledge to give out $36 billion (of our money) to its citizens to quell their thoughts of uprising. Also, not unlike the old joke about the reaction time of kicking a dinosaur in the tail, investors are also most likely coming to the realization that the Philly Fed Index released last week was very strong and that most banks passed the Fed’s Stress Test II on Friday and may now resume paying dividends. Both speak to the health and strength of our economy and its financial system. Putting it all together, the weekend navel contemplators have their buy orders in this morning. We wonder who makes money selling during panic and buying on euphoria.

In any case, the point of this week’s Ramblings is to look beyond the current world turmoil for signs of what it will all mean to the markets in the intermediate term, not just this morning, and opportunities presented therein. The last two weeks have seen oil and coal (and companies supplying both) rise on Mideast supply interruption fears and rumors of the early demise of Nuclear power. Stocks of Uranium producers have been decimated. Infrastructure plays only caught a bid on Friday after Larry Kudlow stated what we mentioned two days earlier—that the quake may benefit these companies. High-end retailers have gotten bombed as hard as Quadafi’s compound on fears of a pull-back in the Japanese tourist trade and, most perplexing of all, technology companies have been indiscriminately sold off on the belief that parts supply disruptions from Japan will crimp their earnings. How can one make money on these dislocations?

We like coal and oil, not so much for the temporary positives but for the long-term industrial and consumer need for these energy sources. Yes, US energy independence, solar, wind and other alternatives are wonderful dreams but, like Obama, Jimmy Carter had them too. We don’t know what to make of Uranium but 25 years ago we listened to a presentation by Alan Greenspan to the University Club in New York in which he predicted that the risks of Nuclear power may someday outweigh the risks of oil. We may be there now and that line of thinking will probably weigh on politicians for years to come. Plentiful and cheap coal will most likely slow the return to reactor building even in China. So Uranium is probably worth a miss for the not-so-stout-hearted. As for the other sectors hit by the turmoil, we believe that this is a great opportunity to pick from amid the market rubble. First of all, the indiscriminant selling of companies with supplies or sales wholly unconnected to Japan have given US investors an unprecedented gift. Secondly, even US companies somehow impacted by Japan have now been given a “bye,” meaning that whatever they report for the second and third quarters of this year, they will be able to blame it all on Japan, a one-time extraordinary event, rather than any kind of US economic weakness or company-specific issues. Any investors out there old enough to remember when El Niño was an excuse for missed estimates at everything from retailers to Caterpillar? It’s gonna happen again, trust us.

Some tech companies, like Alcatel Lucent and Texas Instruments, have already warned investors that supply disruptions will likely impact earnings for the upcoming quarters. For companies such as these, we suggest the buy on the rumor strategy, particularly for the tech companies. Yes, supplies will be interrupted in the short-term but demand (despite the trouble in Japan) will not. Prices will rise at the supplier end of the chain, giving those companies an earnings boost, and we should not underestimate their ability to quickly shift production to other locations (without publicly letting on), easing supply constraints but maintaining the higher prices. Beneficiaries of Japan’s ills are probably a good place to look but we caution that Japan’s insular, protectionist attitude has not been changed by this tragedy so they will look first to domestic companies before calling for help from the US and China. Still, let’s not forget that Libya will need some rebuilding and has no industry of its own—just ask the folks at Halliburton what Kuwait did for them. Indirect beneficiaries like commodity producers (steel, coking coal, aluminum, building supplies) are good places to look as Japan and Libya don’t have much in the way of their own raw material stocks and the Japanese producers, like steel plants, are currently off line due to power constraints and will be for some time. This list goes on. Interested investors should give us a call.

So, looking out into the next few quarters, we see many positives from US companies reporting earnings. Some will be directly benefited by recent world events; others will be negatively affected but given a free pass. Eventually oil should return to price levels commensurate with real demand, not war panic, giving the consumer a tax break and investors may finally start focusing on fundamentals, which are good, rather than headlines, which have been bad. All-in-all, then, we see the US equity markets rising from the recent ashes and would be buyers, although not on the euphoria of the moment. We have yet to return to pre-crises market levels and investors will be given another opportunity to get in before we do so. Remember, stocks take the stairs up but the elevator down—that gives prudent investors time to take advantage of the dislocations the recent negative headline events have produced.

Ramblings of a Portfolio Manager

2011-03-17T04:57:00.000-07:00

Interim Ramblings -- Japan

10 basis points of World GDP growth. That’s it. One tenth of one percent of world GDP is expected to be affected by the terrible tragedy in Japan. And that is in the short term. No one has yet to quantify the longer-term benefits to manufacturers and exporters in the US and China from the strengthening Yen and the enormous needs for building materials and equipment soon to be hitting the order books during Japan’s reconstruction phase. It sounds perverse (and cruel) to say but it is very true that this tragedy has become Japan’s own Economic Recovery and Rebuilding Act—similar to our own except that the funds will doubtless be channeled into needed, productive projects rather than the many worthless make-work boondoggles the current Administration has squandered our funds upon here. And US exporters might just be the beneficiaries.

The US currently imports one half of what it did from Japan just 10 years ago and while our exports have increased, estimates are that only about 2% of the S&P 500 earnings are dependent on that trade. And it is unclear if exports from the US will even drop off. True, some industries like auto parts may suffer but food, medicine, building materials and energy (oil, coal) may actually increase to satisfy immediate needs and to replace lost productive capacity. For example, Japanese steel and aluminum plants are offline or damaged and much of both of those commodities will be needed for reconstruction. So far many tech companies have announced supply disruptions but they remind us that these disruptions will only be temporary and are the result of power outages rather than damages. Furthermore, for some segments of the Tech Sector, the damage to Japan’s infrastructure should be a good thing down the road: First, competitors are eliminated from the market temporarily. Secondly, some sectors, like optical components, were in a glut prior to the quake—the disruption will help them work down inventories, eventually raising prices. Finally, when the rebuilding occurs, the repairs will most certainly include the Country’s technology infrastructure and that will be good for US Tech manufacturers. Multiply these factors across many US industrial sectors and you will see where we’re going.

US equity markets are trading on sentiment—fear of nuclear fallout and of economic disaster in Japan, fear of the Middle East burning and fear of European debt defaults. Yet we have lost only about 6% from the top on all major US equity indices. That’s not bad considering the spike in the VIX and the huge drop in investor sentiment. For those of you who have hit the sell button, we suggest a long bike ride, maybe a cocktail and some re-runs of Two and a Half Men rather than shivering in front of CNN or CNBC, pondering more sales. The images coming across TV and the minute-by-minute conflicting headlines are only a recipe for angst and making an investment mistake. As Warren Buffet is fond of saying, be greedy when others are fearful, be fearful when others are greedy. Right now, it sure looks to us that others are panicking. It may sound mercenary and vulture-like but we’re investors so we are taking advantage of the situation. We suggest that you do too—but before the TV talking heads figure out that this tragedy, in the long run, may be just what both Japan and the US need to pull our respective economies out of their current malaise.

Happy St. Patrick’s Day.

Ramblings of a Portfolio Manager

2011-03-07T07:09:00.000-08:00

Why isn’t Higher Oil the Straw in the Proverbial Camel’s Back of the Market?

After two weeks of turmoil in the Middle East and Africa, the major US equity averages have moved very little. Since riots in Egypt broke out at the end of January NYMEX crude has risen approximately $21/bbl, from roughly $85 to $106, a nearly 25% increase. Gasoline prices at the pump have risen a more modest 10%, yet despite the hike in real costs to consumers and the flood of negative press and television images, the Dow and S&P 500 have only declined by about 2% respectively from their highs. In fact, both indices are now trading exactly where they were at the end of January, when all this turmoil broke out in the first place. The spike in oil, naturally, has drawn pundits from out of the woodwork declaring potential economic Armageddon from higher oil, quoting such sensitivity numbers as a $2 per share impact in S&P earnings per every $20/bbl rise in oil. We don’t have the economic inputs for the model nor the Cray computer to run them to test this assertion so we’ll just take if for gospel (dangerous, we know). Based on current 2011 S&P earnings estimates of about $93 per share, that $2 would be roughly a 2.2% decline in corporate earnings for this year. Assuming no multiple contraction, that would equate to about 29 S&P or 270 Dow points, which would put us back just to where the markets were at the end of January, when all this began--that just so happens to be where we are right now!. Of course, with decline corporate earnings, one would expect some multiple compression resulting from the attendant dampening of investor sentiment. At the current multiple of the S&P 500, 14.2, a full multiple point of compression (pretty high historically) would equate to another 7% decline in the index. Combined with the prognosticated reduced corporate earnings power, that would give us the 10% decline that “everyone” is expecting as a pullback. A decline of that magnitude would just bring us back to about December 1st in the S&P 500.

But the tradeoff between oil prices, GDP and stock market levels is not rigidly formulaic. There are a number of variables that impact market levels in a rising energy market and make for a dynamic situation that, in reality, no economist or oil company executive (let alone a politician) can predict. For example, investor sentiment, which at the beginning of February was at a level that just about every talking head on TV who could emerge from under a rock proclaimed signaled a market pullback, has dropped significantly. According to AAII, the percentage of investors who are now bullish is nearly equal to those that are bearish at 36% vs. 32%. This is down from a level of nearly 52% bullishness at the beginning of February, just as the oil region turmoil began. The contrarian in us likes this move, especially in light of the relatively small decline in market averages.

Another factor that goes into the GDP vs. market level vs. energy price tradeoff is the impact at the consumer level, something the TV pundits like to take throw out continually. Here, simple math that even we can do throws this argument into doubt. According to the NHTSA, the average American drives 15,000 miles per year. According to the DOT, the average fuel consumption of all cars, light trucks and SUVs on the road today is 21.4 miles per gallon. Since the rioting began, gasoline at the pump is up, on average, about $0.33/ per gallon. Simple math tells us that the impact per average driver would be about $231 per year IF these higher gas prices persist for another year or more. Now, $231 may not seem like a lot to Wall Street types but it can be meaningful to the average American, at the margin. However, taking an adage from Wall Street, “nothing cures high oil prices like high oil prices.” That means, in basic economic terms, as gasoline prices climb, demand, being elastic, declines, thus reducing the per-family dollar impact and, eventually, bringing down the price of the commodity. The latest data we have on this phenomenon is from March 2008, when gas prices reached highs we are currently seeing at the pump. At that time, the number of miles driven dropped 4.3% in response, according to the Federal Highway Administration. Right now, even though oil has jumped 25%, stockpiles (you’ve heard all about Cushing and the spare oil sitting around in tankers in harbors around the world) have kept the pump price impact to half of that and will probably do so for several months. And that pump price needs to stay here for another 12 months before we see any significant impact to the average driver. At that point, miles driven will most likely decline, negating some of the impact. But we have a long time for stockpiles to be reduced (remember, ONLY 1.8% of the world’s supply has been cut and that has only seen a 50% reduction). In the meantime a situation such as we saw in 2007 and 2008, a significant move to more online shopping, will further negate the impact to consumers and consumer-related companies.

Of course, the GDP impact of higher oil isn’t just dependent upon consumers’ driving and spending habits. Energy is also used for home heating and transportation of goods, in addition to manufacturing (think plastics). On the first point, the Northern Hemisphere is now entering Spring/Summer. Heating demands will plummet, lessening both demand and the impact to consumer wallets. Transportation (trucking, rails, airlines, etc.) has gotten much more efficient over the last decade, further lessening the impact to the economy versus prior oil shocks. Our manufacturing economy has become both more efficient in energy use but has also transformed over the years. In fact, the dollar output of GDP per unit (BTU) of energy consumption has almost halved since 2000, according to the US Census Bureau. Simply put, our economy, despite all the hand wringing by opposing political parties, has indeed become less energy dependent as it has transformed from manufacturing to high-tech and financial services. Another 70’s style oil shock may well have a GDP impact but it can be expected to be much, much less in terms of reduction of domestic output.

The quoted $2/share S&P earnings impact per $20/bbl in oil presumes a permanent upward spike in oil to that higher level. So far, we have had only two weeks of rising oil and the new, higher price has not arrived all at once—it has been a steady incline. Except for airlines and other energy sensitive transportation industries, few US companies have yet felt the bit of higher oil. And, unless this new level of crude remains permanent or rises further, we believe few will. Right now a 25% rise in oil based on a 0.9% decline in supply says to us that there is a big “contagion premium” built into in oil prices right now. That premium probably assumes several Middle East countries undergo what Libya is now seeing, but probably not Saudi Arabia. A lot needs to go wrong in the Middle East for that scenario to develop—a fairly low probability, in our opinion. One thing we have to stress, though, is that all this turmoil represents a disruption, not destruction in supply. The length of this disruption is anybody’s guess but you can be sure that, as economies wholly dependent upon selling the black sticky stuff, the oil producing nations will ensure that it is as short as possible—or their troubles will only compound. That says to us that the price of oil has most likely over-reacted to current world events and that the equity markets have reacted rationally. Now that investor sentiment is low and oil is high, when we get a reversal of both (which we will and they will come together) the base will be set for much higher equity markets.

Ramblings of a Portfolio Manager

2011-02-21T13:07:00.001-08:00

Is the Inflation Boogie Man Really Hiding in Ben Bernanke’s Beard?

Since the Fed embarked on its second round of quantitative easing back in mid-November, economists, portfolio managers and politicians alike have appeared on TV to argue whether the program is an effective stimulant to the US economy in the long-run and whether the end-result would be much higher levels of inflation in the short-term. Here we examine the inflation argument.
One faction of the inflation camp argues that loose monetary policy is a recipe for runaway price rises as it raises the demand for consumption and capital investment, often in projects that would be uneconomical under a normal monetary regime—the old “demand-pull” cause of inflation from the text books. An opposition group, the “don’t worry just yet” camp, however, have argued in favor of the classic Phillips Curve theory, that inflation is directly related to the level of employment in an economy and that there is a historical inverse relationship between the rate of unemployment and the rate of inflation. This “cost-push” textbook inflation, they believe, is unrelated to monetary policy and is far off given the persistently high levels of U3 (the official unemployment rate, hovering around 9%) and, especially, U6 (total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force—currently 16.1%) labor underutilization. Yet a third group, in the inflation camp, the “competition for resources” faction, has postulated that surging commodity prices (in part related to the weak dollar from QE2 but also directly tied to insatiable demand from fast-growing emerging markets) will export inflation to our shores regardless of easy money or tight labor. In this scenario, monetary policy is somewhat responsible for the level of prices as it drives up demand for commodities, thus raising the costs of raw materials to producers and food, energy and other necessities to consumers, but the rest of the world is the real culprit behind inflation, rates and money supply independent.
Whom should we believe in this heated and ongoing debate? To begin, there is some basis to support the inflationary camp’s position that loose money will ultimately result in inflation. The rise in the money supply, combined with no change in the output of goods and services, can create a situation where there is an elastic and excess supply of money chasing a relatively inelastic supply of “wants.” The result is, at the margin, the prices of those “wants” will increase, driving inflation. Where this theory falls short is that output, in the longer run, is fairly elastic as companies can increase capacity, explore for more natural resources, etc. Money alone doesn’t drive inflation, it is the consumers’ demand for that money and the things it can buy paired off against the producers’ ability to supply that demand. Currently, capacity utilization in the US is around 76%, about 10 percentage points below the normal rate of an economy at full output, and has slightly contracted in the last few months. Over the years, both the level of capacity utilization and the rate of change in capacity utilization have been good predictors of future inflation. Right now, neither indicator is pointing in the right direction, suggesting that even though demand for consumption and investment may be rising there is still sufficient slack in production capacity and the interest to increase it to keep inflation at bay for the time being.

As for the Phillips Curve crowd, there is evidence that employment levels can manipulate inflation in the short run. In the US services account for almost 80% of GDP, when Federal, state and local governments are included. As a result, labor costs are nearly 70% of total input prices to the economy. Any uptick in demand for labor, therefore, would seem likely to produce much higher costs to business and, thus, inflation. The Curve predicts an upward “death spiral” as lower unemployment produces a lower supply of workers and the higher wages they are able to demand further increases want of goods and services, thus causing companies to need to expand capacity and employment further. The dynamics of the Phillips Curve are complex and there has been much debate on its efficacy in predicting inflation over the long run, at which it has not done well. Many have argued that we need to get below a “natural rate of unemployment” (one that includes those perpetually in search of different employment or who just don’t want to work) before the demand for labor requires companies bid up the price to attract employees. Still others have argued that, over the long run, workers price their compensation to exactly match the rate of inflation, eliminating the upward “death spiral” the Curve prophesizes. The “stagflation” of the 70’s attests to the limitations of the Phillips Curve.

Finally, the commodity price theory has some basis but a number of drawbacks. As we mentioned, the stagflation of the 70s is an example where inflation was imported in the form of higher oil prices from OPEC while the economy sat with relatively high levels of unemployment. There is nothing to suggest that scenario cannot happen again, given the current turmoil in the Mideast, however, the 70’s OPEC embargo was an exogenous, manipulation of supply which turned out to be temporary. The world is a much different place in the current decade and though we have not reduced our addiction to imported oil, we have a much more flexible and diversified economy in which substitution can mitigate rising commodities prices (we’re already seeing such examples as aluminum replacing copper as those prices surge and abundant solar, nat gas and coal replacing more expensive oil). In addition, as we mentioned, services drive this economy, not manufacturing; raw materials comprise only about 5% of input costs. Inflation is an economic condition in which all prices rise, not just some. So we have a long way to go before the commodity alarmists’ dire predictions become of concern.

The ultimate question in predicting inflation is whether manufacturers will be able to pass the higher costs they incur (from whatever source) on to consumers. On Wednesday the Labor Department released the core producer price index, which excludes food and energy costs. It increased 0.5 percent in January, the biggest advance since October of 2008. Economists had expected a 0.2 percent gain. Most of the rise, however, reflected a jump in drug prices, which accounted for 40 percent of the increase and probably reflected a one-time price hike ahead of the implementation of Obamacare. The overall, non-core number, reinstating food and energy prices, rose a more hefty 0.8 percent, lending credence to the commodities inflation argument. This advance followed increases of 0.9 percent in December and 0.7 percent in November and marks the seventh straight rise in prices. These numbers represent costs to manufacturers. As we said, the ability to pass them on to consumers will ultimately determine whether we get inflation. On Thursday the BLS released the Consumer Price Index. The CPI increased 0.4 percent in January on a seasonally adjusted basis, half the level of the PPI. Moreover, increases in indexes for energy, commodities and for food accounted for over two thirds of the all items increase giving further support to the commodities faction--in fact, over the last 12 months, the food index has risen 2.1 percent and the energy index has increased 7.3 percent with the gasoline index up 13.4 percent—yet the annualized inflation rate for all items including food and energy, is rising at a rate of about 1.6%cent.

So how do we interpret the data above in light of the arguments from the various inflation/non-inflation camps? First we note that while prices have indeed risen to business, they have not shown to have risen as greatly to consumers, lending support to the fact that companies are currently unable to pass on price increases. There may be a time-lag effect operating here, however, the persistently high level of unemployment may also well be a contributor. With current capacity utilization levels historically low and unemployment high, we have a way to go before that ability to pass on prices emerges and inflation ignites. That does not bode well for corporate margins, by the way, but that’s a story for another Ramblings.

Secondly, there seems to indeed be a commodities price factor in the rise we are seeing in costs at the wholesale level but those commodity price rises don’t seem to be driving consumer inflation to the same degree. Part of this, again, may be the inability of manufacturers to pass on price increases--Q4 earnings reports from the likes of P&G, Kellogg, Clorox and General Mills suggest that may be the case right now-- but part is also reflective of a change the consumers’ model consumption basket used to calculate CPI—simply put, energy, food and other commodities are less of a component in the basket used to measure inflation than they were 20 years ago. In fact, housing is almost 40% of the CPI index weightings and the continued oversupply in that segment of the economy portends to hold down reported inflation for a long time to come.

Finally, as we have seen throughout the recession and recovery, manufacturing productivity has risen dramatically—something no camp can seem to fit into their models. This means that companies are now, and most likely will be into the future, able to produce the same amount of output with fewer workers and fewer raw materials. This argues against any short-term Phillips Curve bump in inflation—unless 9% becomes the new natural rate of inflation, which we doubt (and pray for to be otherwise)—and suggests that companies will continue to be more efficient in their raw material per unit consumption. Continuing productivity enhancements are the one glitch in all the above camps’ inflation models.

In summary, in our opinion, all three theories of inflation are at work here and for the moment, are counterbalancing one another, keeping inflation low. We may yet see the inflation the easy money and commodity camps suggest, but the Phillips Curve folks, combined with a fair amount of slack in manufacturing and productivity enhancements, are keeping it in check for now and into the foreseeable future. Interestingly, from the recent Fed minutes, that also appears to be what the Federal Reserve is seeing…so for now we’ll take a page out of Investing 101 and not fight the Fed.

Ramblings of a Portfolio Manager

2011-02-07T06:29:00.001-08:00

So Has The Retail Investor Finally Thrown In the Towel?
As the old saying goes on Wall Street, equity markets tend to top out when the so-called “dumb money” (smug Wall Street jargon for the individual investor) finally realizes that stock prices are rising and dives in. The theory goes that individuals are the last to be informed that the economy and earnings are improving, thereby making the investment decision after all the good news has already been discounted by the markets—coming very late to the party, so to speak. Typically this adage is paired with something about the level of the Dow being published on the cover of Time Magazine or another similar pop-culture publication.
The theory, as we said, is a smug, insiders’ view of the markets and one that is most likely based on ancient foundations, given that the world is now “wired” with the average investor having as much access to financial and economic data as the pros on Wall Street. That’s not to say that the theory doesn’t still hold—only that its underpinnings may have changed. The last three years in the equity markets have probably done quite a bit to reinforce the foundations of this maxim with the financial crisis, huge market volatility, flash crashes and hedge fund fraud all making headlines impactful enough to scare even the professional investor into the mattress as a safe haven. So for the individual investor to begin to put his or her toe back into the equity market waters, there is a huge psychological ocean ahead to cross. And, like anyone facing a long, arduous swim, there has to be preparation—both psychological and structural—and that takes time. Thus, indeed, the individual investor may still be the last large pool of investment funds to commit money to these markets this time around.
With earnings coming in better than expected for the 10th quarter in a row and US equity markets seemingly shrugging off bad news from abroad (i.e. the good news is discounted yet the bad is being ignored) our investing sixth sense tells us that there are cash flows supporting stock prices that either need to or are desperate to be invested. That in mind, we thought we would revisit the ICI Weekly Money Flow tables to see if we can find anything unusual going on.

Estimated Flows to Long-Term Mutual Funds Millions of dollars (courtesy of ICI)

As one can easily see, funds’ flows into the US equity markets (a proxy for the individual investor) turned solidly positive in mid-January. This, while cash flows into foreign equity funds appear to have topped out and begun a decline. Where is the money coming from? At first glance, it is obvious that the outflow from municipal bonds appears to continue, with investors fearing defaults by state and local issuers thanks to dire warnings from the likes of Meredith Whitney. But that doesn’t explain everything. Have a look at the chart below, also courtesy of ICI.

Assets of Money Market Mutual Funds Billions of dollars (courtesy of ICI)

This chart describes what is going on in the money market and Treasury markets over the last few weeks. There is a slow, but noticeable, outflow from the so-called “safety” of short-term and government-backed fixed income securities that, combined with the outflow from munis, can explain whence comes the funds to invest in US equities.

Now, all this data can be very volatile and subject to the psychology of the markets of the moment but it does show a definite trend out of fixed income and into US equities. As talk of inflation in this country ramps up with every strong economic report, we would expect bond prices to make further declines, accelerating this trend. And while the funds flow into foreign equities continues to be positive, that is also in decline and with continued rate hikes in China and now India and perhaps Australia, along with more turmoil in the middle east splashing across the TV screen, we can expect this trend to hasten as well. Combining foreign equities and foreign bonds with US fixed income investments makes for a heckuva lot of money that can be freed up to flow into US equity markets, the one remaining perceived safe haven.

What does this all mean? Well, we hate to agree with the economists but many did say at the end of last year that 2011 may be the year for US equity markets. From our work, with very few other places to earn a “safe” return around the globe, the economists may have gotten it right this time.

Ramblings of a Portfolio Manager

2011-02-01T08:58:00.000-08:00

Despite international concerns and related volatility late in the month the US Equity Markets largely turned in positive gains for January, 2011. Large cap stocks outperformed small caps, however, the Kettle Creek fund generated a positive return for the month as our low exposure to companies deriving revenues from foreign sources protected us from the continuing concerns in Europe while our overweight position in energy and shipping benefited the fund during the late-month turmoil in the Middle East.

January is best described as a month during which the same old fears regarding China and Europe continued to stalk the equity markets but went largely ignored, having been fully discounted over the prior quarter. With little to no new information being added into the equation the US equity markets climbed the proverbial wall of worry for most of the month, despite a brief, one-day sell-off at the end of the month on fears of unrest in the Middle East, sparked by riots in Egypt. Even these concerns over tensions in the Suez were short-lived as the market resumed its upward climb on the final day of the month.

In the US front, most economic data came through better than expected, with the exception of housing and employment, which continued to languish although many economists blamed the poor weather (principally in the Northeast) and were quick to remind investors that both are lagging indicators in an economic recovery. The one area of concern in the string of positive December data was new home sales which, released at the end of the month along with equally soft Case-Shiller home price data, were weak enough to ignite talk of a double dip in housing. Yet even that data couldn’t derail the rally, which pushed ahead despite the temporary weakness in housing and related stocks.

January also kicked off earnings season for most US companies and as the month began there was some concern that expectations had been elevated too high. Not only had analysts, encouraged by Q3 reports, QE2 impact and the positive developments on Capitol Hill, raised their forecasts significantly for Q4 earnings but traders and portfolio managers had further boosted those expectations through the whisper network. Along with the nearly straight run in US equities since the September lows, the record investor confidence it engendered, the high earnings expectations anxiety gave a great deal of material for the “correction” hand-wringers in the media. With the exception of two very bad days in the Russell 2000 and the one-day across the board sell-off on Middle East fears, however, the correction never came. With so many investors so worried about investor enthusiasm and the correction it was supposed to create, the sentiment essentially created a non-self fulfilling prophecy.

Our outlook on the US equity markets continues to be favorable for 2011 and into 2012. Late last year we were a little concerned about the recent bump in investor confidence, however, with so many other portfolio managers sharing the same concern, we essentially have a wall of worry ahead of us rather than a stock market bubble. In addition, with many emerging markets now in tightening mode and turmoil erupting in the Middle East—along with rising rates at home thanks to a strong economy—we believe that investment capital will begin to flow into US stocks, giving ample support for the theory that the US will be the place to invest for the next 18 months.

Ramblings of a Portfolio Manager

2011-01-12T06:38:00.001-08:00

Bullish Sentiment on us Equities is at a Recent High…and so is Market Pessimism Regarding the Bullish Sentiment on US Equities.

What a terrible time to invest. We hear it every day: the VIX is at a 2 year low, the put/call ratio is the lowest since January of 2006; US monthly stock market sentiment indices show the ratio of bulls to bears at 2:1, also a two year high; NASDAQ sentiment index is the highest since October of 2007; short interest fell 5.5% on both the NASDAQ and NYSE in December and, finally, the AAII Bull-Bear Spread is around 53%, also a two year high. All this points to investor sentiment at a near-term zenith and if you are a contrarian, as we tend to be, it’s about time to liquidate and run for the hills. The pragmatist in us, however, says hang on, not so fast.

A look at long-term mutual fund cash flows (courtesy of ICI), however, shows the movement back into US equity funds is only just beginning—a proxy for retail investor sentiment. In fact, net outflows from US equity funds stopped and turned positive for the first time only as recently as December 21st—and the net inflow number was tiny, dwarfed by flows into foreign equity funds by some 265:1. That trend continued through year-end with flows into US equity funds positive but tiny in comparison to those into foreign funds. For all the hand-wringing over rising rates, net cash flows into bond funds just went negative during the week of December 8th, continuing until the last week of the year when there was a big reversal, most likely due to asset allocation strategies pegged to the higher interest rate environment engendered by the recent rout in the Treasury market. Meanwhile, the flows out of Muni bonds continues amid fear of defaults by certain states. What to make of this? Well, if sentiment is so high on US equity markets, it has yet to be backed up by the money. And as Jerry Maguire would say…

A day doesn’t go by when we tune into one of the financial channels only to hear a half dozen market experts rehashing our sentiment analysis, using it as evidence that markets are overbought and due for a correction. We don’t necessarily disagree with them except for three important points: first, if everyone is so negative on everyone being so positive, doesn’t that sort of cancel things out? In our humble opinion, the answer is yes. Secondly, and we expect to be laughed at this given our view of technical analysis, the technicians look at all this bullishness with half see it as a good thing, half as bad. Synopses for several technical analyses:

The Pro:
At present, the short-term bullish outlook is supported by a strong technical backdrop, with the SPX advancing above the 1,250 area in mid-December. U.S. equity investors are more bullishly positioned than at any time in the last two years, figures show, following a sharp market rally since September. Investors currently have 10.8 times as many long positions as short positions -- bets on falling prices -- in the United States, the highest since the ratio was calculated two years ago, according to the data. Things that support this positive outlook:
1. Accelerating stock buybacks
2. Accelerating M&A activity
3. An extension of the capital gains and dividend tax cuts originally set to expire in 2011
4. The third year of a presidential term is historically bullish
5. An accommodative Fed
The Con:
We are seeing optimism enter the market recently, which means we may be vulnerable to a short-term pullback. For example:
1. Equity call buying relative to put buying on the Chicago Board Options Exchange and International Securities Exchange is at an extreme.
2. The CBOE Market Volatility Index (VIX) is now trading at a level that is twice SPX historical volatility. During the past two years, when the VIX is trading at such a high premium to SPX historical volatility, a mild to large pullback soon followed. The last time this indicator signaled was early November, ahead of a 3.8% retreat in the SPX.
3. For the first time since late April, domestic stock mutual funds experienced net inflows last week. The inflows are minute relative to the enormous outflows during the past three years, but one has to wonder if this eight-month "extreme" in optimism might precede a pullback in stocks? After all, during the past 10 years, the month of January experienced a correction, or marked the start of a correction, in five of those years (2002, 2003, 2008, 2009 and 2010).
• The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish or neutral on stock market for the next six months. As the masses are usually on the wrong side of market movements, particularly at tops and bottoms, sentiment indicator serve a useful function as contrarian indicators.
• The bullish sentiment (55.9%) and bearish sentiment (18.3%) readings are at fairly extreme levels, as also seen from the bull-bear spread being quite a bit higher than the market peak of October 2007.
• Sentiment indicators are fairly blunt instruments from a timing point of view and can stay at high / low levels for extended periods. However, when companies are overvalued and technical indicators overbought, overbullish sentiment indicators complete a threesome of tools arguing quite strongly for a cautious approach to stock market investment.
Since we don’t cotton well to technical analysis, the fact that their jockey shorts are all in a knot as to how to read the current markets is a good thing to us. When they all agree is when we hit the buy or sell button.

Our third reason to give pause before bracing for the coming sell-off is the ICI data. Yes, money is flowing strongly into equities….but it’s NOT going into US equities! In fact, the recent big flows out of bonds (only after they have sunk in market value by close to 20%) has been redirected into Foreign equity funds. Guess what? India is now down 6% for the year with many of the smaller Asian/Southeast Asian markets dragged lower in tow. So there is definitely some validity to watching the cash flows as an indicator of the retail investor coming in during a market’s last legs. The problem is, it’s not our market they are top-ticking. Predictably, they are chasing the past returns in India and the “Tigers” (or so they used to be called). We like that—because as retail left bond funds after having been burned, so too soon they will leave foreign equity funds after being burned…and where will they have to turn? The US, of course. What else is left? And it will be just in time for all the better economic data, which has been hitting the wires lately.

After a big move on January 2nd, the US markets have tread water, mostly with a downward bias. This is contrary to our, and many other fundamental analysts’ beliefs, that we would see a very strong run through the middle of January followed by a sell-off, which would be a buying opportunity. We’re not sure the sell-off is coming—or if we haven’t already had it (a consolidation as the technicians would say). Perhaps January will be a reverse of what we expect—early weakness followed by a month-end rally. That would sure put a knot in the socks of the fundamental guys as well as the technicians. We’re not saying that there wont be pullbacks, just that it’s too pat to try to call them based on the calendar and that, if they come, they should be short and shallow and present a good buying opportunity. Let’s not forget that the markets are still awash in liquidity and that European weakness/Chinese, Indian Inflation headline risk is not only discounted in investor’s minds but is being addressed in part with China willing to backstop Spain and Japan willing to pitch in to support Portugal. What other headlines do the Euros have to throw at us? And are there not piles of cash lined up for the day when China says “done raising rates?” If this market sells off the catalyst will have to come from within—we’ve heard the China/India/Euro record before.

Ramblings of a Portfolio Manager

2011-01-03T11:18:00.000-08:00

Santa Claus smiled upon the US equity markets in December, delivering solid gains with much reduced volatility versus prior months. In this market environment, the Kettle Creek fund generated a strong positive return for the month as the high correlations among individual stocks, seen for most of the year, unwound allowing those with stronger intermediate-term fundamentals to outperform.

While 2010 can be characterized as the year investors in the US equity markets spent most of their time looking abroad and worrying, fretting over everything from debt defaults in Europe to inflation in China and military tensions in the Koreas--to name a few--December will be remembered as a welcome respite from global concerns, a month when investors turned their focus to the improved political landscape and strengthening economy at home. It was almost as if investors looked at the troubles overseas and decided, for a month anyhow, to adopt Alfred E. Newman's philosophy of “what, me worry?”

This isn’t to say that there was nothing happening in the global landscape to cause concern to investors at home. Ireland, one of the “I”s in the now infamous PIIGS (the second “I” having been recently added over concerns for Italy), continued to be thrust to the forefront as yet another over-leveraged, slow growth, entitlement-addicted European country in need of a bailout from the IMF and EU while Portugal, the “P,” loomed ever larger on the horizon as the next domino, followed potentially by Spain, the big “S.” China also continued as a global macro concern but for opposite reasons. In an effort to tame inflation in December the PBOC hiked bank reserve requirements for the third time in two months, followed by a Christmas day surprise of a 25 basis point hike in its discount rate. Suddenly, the same investors who have been calling the stated growth rates in Chinese GDP “falsely inflated” began to worry that the PBOC’s attempts to reign in the inflation generated by those “lies” would overshoot, slowing the “engine” of global economic growth too far and thrusting the world back into recession. And even while the mid-term elections in November improved the political backdrop at home, in December we were reminded that the bureaucrats are alive and well in Washington as the SEC launched a massive insider trading probe with some high-profile hedge-fund arrests while their counterparts on the other side of the hill at the newly created Consumer Financial Protection Bureau continued to attempt to weaken domestic financial institutions this time by drastically cutting debit card swipe fees charged by credit card companies.

Still, in December, investors believed that much of these concerns had already been discounted in the equity markets and a few early Christmas presents in their stockings helped them think more positively on
equities. On the European front, the IMF and EU moved much more rapidly than in prior situations to
staunch the bleeding in Ireland. Serious talk of a bailout fund to deal proactively with future crises ensued and China began buying up distressed bonds of many European countries (eschewing our own overpriced debt instruments), emerging as a potential financial backstop in future European debt dilemmas, particularly should Spain look to begin sliding into the same morass. As for China, while inflation fears persisted, a weaker-than expected PMI brought comfort to some that the tapping on the brakes efforts were beginning to work. Here at home our own PMI, Consumer Confidence, Industrial Production and Unemployment Claims numbers all came in better than expected and on the political front the Obama Administration rolled over on the Bush tax cuts, extending them another two years for all income brackets while unexpectedly tacking on a Social Security tax cut for all, an extension of unemployment benefits, more generous estate tax provisions and, best of all, a one-year 2% payroll tax cut with a 100% writeoff on capital investments for business. All of this positive news on the domestic economy caused many economists to lift their GDP forecasts for 2011 through 2012 by 50 to 150 basis points, something the markets had not been expecting.

With little new negative news and a spate of good political and economic data the US equity markets responded positively. The VIX dropped to at 3 year low, while Treasury yields began to climb despite the Fed’s efforts on QE2. The dollar climbed as well as did oil prices on expectations of economic strength. Suddenly, talk of a double-dip recession, rife over the summer, turned to hand-wringing over if the Fed would even complete QE2 and when they would start withdrawing liquidity ala the PBOC. In this market environment the Kettle Creek Small Cap Fund performed well as we have been exposed to the cyclical
sectors of the US equity markets all year long in the belief that the domestic economy would continue to strengthen, despite the turmoil in Europe. While this thesis hurt us during the downdrafts of May and August, when the talks of a European contagion were at their zenith, our discipline to stick with the thesis paid off in December. The strongest performing sectors in the fund were Financials, which were helped by the steepening yield curve, and Industrials and Materials, both of which got a boost from the improving economic data even in the face of a slightly rising dollar. Weaker sectors included Technology, to which we have been reducing our exposure, and Consumer Discretionary, which saw some profit taking after a nice run-up into Christmas.

We haven’t changed our outlook on the US equity markets, which continues to be favorable for 2011 and into 2012. We are a little concerned about the decline in Short Interest along with a recent bump in investor confidence—both signal that much of the good news in the Economy may be already discounted in investors’ minds and stock prices in the near term. We also have our eye on interest rates and energy prices with concern that the recent climb in both might begin to choke our nascent recovery. We expect, however, that the news flow domestically will continue to be positive and, though it will drive Treasury prices even lower thus further raising rates, will produce a net outflow from US bond funds and into US equity funds—something that hasn’t happened for over three years but the beginnings of which are just becoming manifest. That would signify an asset allocation shift among institutions as well as a return of the individual investor to the US equity markets. Given the relative size of the US bond market to the equity markets, such a cash flow reversal can produce sizeable stock price gains over the next several years.

Ramblings

2010-12-20T10:15:00.002-08:00

2010-12-20T10:15:00.001-08:00

Ramblings of a Portfolio Manager

2010-12-13T04:53:00.001-08:00

Does Chinese Inflation Matter?

For over a year now we have been hearing in the press that the Chinese economy is in a bubble—that too much stimulus in the form of post-crisis Government-injected liquidity has generated scores of worthless, non-productive infrastructure projects, related speculation on real estate and a resulting runaway inflationary economy. The paradox is that many of those bright economists and money managers repeating this mantra also couch their warnings in “if you can believe the data.”

Are the Chinese, in fact, lying about growth and inflation (i.e. is it really lower than reported figures) or do they really have the makings of an overheated economy. And if their economy is overheating, should the People’s Bank of China be concerned along with, by proxy, the rest of the world? Let’s address the purported lack of candor for a second. The story goes that, though China reports an unemployment rate of just 4%, they are really only counting permanent labor in the big cities, and only short-term contracts in rural areas, and there is a big mismatch between skills needed and those available. Unemployment levels, therefore, are understated. As for GDP, the pundits’ favorite theory is that the Country’s growth is supported only by the sheer volume of money injected by the Central Bank and that it is all being funneled into worthless projects, which will contribute no productivity or return to GDP once completed—i.e. once the gas pedal is released, the car will stop —a Chinese Potemkin Village, to mix metaphors. Along with this axiom comes the assertion that the Chinese are just making up the GDP growth figures—that they are doing so not so much for the world’s benefit but to preserve domestic content. On this score there may be some theoretical basis (although not reality) for such allegations. Many economists believe China needs to sustain nearly an 8% GDP growth to keep full employment in the cities or risk many of the rural peasants who migrated there in search of a better life losing their jobs, thereby promoting internal strife. However, just releasing big numbers does not keep people in jobs. We have yet to see a reverse migration of workers back to the countryside nor have we seen any domestic unrest resulting from economic conditions (and believe us, even the Chinese State couldn’t hide that from the world). Doesn’t sound like overstated employment figures to us. As for the productivity of projects completed or in the works, there may be some truth behind the claims, yet the projects often cited (unoccupied apartment buildings, empty towns) are not necessarily ones that will be worthless in the future (unlike our own bridges to nowhere). They are more like bets on future growth and if the State really can engineer a soft landing to 8-9% annual growth, these projects will doubtless become productive and bear economic fruit in the near future. Finally, as of Friday, the Central Bank lifted bank reserve requirements by 50 basis points, the sixth such hike this year. And that is no lie. Central banks don’t just hike reserve requirements to bolster their own government’s “lies” about economic growth—not even in a well-controlled state like China. So there must be some truth the to GDP numbers we have been seeing.

But if the Chinese aren’t lying about their growth, employment and inflation figures, is there cause for concern? Over the weekend the Central Bank released their inflation data for November. Expectations were for 4.7% although the whisper number was for over 5%. The data came in at 5.1%. After Friday’s hike, the Chinese so-called benchmark interest rate stood at 5.56%. That would leave real interest rates at or near zero—what we are trying to engineer in the US and ordinarily a cause for inflationary concern in an economy already back up on its feet. But are rates really hovering at zero in China? No. A further look at Saturday’s inflation data casts a slightly different picture on the so called “overheated” nature of the Chinese economy. Ex-food, the actual inflation rate was only 1.9%--not far above that of our own lackluster economy. That means fully 63% or more (some peg it as high as 78%) of stated Chinese inflation comes solely from rising food prices, which have jumped 12% this year alone but are expected to moderate over the next twelve months. In the US inflation data is typically presented “ex food and energy” as these inputs tend to be volatile and are not considered “structural” components of a long-term inflation picture—certainly the Federal Reserve wouldn’t consider a domestic rate hike based on inflation data, over half of which was based on these non-structural inputs. Why should it be any different in China? In fact, China managed to produce year-over-year industrial output growth of 13.3%, a true indicator of economic health, with retail sales up 18.7%--important to the government’s effort to boost domestic consumption—all with a “core” rate just slightly higher than ours. Not bad in our opinion. In more fully developed economies, like the US, where there is much less “slack” in capacity utilization, employment or wages, such growth would already be producing significant inflation. In an emerging economy like China’s, where there is such slack, high growth can still occur with modest inflation. This is what we are seeing now.

So, back to the question, what will the Chinese do with their benchmark rate and should we be concerned? Reviewing the components of Chinese inflation, if taming the “stated” inflation rate is the policy goal, raising rates will do little to make a dent. People don’t buy food based on interest rates either here or in China—which is why our Fed tends to factor out that part of our inflation data when considering its next move. And, perhaps, that is why we have seen the PBC wait so long to hike the benchmark rate even in the face of very high stated rates of inflation. However, the Chinese Central Bank has a deeper objective in its rate policy and that is reigning in real estate speculation. There, as it does here, rates do matter and the hope is that the Central Bank wont kill the golden goose while aiming at an entirely different target. Will it do so? As the theory goes, if a bunch of educated PhDs here in the states have difficulty engineering a soft landing in an economy whose metrics are well understood, how can a bunch of ex-communists accomplish that in a wild west version? Well, let’s not forget that for better or worse, most of the economists and analysts manning the PBC were educated in the West—in the finest graduate schools, no less. So what we can expect to see in Chinese economic policy probably wont be much different from what a western Keynesian or monetarist would espouse. That’s not to say they will get it right (as certainly economists here seldom do) but let’s not assume they will just be shooting from the hip either. There are lots of tools to accomplish their objective, short of raising interest rates (as we have seen with the reserve rate hike, for example). In our opinion, there most likely will be rate hikes to come in China but they will be modest, measured and well telegraphed. And the PBC will put forward other programs to slow real estate speculation, as they already have. That’s a page from our own Federal Reserve’s manual, something the Chinese have long studied. And if we are right and food inflation moderates, perhaps the cycle of tightening might be much shorter than most forecasters expect. That would be good news for the world economy and, of course, the world’s equity markets.

Ramblings of a Portfolio Manager

2010-11-23T07:20:00.000-08:00

And They All Said QE2 Would Fail.

In this holiday-shortened week we thought it only appropriate to publish a holiday-shortened Ramblings. With all the crises around the world, why do we eschew addressing the global troubles in depth? Alfred E. Newman comes to mind. “What? Me worry?”

It’s Tuesday. Let us briefly recount the global fears of the week so far: 1. China is going to tighten itself into a recession. 2. Ditto for Hong Kong. 3. Ireland is either going to sink into the Ocean or go to the Greens (why not? it is the Emerald Isle) 4. The rest of the PIGS are going to be taken down by Ireland. 5. The SEC, seeking to burnish its image post Bernie Madoff, is going to destroy the US financial system and 6. Just in, North Korea took a few pot shots at South Korea, causing the Japanese Prime Minister to suggest that war might ensue. Just another week in the richly diverse ecosphere that we call mother Earth (makes you wonder where all those hand-holding, Coke-holding kids singing on the mountain top went). So why are we adopting a c’est la vie attitude toward it all, just two days from Thanksgiving in the US? Exactly.

We’re not big movie buffs but we’ve seen all these titles before—some more times than our kids have watched the Spongebob Movie (ugh). So, let’s close our eyes and describe that film, scene by scene. 1. The pundits tell us that China is either a fraud or a bubble. Get your story straight and we’ll decide whether or not to start worrying. Meanwhile, we’ll take 9+% growth and p/e ratios on their ADRs of 5x or less. 2. What is Hong Kong and why do we care if their property market cools? Do they buy anything from us, or from anyone else for that matter? They’re an exporter—actually, a re-exporter, turning around products from the Mainland and shipping them worldwide. If anything, cheaper land there means more arable property on which to grow bamboo for chop sticks. That sounds good for the US. 3. The IMF and EU have Ireland under control. Yes, we know they are all wine-drinking socialists but they are acting fast (unlike what they did with Greece) and with determination. They have everything at stake to save the EU and the Euro and they will do so or die. 4. We’re tired of hearing about the PIGS. The only thing they all have in common is the aforementioned affinity for wine. Not a recipe for contagion. 5. No-one kicked in our door looking for files yesterday. Goldman will pay another $half billion to the SEC to make things go away. So will dozens of other wealthy hedge funds and, after the obligatory “perp walks” blazoned across the TV screens over the next week or so, we will hear nothing more about this—certainly nothing about what the Treasury will do with all that money it will collect from settlements. 6. South Korea is very, very limited by treaty in the response it can take with the North. Over the years we’ve seen shots fired across the border, ships and subs sunk, missiles fired and countless other antagonistic actions, all without serious repercussion. The reality is that the Russians don’t want them fighting, the Chinese don’t want them fighting and the US doesn’t want them fighting. They will not fight. Besides, battle hardened Hillary is on the case.

We like turkey and we like thanksgiving buffets. Our favorite buffet, at $40/head for kids, $75 for adults, was booked months in advance and is no longer taking wait list candidates. Meanwhile, we can’t get that Lego Harry Potter set for the kids because Amazon is already sold out of the $140 toy. The dumb bunny on CNBC (it’s just too pat that her IQ is double digits and, literally, her last name means rabbit) at 4am just told us that EU Consumer Confidence and PMI both beat expectations and that US retail sales are already coming in stronger than expected. Expectations for Black Friday in the US get ramped up every day. Of course, all that information will probably soon be deemed insider information but, in the meantime, we call it empirical research and it tells us that things just aint so bad, even here.

“Risk on, Risk off” in the markets, says the dumb bunny. We wonder if she understands how hard it is to hedge and unhedge a $5bn portfolio overnight--even with options and ETFs—as if any responsible manager would do that in response to a headline, even if permitted by mandate, after every financial instrument has already reacted accordingly. Meanwhile, amid all this “turmoil” the worry warts and hand wringers will do the “Risk off” trade and sell their stocks and go back into the Dollar and US Treasuries as a safe haven. Heck, they’ll probably buy some really cheap gold while they’re at it. And as they do, Mr. Bernanke will thank them for making his work on QE2 so much easier and potentially more successful and we thank them for another opportunity to get some good multinationals on the cheap. So much to be thankful for. Gobble Gobble.

Happy Thanksgiving!

Ramblings of a Portfolio Manager

2010-11-17T06:09:00.000-08:00

News Flash: Lincoln Shot. South May Rise Again. Hide in Your Root Cellar and Don’t Forget Your Musket

It has always amused us that, while we operate in a stock market deemed highly efficient by the economists and other smarter-than-us PhD types, the same news tends to discounted once, twice, even three times chronologically though the contents and substance of that news package never changes. Take for example a negative preannouncement by a company—Management typically lays out a narrow EPS and revenue range expected to be reported for the quarter gone by, gives full reason for the miss and often gives a narrow projection for the next quarter and the rest of the year. And Wall Street, ever the immediate discounting mechanism (some might say spoiled child not getting its way) will send the stock post-haste to the nether worlds of price and valuation. But that price reaction doesn’t provide a great bargain hunting opportunity for value investors—for, 9 times out of ten (our back of the envelope observation), when that same company reports the exact same news on the originally planned reporting date, the geniuses in portfolio management will engender the same reaction for the same reason. And, God forbid, the company tapes the call and offers it up to those missing the original, we can fully expect the markets to put the stock in the penalty box yet again until the tape is pulled from the web. So much for the Efficient Market Theory.

But that’s all anecdotal evidence (although we are doing some home work on this phenomenon) on individual company reports. What has really gotten our goat (literally) is the markets’ reaction to the “same old same old” vis-à-vis European debt crisis—i.e the PIGS. Personally, we thought we had slaughtered those pigs months ago. Remember when the dollar was to reach parity with the Euro back in May? It was all due to weakness in the PIGS. Remember when commodities and exporters were crushed because a stronger dollar would hurt their sales and earnings? That was the talk back in May. Remember when a weakened Europe would engender a double-dip here in the US? That was back in May as well. Let’s examine that happened and rate the economists’ dire predictions: First, the Euro, instead of hitting parity versus the dollar, climbed steadily to nearly 1,50/1,00 (we intentionally used commas to look cool and Euro). US multinationals, instead of reporting weaker international sales, consistently beat estimates solely bases on European strength and are on fire. Greece, whom Long Island can kick in a rumble, seem settled; Portugal and Spain, larger than Greece but still a speck on the screen, were tamed and sent away with strong assurances. All markets moved up as a result. Meanwhile, ever looking back into the rear view mirror, the Fed decided to launch QE2 in response as an insurance policy, a move which initially sent the US markets into a roil because it was interpreted at the Fed knowing something negative about domestic economic weakness that the rest of us mere mortals did not. In short, none of the dire consequence have occurred and, in fact, things have gotten much, much better on both sides of the shore since May. Yup, the economists got it wrong again. Surprised?

So, here we are again, markets in turmoil, dollar rising versus the Euro, commodities and multi-nationals in the shit can and a host of pundits thinking maybe a double dip might be back n the front burner. The amusingly hypocritical part of it all is that many of those pundits, who at first lauded QE2, then begged for it, are now on the lecture tour panning the whole idea because it could cause—heavens to Betsy—inflation! All based on a few stronger than expected reports from the US economy. What, exactly did those pundits think was the intent of the program? Funny case is that Greece is somehow back in the mix (they are fixing their problem but not as fast as the Austrians or Greenwhich PMs would like). All that’s missing is the goat negotiating the riots. Perhaps Greece would like to lend the goat to the French—they could use a little humor in their seemingly constant parade of protests (we lost count of the myriad reasons years ago--we did too). The goat may also make them feel better about their personal hygiene.

Oh, we forgot China. Things seem to be so strong there economically that they continue to put the brakes on their own economy, hoping to stave off inflation. One pundit we haven’t heard from is Jim Chanos of Kynikos. Smart guy but it was is contention at the beginning of the year that China was in a bubble but at the same time was intentionally over-forecasting its economic strength? Huh? For his sake we hope he covered his shorts before the recent meteoric rise in the Shanghai index.

The Dow, S&P, NASDAQ and Russell have all lost 5+% plus in the last week or so. Partially on the back of Europe, partially due to China and a fair amount based on post-election blues. Is this the correction/pullback/consolidation that the technicians have been calling for? Notice that, long absent from the Tube, they are now back on again, all with a universal call for a drop of anywhere from 3% (done) to 50% (uh huh). Our answer, or question rather, is “what has changed in the global macroeconomic environment since April.” In fact, things have gotten better economically in the world with many of the global imbalances beginning to self correct (no disrespects to the central banks).

Michael Steinhart was on CNBC yesterday calling this price action temporary and based on information already discounted by the market. We tend to agree. Though he is light years smarter than we, we both look at the market from a bottoms up perspective—that is, companies and markets first, then look at what’s going on the world and how it may affect those companies.

And for all those wringing their hands about pending inflation, if you really believe your own PR, sell you Treasuries before you become a casualty. And remember that inflation is good for commodities. The Fed has gone from savior to villain based on your naive concept of what causes inflation (its employment costs, not interest rates per se). So when we reach full employment and the S&P is 500 points higher as a result, look at your depleted bond fund and remember that you were warned.

Ramblings of a Portfolio Manager

2010-11-08T07:26:00.000-08:00

The Neville Chamberlain Market?

The mid-term elections are over and they largely went the way of consensus with Republicans re-taking a majority in the House of Representatives and making inroads into, but not capturing, the Senate. The equity markets, ever the discounting mechanism, read the late polls and bid the market higher ahead of the actual results, leading us to believe that those results were indeed fully discounted on November 3rd. And like many observers, we expected some sell on the news action on that day, albeit shallower and quicker than the bevy of analysts in the financial media were predicting, primarily because that was what the bevy of analysts in the financial media were predicting. But then something happened that the skeptics, including ourselves, weren’t expecting: a quadruple of headlines that seemed to come from the equity owners’ Christmas wish list hit the tape. The sell on the news reaction, whether it was indeed a discounted discounting or actually responding to these headlines, turned out indeed to be shallow and quick. In fact, the “dip” lasted approximately a half a day.

The equity markets started strong the morning of November 3rd on post-election euphoria, even though some of the Market’s most wanted “villains” (e.g. Harry Reid and Barney Frank) survived the Democratic drubbing. The Market’s Santa list item #1 was soon delivered by President Obama, who appeared on TV to make what sounded to all like a conciliatory concession speech. In fact, the President sounded downright humble, if not contrite, in his pronouncement that he had learned from the “shellacking” the Democrats took on Tuesday. To many, that sounded so reminiscent of Clinton’s move to the Center after his first mid-terms that the Market rose even higher--but equities soon began to weaken as the Federal Reserve’s pronouncement on the size of QE2 drew near. While the markets earlier had initially expected close to $1Trillion in easing, a Wall Street Journal article late in October cut that expectation in half, to $500 million and there was unease that the announced number could be even lower. Santa list item #2, however, came around 2:15pm with the Fed announcing $600mm in expected easing with the potential for more to come if needed. The market’s reaction was swift and powerful, with the Dow gaining over a hundred points from its lows in about 2 seconds. Bonds sold off as rates rose in anticipation of a stronger economy down the road. Yet for all Wednesday’s volatility and drama, the markets closed the day essentially flat with many investors unsure what to make of the news they had just digested.

That was Wednesday and it seems that investors’ digestion period lasted exactly overnight. Thursday morning awoke to strong equity futures followed by a correspondingly strong opening to the US markets. Why? In our view, there were just too many people on the sidelines waiting for the post-election selloff to get back into the market (or cover shorts). When it didn’t occur on Wednesday, they panicked and jumped in feet first on Thursday. But Santa list item #3 was about to be released—that is, the unbelievable statement from President Obama that he was willing to consider extending the Bush tax cuts to all income classes—something about which he was adamantly negative pre-election. That pronouncement was the icing on the cake for the “move to the Center” crowd and the market rallied right into the close and by the end of the day the Dow and S&P 500 had closed up 2% while the Russell 2000, a proxy for risk taking, closed up 2.6%. The final Santa wish list item came on Friday with a jobs’ report that showed new jobs created over twice the consensus estimate. All combined, with the delivery of the Christmas list, the US equity markets closed the week with a 2.9% gain on the Dow, a 3.6% gain on the S&P 500 and a 4.7% return on the Russell 2000. Not a bad week considering that the consensus was for a big sell off.

So now that the big catalysts are behind us, with a few surprises thrown in, what can we expect from the equity markets for the rest of the year and into the next? In our opinion, it all boils down to the credibility of the President and the Federal Reserve. It was clear that Obama was doing a fair amount of public eating crow last week and much of it was for PR purposes--but if he stays true to his word on taxes and working with the new majority, we could see further gains ahead. The same holds true for Bernanke. If, indeed, the Fed is good for its $600+mm number, then rates can stay relatively low and the equity markets can continue to rally. But, as a former British Prime Minister discovered over 70 years ago, dealing with politicians can be a tricky affair. It’s not that they lie but they often “misspeak.” So we will keep our ears and eyes open to see if this market is expanding into fictitious Lebensraum or if, indeed, it is soaring on the wings of crows.

Ramblings of a Portfolio Manager

2010-10-26T07:43:00.000-07:00

The Cake is Baked. So What’s the Icing?

We’ve been postulating for weeks now that the mid-term elections have already been discounted by the equity markets. That is, the equity markets’ 12+% rise from their late August bottom has been due, in part, to expectations of a Republican retake of the majority vote in the House of Representatives. But election euphoria alone hasn’t done all the work--the other factor contributing to the markets’ rise, we have been proposing, has been the expectation of the initiation of QE2 in November and that, therefore, is also discounted to some degree. In fact, these two “events” have been the principal drivers of this market now for almost two months, all in the face of continued weak economic data. Expectations for the mid-terms probably got it all started and QE2, which has brought the US Dollar to a 15 year low versus most major currencies, has been doing the heavy lifting, acting as the support and continuing driver to equities. In fact, the US market indices now slavishly move in reverse lockstep to the dollar’s strength or weakness, ignoring economic data, earnings reports, or any other fundamental data related to their constituent companies. So, with the two big catalysts already baked into the cake, so to speak, what’s left to drive the equity markets to the end of the year?

According to our research, gleaned from multiple sources, since 1922 the average fourth quarter rise in the Dow in a mid-term election year is 8.5%. In fact, there were only two times when the equity markets were not higher in the 90 days following a mid-term election and in both situations the Fed was actively raising rates in an attempt to reign in the economy. Given October’s performance to date, we’re already half way to the average. But this has been a year of historic swings—worst May since the 50’s, best September since the 30’s, etc. etc. Have we already gotten half the expected gains for Q4? We don’t think so. There are several drivers still remaining, which have not been fully discounted by the markets. The first is a Republican retake of the Senate as well. Polls are notoriously inaccurate but many show this as a possibility. Would it drive stocks higher? We think so. In fact, we are beginning to believe that political “gridlock,” usually so good for the markets, may be a detriment this time around. Much of what has been suppressing the economy, and thus the markets, over the last year-and-a-half have been the onerous bills passed by the current Congress—Health Care and Financial Reform. With gridlock, these two items will most likely persist, unmodified. With a Republican mandate in both the House and Senate, there is a fair chance that they will be lightened up to the benefit of business or, better yet, go away altogether.

Another driver we see is the size of QE2. Right now it is difficult to find a portfolio manager appearing on TV who doesn’t believe that QE2 will be anything less than $1Trillion but there are still some skeptics. We think the Fed is listening and doesn’t wish to rock the equity markets, which it is attempting to lift to spur the wealth effect. Therefore, we believe that the minimum amount of the easing will be $1trillion. Anything more and the dollar will plummet further, with the markets off to the races.

Finally, there is—gasp--fundamentals and valuation. Does anyone pay attention to those anymore? We think investors will start doing so again, particularly if the “government overhang” is eliminated in the mid-terms. Right now First Call is looking for $92+ in S&P500 earnings for 2011—that’s a 14% rise from this year’s estimates, ¾ of which are “in the bag” with the remaining quarters inching higher as this earnings season progresses. That puts the S&P at 12.8x forward earnings, a decade low. And with those earnings estimates poised to rise with renewed confidence and guidance from Company Management (again, post elections), we may well see a market that not only grows along with earnings (just like the good old days) but gets some long awaited multiple expansion. Given this and the “icings’ mentioned above, we believe Q4 and 2011 will be sweet for equity investors indeed.

Ramblings of a Portfolio Manager

2010-10-18T09:51:00.000-07:00

The QE2 is Setting Sail to New York. So Why Were All The Passengers Wearing Sombreros and Blowing Didgeridoos?

Ben Bernanke gave his much anticipated speech regarding the Fed’s propensity to reinitiate Quantitative Easing at an FOMC-sponsored Conference in Boston last Friday. The speech was intended to give insight into the probabilities of the FOMC announcing a resumption of Quantitative Easing (dubbed QE2) at its November meeting. In his remarks, Bernanke said inflation is currently too low and the unemployment rate is too high given the central bank’s dual mandate of maximum economic growth and price stability: He made a case for new Fed action to boost growth, saying inflation is running below the Fed's objective of 2% and that the economy is growing too slowly to reduce unemployment. But he also cautioned that there were costs associated with the policy as well as benefits and the Fed had much less experience in judging the economic effects of asset purchases, “which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public.” He went on to say that “These factors have dictated that the FOMC proceed with some caution in deciding whether to engage in further purchases of longer-term securities.” “Even though the conditions are in place for growth to pick up next year,” he said, “high unemployment and low inflation will probably linger.” “Given the FOMC’s objectives, there would appear -- all else being equal -- to be a case for further action.” Sometimes, around here, we miss the cryptic ramblings of Alan Greenspan. At least, under all that enigmatic Fed Speak, there was a definitive answer to the Fed’s next course of action. One just needed his Captain America decoder ring and a Cray XT-3 with language processing software and all was clear.

There was much economic data released on the day Bernanke spoke but the markets reacted almost solely to the Chairman’s words and the speech was greeted with little more than a yawn by the equity markets. Initially it gave a mild boost to equities and took some of the steam out of Gold. But Bernanke said very little that the markets were not already anticipating--since the Chairman outlined the potential second round of quantitative easing during an Aug. 27 speech in Jackson Hole, global equities have climbed 14.1% and commodities have gained 13.1%--and by the end of the day most equity markets were down and Gold had recovered some of its losses. The dollar, however, turned higher against the Euro and a basket of major currencies, but was still down broadly for the week. The interesting price action came in the 30-year Treasury bond where the bonds slumped, driving the yield up 18 basis points to just under 4.0% for the week. That’s a big jump in long rates from their September lows in the 3.5% range. Why the seemingly perverse reaction to an announcement by the Chairman of the FOMC that the Federal Reserve would begin a program of attempting to hold down long-term rates for a very long time?

We have been tracking street expectations for QE2 since the initial announcement in August. Since the markets began to digest that the Federal Reserve was serious in its plans, expectations for the timing and size of the operation have continually grown. By our analysis, there is now little market doubt that the FOMC will launch QE2 at the November meeting. Expectations range from $500 Billion to a $1 Trillion program, with some as high as $1.5 Trillion. Such a large disparity of viewpoints is a clear indication that the FOMC has done a poor job communicating its policies and managing market expectations. In fact, the way we see it, the FOMC has probably let expectations run too high and has created a situation where the current actions we have seen in financial markets are being driven almost entirely by QE2 expectations. The Fed, in essence, have painted themselves into a corner whereby there will be a negative reaction in equities, currencies and bonds if the markets’ expectations are not met.

So what will be the size of QE2 and will it work? Bernanke called the first purchases of $1.7 trillion in mostly housing-related assets successful. There are a range of opinions on the FOMC about the method of further asset purchases, and the details will be hashed out at the FOMC’s next meeting on Nov. 2-3. The market’s focus, however, will be “how much?” From our work it would appear anything short of $1.0 Trillion in QE2 would disappoint both equity and currency watchers.

But the markets’ trepidations go beyond the final amount of the QE2. The big fear, for many experienced investors, is whether the Fed will have an adequate exit strategy and will they time it properly—i.e. will their program work too well and ignite hyperinflation before they can shut it down. That’s why bonds sold off and the dollar strengthened on Bernanke’s speech, in our opinion. The Chairman’s response was that he is confident the Fed will be able to tighten policy when warranted, even if the balance sheet is larger than normal but he also pointed out that the FOMC might consider modifying the language of its policy statement to indicate that it will keep rates “low for longer than markets expect.” At the moment, the FOMC statement is that the exceptionally low levels of the federal funds rate are likely to be warranted “for an extended period.” Remember, the target is to get inflation higher and Ben Bernanke, student of the depression, will not be the Fed Chairman who presides over a US economy in depression and with deflation if he can avoid it. So in addition to preventing deflation, we believe QE2 is intended to boost equity prices and thus, net worth and the economy in general. The question is, will the Fed cave into market expectations and target the $1.0 Trillion number?

We expect the Fed to hit the $1 Trillion number but for the perverse reaction to QE2 to continue. That is, we expect long-term rates to rise and the dollar strengthen even as the Fed begins its purchases. Why? First of all, as we noted, the markets have already priced in a significant size of QE2; long treasuries are almost certainly discounting the $1.0 Trillion number so probably don’t have much more to rise. Secondly, as the Fed injects more liquidity into the capital markets stocks will most likely rise, adding to the wealth effect. This, combined with potential strengthening confidence in the economy post mid-terms, will serve to steepen the yield curve by raising the long end, even the face of Fed purchases (its almost impossible to steepen the curve by dropping short-term rates, which are essentially zero). Finally, most missed it but Bernanke raised the Fed’s expectations for US economic growth next year. If our scenario and theirs is correct, it all points to risk in holding US fixed income securities and a rosy future for US equities. We don’t know much about them but if you’re looking to invest in fixed income, you might look toward the countries nearing the end of their tightening cycles—Brazil and Australia. Happy sailing!

Ramblings of a Portfolio Manager

2010-10-04T12:06:00.001-07:00

Will Santa Deliver an Early Christmas Present or Will a Turkey Fall Down the Chimney?

Earnings season officially kicked off last week with the turn of the calendar, although we have already heard pre-announcements from several companies. As has been the tradition for years now, the preannouncements came ahead of the regular reporting season (by definition, duh!) and carried no particular good news—Company Management has long been cowed by litigation to release the bad news as soon as it is discovered and accurately calculated, lest they be sued for of hiding it from shareholders. So the routine, for a long time now, has been for the markets to receive the bad news first, react to that bad news (usually a negative reaction—after 15 years of Reg FD most investors still haven’t figured out this pattern!), then have the comprehensive news follow during the regular reporting season. Typically that data is better than the preannouncements (again, definitionally) and the markets react to that data depending upon its current mood. That’s certainly what happened last quarter.

We expect nothing different behaviorally for the third quarter reporting season vis-a-vis past trends. The questions, as always, are, what percentage of the reports will be negative pre-announcements, how many will match recent the urban myth of “light on revenues, better on bottom line” and what percentage will actually surpass all metrics pre-cast by the analysts? Yes, this is the question we and the markets ask every quarter, particularly since the market bottom in March 2009, but forgive us for asking it again, given its importance in market performance going forward. And besides, we wanted to get it in ahead of CNBC, which will repeat these lines at least 1543 times between now and November 15th, as always, forgetting that retailers’ reports come one month later.

So what to expect when you are expecting (royalties already paid to the baby book authors)? First, let’s explore what the few market watchers that have publicly spoken on the subject have been saying. Despite better than expected reported statistics and higher than expected guidance last quarter (which did nothing more than temporary for the markets) analysts are still calling for earnings misses and weaker guidance. Their reasoning? Q3 encompassed July and August, two critical months in the European debt crisis and the US ”soft spot.” So, naturally, the expectation is for weak results (perhaps weather than forecast) with soggy guidance (don’t they get that they, themselves, have already baked that fact into their numbers? Guess not). Sounds exactly like the forecast for Q2 earnings, the reality of which stubbornly didn’t comply. Is that how it will be again this time ‘round? And what will be the market reaction? Addressing the first question, we think not. As we have continually stressed, Company Management has learned from years of playing the “beat and raise” game to lower the bar to an appropriate level that can be easily hurdled without seeming suspicious. Nothing we heard last earnings season suggests that we will get anything different this time around—despite the beat and raise environment we had in Q2. No manager on a Q2 conference call was about to stick his neck out given the environment at the time so we feel confident that this fact, combined with the usual conservative game theory behavior in which managers quarterly participate, will produce yet another round of 70%+ earnings beats, given that analysts simply take Management numbers to form their own forecasts. What about guidance? Here again, we expect the same. In fact, the Company Management with whom we have spoken recently are getting more optimistic in light of expected mid-term regime change and may, in fact, be emboldened enough to say even more positive things about Q4 and beyond, especially on the hiring front—and this is despite the political affiliation of the manager (we always ask).

Market reaction? We’re tempted to flippantly (pun intended) suggest one “flip a coin.” Even though the expectations are for weak reports and guidance, the opposite may not have the expected reaction in equity prices. They didn’t, on net, during Q2 (July having been taken back in August) so what has changed that will produce a different result in October? Well, for one thing, the [very] long term data suggest that better than expected earnings reports and guidance produce stock price gains overall and alpha specifically for those companies producing it. A couple of quarters during which the markets are in a sour mood and choose to ignore that fact are statistically insignificant. This doesn’t mean October will fall in line with history, however. What we believe will give the markets a boost on better earnings in the next few months is rising investor optimism. When Q2 earnings were reported in July, investor sentiment could not have been worse and even though we got a temporary run in stock prices, the tug-of-war with macro economic data ended with macro winning and tamping down the enthusiasm and, thus, stock prices. But this quarter is different. We have investors looking optimistically toward the upcoming elections, others looking at their underperformance and realizing that further investments in 10-year Treasuries just aint gonna beat the competition, and still others looking at 2011 as the year Obama’s damage is softened by a new congress while the economy continues to heal on its own. Like us, this last group has seen productivity gains slow and capacity utilization additional reach cap-ex levels, and both recognize this means jobs and further economic growth down the road.

So, to answer our own headline question, we thing Santa comes early this year and that the turkeys will be sucking gravy come earnings season.

Ramblings of a Portfolio Manager

2010-09-27T09:19:00.000-07:00

Is the Bear Case Really That Fragile or is Everyone Just Short?

Friday brought us a very nice rally across the US equity markets with the Dow, S&P500, NASDAQ and Russell 2000 indices all up nearly 2% or more. The rally capped off an odd week—after a strong rally on Monday, fostered by better than expected news from the Basel III bank capital accord over the weekend, where regulators gave firms more time than analysts expected to comply with stiffer capital requirements aimed at preventing future financial crises, the markets slowly began to give back the gains on the back of mixed financial data coming out of the US and Europe. Mixed data on housing starts in the US, a weaker than expected PMI out of Germany (which, of course, caused all the analysts to proclaim “the bloom is off the European rose) and the FOMC refusing to rule out further Quantitative Easing, all conspired to cause investors to start questioning the recent run up in stocks. Even Treasury yields started to head back downward again and the dollar weakened throughout the week. Then came Friday.

What happened on Friday? Thursday’s close saw the markets go from holding in positive territory all day to a strong late-day sell off. Considering that the economic data expected to be released on Friday (Durable Goods Orders and New Home Sales) was of fairly low import on the broad spectrum of impactful data, the market reaction was as odd as it was unexpected. Yet the futures opened strongly Friday morning with the one decent piece of global economic news having been released that morning being the German IFO, their version of our Business Sentiment Index, which came out stronger than expected. So what was with the rally? It may sound laughable and weak peg on which to hang one’s hat, but we truly believe that Friday’s rally was based nearly in whole on the guests who appeared on CNBC. The morning started with Jack Welch, former Chairman of GE and no fan of Obama. His strong opinions on the fate of the Obama machine and the Bush tax cuts come this election period added to the strength of the futures throughout the morning even as he declared “slow growth” in his ex-firm’s business lines. Following Jack came good old Doug Kass, the man who proclaimed the generational market bottom (and was right) on March 6th, 2009. His fairly bullish commentary on the value of stocks and own opinion on the upcoming elections added even more steam to the pre-market futures. You could almost see the shorts playing at home getting nervous as they sat at their laptops, in their boxer shorts, coffee in hand, trading on E-Trade. His final punch, however, was his call that shorting Treasuries would be the trade of the next century. Of course, outlining the reasons for this call gave him the opportunity to present some fairly bullish economic commentary, which certainly did not hurt the gathering strength.

The knock-out punch, however, was the appearance of David Tepper of Appaloosa Management, a legendary hedge fund manager who has been more right than wrong over the years and who made a killing on financial stocks last year when no one wanted them. Tepper rarely gives interviews, certainly not several hour-long appearances on financial TV, so his appearance was closely watched. Tepper didn’t disappoint. According to him, we are in a virtuous cycle (not his words) given the Fed’s stance on QE. Appaloosa typically allocates about 30% of capital to stocks and 70% to bonds and Tepper disclosed that he is still about 10% in stocks but moving more into them as he finds them cheap, particularly amid the current interest rate/Federal Reserve backdrop. To Tepper, if the economy strengthens stocks will do well. Conversely, in that scenario he thinks bonds and gold will not. On the other hand, he believes the Federal Reserve is acting as a put option for his strategy because if the economy worsens, the Fed will step in with quantitative easing, lowering long rates further and then all asset classes (except the dollar) would do well. It was his version of a win-win scenario and one could just watch the futures jump as he built his case.

All this CNBC commentary certainly added fuel to a fire that had started smoldering after the German IFO but the gasoline came at 8:30am when Durable Goods orders came in slightly better than expected, flying in the face of several back-to-back bad Philly Fed reports. Then, at 10am, New Home Sales came out mixed but overall stronger than expected and the fire was lit. Markets jumped and never came back. The funny thing about Friday’s market action was that, after the Dow hit it’s high of around +200, it sat there all day long, barely budging. No trader we questioned is quite sure why the daily stability but so much for 3pm being the most important hour of the day.

Did the favorable market opinions on TV Friday really drive the strong market reaction? And if it did, would wheeling out Nouriel Roubini and a few other bears bring it right back down? We suppose no-one will ever know the true answer but the commentary given certainly was rational, well thought out and made a helluva lot more sense to those schooled in economics (including us) than the knee-jerk “we’re the next Japan” headline grabbers that have been populating the airwaves lately. So, to answer last week’s question, are the elections already baked into market prices, we would have to say not yet. If a week’s worth of hand wringing over the margin by which Republicans will win in November managed to rock the markets back and forth only to be erased by some positive commentary from a couple of smart guys, then we think there is a lot more “kicker” left from certainty creeping into the eventual outcome of the elections and the events beyond. And to answer this week’s question, it sure seems to us like there’s a lot of non-believers out there—whether they are short or just plain underinvested, the case for being so is starting to look a little thin.

Ramblings of a Portfolio Manager

2010-09-14T10:14:00.001-07:00

Running Scared, Running Right

R&D tax credits for small business. $50bn to build and improve our transportation infrastructure (none of which would be spent on signs touting such!). Extension of capital gains and income tax cuts. A $30bn fund to invest in banks to lend to small business. $17bn in tax breaks to business to hire unemployed workers. Tax credits? Tax cuts? Sounds like George Bush in year 5 of his administration. Oddly enough, in the Bizzarroland that is Washington D.C. these days, these are all proposals that have come out of the Obama administration in the last month alone! Odder still are the Republicans who are breaking rank with their party to jump on the President’s bandwagon for these plans at the same time a fair number of Democrats are jumping the ship of Obama like rats. Yup, the mid-term congressional elections are coming up and with the economy wallowing in the doldrums of no-growth, the politicians up for re-election are starting to fear for their cushy jobs. Now you understand why they call this the “silly season.” Desperate times call for desperate measures and, it seems, even the starry-eyed ideologue in the White House seems to be getting the message. We had postulated that that lone intractable zealot would wait for the election outcome to head in the right (double entendre intended) direction but it seems that he actually, albeit slowly, may be taking some cues from history. Specifically we refer to the Clinton years and it sure seems from our perspective that Obama is already taking baby steps toward the middle of the political spectrum. In the 90’s this move worked for Clinton, it worked for our economy and, ultimately, it worked spectacularly for our stock market. Now, Mr. O may not care about any of these three items but he certainly has a big concern for retaining sufficient power to push through his agendas and, well, if he has to bend a little to retain that power, maybe that’s a good idea. If any of this sounds like a 180 degree turn in the administration’s thinking, it is; and for the equity markets it has been recently, and will continue to be, a good thing.

Will it last? Since the President began his (begrudgingly) pro-business stumping, the S&P 500 has risen over 60 points and the Dow is up close to 500 points. Is the market discounting a kinder, friendlier Administration post-November? Or is it looking forward to all the congressional bums being thrown out? Or is it starting to read the tea leaves that have been showing the World economy (including the US) was and is not as bad as believed in May through August? Did interest rates get just too low? Or was the market just oversold on light summer volume? Yes. The answer, in our humble opinion, is probably a combination of all these factors. Taken with the extraordinary build up of negativity in the markets since April--which we have been discussing over the last month--all these factors conspired to take what was a very over-sold US equity market and give it a lift. But, we ask again, will it last? And if so how long? Sentiment has definitely improved, the extension of the Bush tax cuts is seen as all but a given (the only debate is how far up the income ladder to extend them), Vegas is long a Republican victory in November, Obama is obviously on some pro-business narcotic (where can we buy more?) and even Warren Buffett is out saying “no way will we have a double dip.” Is all the good news already in the market? Will the markets sell off post-election day? The trader in us says “probably.” The long-term investor in us, however, says “ we still have some way to go and if the market does sell off, buy, buy, buy.” Over the last two weeks, taking advantage of historically low rates, corporate America has been drastically improving its balance sheet. Equity issues, sub 1% debt issues, 100 year bond issues, you name it, if healthy corporations could exploit the dislocations we have in interest rates and stock prices, they did it. And that bodes well for the future—for earnings and growth.

We’re buyers into mid-October when we will get a better read on the political polls. Investors will probably take whatever those polls say as an opportunity to take profits. Late October and early November may be rocky but that’s when you buy—economic data and the political landscape will be better then than they are now, earnings estimates will be higher and the market will start focusing on 2011 earnings, which are sill around $90 for the S&P500, an all time high. Remember, stock prices are a function of the multiple (Price/Earnings, for example) and that which the multiple is measuring. Right now we have a good number to measure (S&P earnings) but sentiment is keeping the multiple down. We expect late November and December will bring us a lot to be optimistic about and with both multiples and earnings estimates high, we could see a very, very nice Santa Clause rally.

Ramblings of a Portfolio Manager

2010-09-07T04:04:00.000-07:00

The Culture of Pessimism

The markets just closed out their worst August since 2001. After a strong July, based on good corporate earnings reports and guidance, the markets looked to be poised to continue the rally. Unfortunately, that rally lasted exactly one day into the month and then fizzled. A string of mixed economic data during the month trumped what were some fairly impressive numbers from Corporate America and investors, having been once burned in 2008, chose to shoot first and question later. The August Federal Reserve meeting, which was intended to calm the markets instead caused fear and renewed discussions of deflation and a double-dip recession. By the way, a strict definition of a double-dip assumes we have already emerged from the prior slowdown to the pre-recession GDP—we haven’t so yet just keep that in mind when the CNBC talking heads get going on their “double dip” talk.

In terms of Q2 earnings reports we had over 75% earnings beats with similar results in raised guidance. While these statistics are near an all time high and contributed to a strong July, the market’s mood turned sour in August on some of the macro economic data, particularly the Philly Fed Index, and good earnings reports, rather than being rewarded, in fact, turned into an opportunity to SELL.

The equity markets are now in a culture of pessimism. Time Magazine just ran an article questioning whether Americans should own homes. A poll of Hedge Fund managers showed the highest degree of pessimism regarding the equity markets since 2008 (47%) . The AAII index of investor bullishness is at 20%, a 5 year low. Yet another poll put investor sentiment at the lowest point since March of 2009, the “Generational Low” we hit after the financial crisis. Outflows from equity funds and into Treasury Bond funds is at the level of late 2008. Gold and US Treasuries have become cult investments with gold just off its all time high and the 10 year bond yield near its all time low. Wall Street Analysts, usually a lagging indicator, have for the first time in more than a decade, rated the percentage of stocks as Buy below 29%, down from 75% in 1997, according to Bloomberg. Paradoxically, analysts aren't telling investors to sell either, with Sell ratings remaining near a low 5%. Instead, Hold ratings have ballooned to a record 66%. All along these analysts are raising their earnings estimates for companies while dropping their target prices for their stocks. Finally, the London FT just ran an article that it has become fashionable to be negative both in the financial and popular press. Typically, all this pessimism would signal that we are nearing a low in the equity markets. But one has to have a strong stomach and a good dose of contrarianism too hold ones nose and jump into the equity markets. We have both.

We think this is an excellent time to build a portfolio in equities. Why? First of all, we were on almost every earnings conference call and spoke with management during earnings season. The tone and the guidance we heard was almost universally positive. And, nowadays, when Managements lie they do so to the downside so they can sandbag the upcoming quarter. This means the rest of the year is probably going to be better than to what they are guiding. The problem is, no one believes it. That’s why there is so much cash sitting on the sidelines and in bonds. One little hiccup in bonds and there will be a panic move into stocks, small cap stocks in particular. What will cause the hiccup? Getting those idiots out of Congress for one, better economic data (as we have seen in the last few weeks) is another. We’ve had 13 months of improving manufacturing data. At some point even the dense guys sitting in cash will get it.

We believe that the markets are discounting an economic scenario that is much worse than what exists. In addition, we have several catalysts ahead of us to further bolster equity returns. Republicans now have a 10 pt lead in the polls versus the Democrats going into the mid-term elections, the largest in 68 years. This signals political gridlock at the least, usually good for the markets, or a Republican sweep, which would ensure that the Bush Tax cuts will be extended for all income classes. Additional tax cuts may also follow a Republican regain of control. One little tidbit: the six months following a mid-term election have shown strong positive equity gains every year since 1950.

Last week we got a little taste of what a rally based on “not as bad as feared” data might look like. It was strong with many of the indicies erasing nearly all of their August losses in just three days. Will it last? That depends upon the data we continue to get but imagine the rally that would ensue if the data actually turned positive and beat consensus, if we get regime change and Obama chooses Clinton’s wise course when he lost his majority in the mid-terms and moved to the center . World equity markets have been moving up strongly for a few weeks now on strong economic data. We have not. The ‘decoupling” adherents are starting to come out of the woodwork. Their record had been very consistent—100% wrong. So if the Worlds’ economy is humming along better than expected, perhaps so is ours.

Ramblings of a Portfolio Manager

2010-08-23T05:49:00.000-07:00

“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.

Ramblings of a Portfolio Manager

2010-08-16T08:51:00.000-07:00

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.

Ramblings of a Portfolio Manager

2010-08-02T08:57:00.000-07:00

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.

Ramblings of a Portfolio Manager

2010-07-26T22:11:00.000-07:00

What More Does the Market Want?

We just ended a second consecutive week during which an enormous amount of potentially positive market moving data was released. Two weeks ago we got strong earnings and forward guidance from the likes of Alcoa, CSX, GE and Intel, heard of a Goldman Sachs settlement with the SEC and learned that BP may have successfully capped its leaking well in the Gulf. Last week we saw continuing positive news: the Financial Regulation Bill was passed by the Senate and signed into law by the President, relieving much of the uncertainty surrounding the bill especially when in the final analysis the rules may take up to a decade to be implemented by which time affected firms will have adapted to or circumvented them; the results of the European bank stress tests were released, results that were much, much better than expected both in terms of the number of firms that passed and capital that needed to be raised; housing start data was in line with expectations but new permits were better than expected; weekly jobless claims came in more or less in line and the Senate approved an extension of unemployment insurance, restoring benefits to 2.5 million people; Fed Chairman Bernanke testified on Capitol Hill that the Fed does not see a double dip and maintains its 3%+ GDP growth forecast but is in no rush to hike rates and is ready to implement “QE2” should growth slow; General Electric hiked its dividend earlier than expected, a sign that they see strength in their business going forward and, finally, the string of strong corporate earnings and raised forward guidance continued with the who’s who of the Fortune 500 reporting including IBM, Microsoft, American Express, Coca Cola, Apple, UPS and Ford. The markets responded positively to this data with the Dow and S&P 500 both rallying about 2.3% over the last two weeks. This rally, however, was very choppy (markets initially dropped over 1.5% on Bernanke’s testimony) and still leaves us negative for the year with the Dow down 1% and the S&P 500 just below the flat line.

With all the positive news and dissipation of uncertainty during the last two weeks, the major market indexes still sit in the red for the year. What will it take for investors to feel comfortable enough to get back into the market and move us higher? Last week we opined on the dichotomy between the economic data and company reports. A more accurate depiction, it now appears, is reality vs. the forecasts of economists—i.e. the view from the trenches vs. that from the Ivory Tower. We reiterate our belief that the best prognosticators of the Country’s economic future are its CEOs and not politically (or otherwise) motivated egg heads, most of whom have never held a real job. Still, with all the positive chatter coming out of Corporate America, the markets languish. What more do they want?

We believe that there is one remaining piece to the puzzle, or conundrum in Alan Greenspan speak, and that is jobs. Though companies have painted a rosy outlook for their future profits, most have done so with the assumption of no new hiring. Clearly, for the markets to advance, unemployment must come down, which means these companies must incorporate additional staffing into their forecasts. Two factors are going to cause them to do this: first, their businesses must improve to the point where they cannot possibly grow Earnings Per Share fast enough to meet Wall Street expectations without brining in new workers—i.e. capacity utilization must increase to the point where productivity gains alone (i.e. using more technology or working existing employees harder) will not suffice to drive earnings higher. We believe that many companies are getting to that point right now. Just this morning Federal Express hiked its guidance, saying that they expect volumes to grow 20% this year. Given that their planes are already nearly full, they will have to add new planes, and people to fill and fly them, to meet this growth. We’ve heard similar reports from other industries, who are also beginning to ramp their capacity utilization.

The second factor that will spur hiring feeds into the first, and it involves the reduction of uncertainty regarding Government policy—both on taxes and regulation. Companies will hire when business improves but only if they are confident in estimating the marginal cost of those hires. Right now, given the uncertainty over the cost of health care reform, new taxes in 2011 and any other fiat of regulation that Congress decides to ram through between now and November, that marginal cost of hiring is almost impossible to estimate. For the future to be sufficiently clear to give CEOs the green light to hire, we are going to need a radical change in policy/behavior on Capitol Hill and the only way to achieve that is to get some good old fashioned gridlock, or better yet complete regime change, in Congress. Poll any CEO and it is highly probable that you will hear the belief that we currently have the most anti-business Government in this nation’s history occupying our seats on Capitol Hill. This isn’t necessarily our opinion—it’s a message we have consistently heard from virtually every earnings conference call we have attended—and it is a line of thinking that doesn’t encourage Managements to hire. Fortunately, the mid-term elections are only a little more than three months away and we will be getting early data from the political polls very soon. Given that markets are discounting mechanisms, this means that if the polling data shows CEOs will be getting their wish this election, then we can see continued equity gains through the fall. Let’s just hope that the “dead men walking” on Capitol Hill don’t pull the same tricks as the Corzine administration did to New Jersey just before it was ejected on its ear last fall—that is, ramming through more tax and spend policies at the 11th hour. Hopefully, those soon-to-be lame ducks will start thinking about their futures in the private sector and exercise some spending restraint for a change.

Ramblings of a Portfolio Manager

2010-07-19T09:35:00.000-07:00

The Great Wrestling Match--Top Down vs. Bottom Up. Who Will Win? So Far it’s the Guy Fighting with the Rear View Mirror

Last week earnings season officially kicked off with reports from Alcoa, Intel and several banks. The results were dramatically different than expected…in fact they were much, much better than we or most of Wall Street had anticipated. Second quarter earnings came in as expected—stronger than expected (why does no-one ever mention the paradox in that oft-repeated phrase?)—but the guidance, which every market watcher had expected to be downbeat, was surprisingly strong. In fact both Alcoa and Intel, our two cyclical reporters, guided most of their financial metrics higher for the rest of the year. That was not what the market was expecting. The reports initially continued the market rally that had begun the week earlier: a rally which in truth had begun not in anticipation of such positive results but due to relief that Europe is not melting down and is addressing its myriad problems in a semi-rational manner (e.g. the bank stress tests). Alcoa and Intel were frosting on a cake that had already been baked. By the end of the week JPMorgan and Bank America had reported similar results with credit quality improving amid tepid loan growth and weak trading revenues. Not stellar results, but not the disaster the markets had been expecting, especially in the wake of the Financial Reform bill, which had threatened and distracted bank Management throughout most of the quarter.

The week was full of other positive news as well. BP appeared to have successfully capped its well in the Gulf (unexpectedly), Goldman Sachs settled its fight with the SEC for half of what was anticipated (unexpectedly), without having to subject itself to a show trial, and jobless claims came in lower than expected. With all this positive, unexpected news, the major indices ended the week down -1%+. Huh? Despite the prior week’s rally based, as we indicated, on bullishness on Europe, one would have expected a continued strong market. We didn’t get one and the answer lies in several economic indicators released during the week: the Empire State Manufacturers Survey and the Philly Fed Index. Both came in weaker than expected, indicating that the economy did indeed take a pause in June, and the markets decided to focus on those data points rather than the comments and outlook of company management.

With two conflicting sets of data to analyze, on which one should we rely? Let’s take a quick look at the two culprits behind last week’s decline. The Empire Manufacturer’s Survey is a very narrow survey in which New York manufacturing companies are asked to estimate the percentage changes in their sales and employment levels from year to year (2009 to 2010 in the most recent case)—both year to date and for the calendar year. In addition to being narrow, it’s a backward looking indicator, which largely reports what has happened in New York-based businesses over the last month with little commentary on expectations for the future. Last week’s survey indicated that conditions for New York manufacturers continued to improve in July, but that the pace of growth in business activity slowed substantially over the prior month (June). The new orders and shipments indexes were also positive but lower than last month’s levels and the employment indexes dipped as well, with the average work week index falling below zero for the first time this year. The future general business conditions index component was little changed, remaining close to its May and June levels but below the highs seen earlier in the year. Most of the other components of the index were also positive, but were below the peak levels reached in May. As for the forward-looking part, the median respondent reported that sales were up 7 percent for the first half of 2010 and were expected to be up 8 percent for the full calendar year, indicating continued positive growth. The release of this report on Wednesday dampened the continuation of the rally sparked by Intel and Alcoa.

The Philly Fed survey has been conducted since 1968 by the Philadelphia Federal Reserve Bank and questions manufacturers in the Third Federal Reserve District (Pennsylvania, New Jersey and Delaware) on general business conditions. It comprises a blend of manufacturing sectors and general businesses. The survey is conducted in the vein of the Purchasing Managers Index (PMI) report and has a rather high correlation with that report; it questions participants about their outlook on things such as employment, new orders, shipments, inventories and prices paid. Answers are given in the form of "better", "worse" or "same" as the previous month, and, as with the PMI, results are used to construct an index, only this index uses a median value for expansion of 0, rather than 50. The Philly Fed Report signals expansion when it is above zero and contraction when below thus a higher Philadelphia Fed Survey figure indicates a positive outlook from manufacturers, suggesting increased production. So what did Friday’s survey reveal that sent the markets down so sharply?

Results from the Survey released on Friday suggest that regional manufacturing activity continues to expand in July but has slowed over the past two months. Surveyed firms reported a decline in new orders this month compared with June. Employment showed a slight improvement this month. The survey’s broad indicators of future activity continue to suggest that the region’s manufacturing executives expect growth in business over the next six months, but optimism has waned notably in recent months. The future general activity index remained positive for the 19th consecutive month but fell to its lowest reading in 16 months. The future new orders and shipments indexes also declined notably, falling 22 and 13 points, respectively. For the 15th consecutive month, the percentage of firms expecting employment to increase over the next six months (30 percent) exceeded the percentage expecting declines (17 percent).

How do we rationalize these economic reports with what companies have said so far this quarter First, they all tell us something we already knew—that business conditions slowed in May and June. The combination of fears of a European meltdown, uncertainty surrounding the Government’s attack on financial institutions and the expiration of the Federal Housing Purchase Tax Credit, among other things, caused the consumer and some small businesses, at least, to temporarily put on the brakes. This information should have already been discounted in the markets’ 10%+ slide from its April highs. Secondly, and more interestingly, however, they show a dichotomy between what management is saying about the future in the survey responses versus what they are saying on earnings conference calls. The Empire State Survey is largely backward looking and thus says little about what its small collection of firms is thinking about the future. The Philly Fed survey, however, encompasses a larger number of firms from a broader spectrum of businesses and the outlook from this survey was somewhat more dour than what we have been hearing from company management. How do we explain that? There are several reasons, we believe. First, the Philly Fed Survey is still somewhat narrow in its geographic and business line focus versus the component companies of the S&P 500. Secondly, they are also somewhat smaller and have less foreign sales as well. Finally, the questions asked regarding the future are quite narrow versus the “free association” latitude given company management on conference calls. So what we are hearing from the survey respondents is still a narrow outlook as compared with the likes given by Alcoa, Intel or the banks. IBM and the rest of the technology companies, scheduled to report this week, will further broaden the economic commentary.

How does an investor make sense of this all? Should we believe company management, whom we all know can be promotional about their stocks, or the government reports, some of which encompass the very same companies that have given rosier outlooks on conference calls? Frankly, our money is on company management. First of all, the surveys contain a very large, rearward looking component to them. We all know that May and June were slow, as does a market down12% from its April high. Secondly, while management can say whatever they like to a government survey taker, they are making very public comments, to which they will be held, when they give earnings and sales guidance on conference call. Additionally, management teams have learned over the years that the game is to guide so as to set a low bar that will be easier to beat in the upcoming quarter. So, if anything, management guidance on conference calls to date has been conservative rather than promotional. If that’s the case, then the Q3 2010 may be even stronger than analysts have “estimated” already. Just remember, a rear view mirror may be a great way to kill the mythical medusa but given that markets are anticipatory beasts, it isn’t a good way to invest.

Ramblings of a Portfolio Manager

2010-07-12T12:53:00.000-07:00

It’s Summer—Good Time To Have a Nice BOD

Earnings season “officially” kicks off this evening with the arrival of Alcoa’s second quarter earnings report. The talking heads in the financial media have been analyzing this season and its relative importance to the markets for weeks now. The general consensus is that, while second quarter earnings will be strong—perhaps even stronger than expected—guidance from most management teams will be cautious to tepid at best. Europe, the ongoing anti-business attitude from the Obama Administration and the prospect of higher taxes next year are all to blame for the expected downbeat guidance. Of course, as most investors are aware, the market discounts what it expects to happen, not what has already happened and so if Management guidance is poor, then we can expect stocks to fall further. Or can we?

As we have mentioned, the financial press has been talking about this earnings season for weeks now—ever since the market started to swoon in May. As CNBC said this morning, the sentiment and expectations are “awful going into this reporting season.” Comments like that signal to us that, most likely, the markets are already discounting the poor guidance everyone is talking about. With the major indices all down over 10% from their April highs, one can make the case that quite a bit of negative news has already been baked into current stock prices. Furthermore, with all the talk on the airwaves and internet about the expectations for guidance, it is hard to believe that there is anyone remotely interested in the capital markets who isn’t already braced for bad news.

We believe that the market is setting up for a good “buy on the dips” opportunity in stocks. We’re not necessarily talking about buying on dips in the equity market overall so much as buying on the dips that may occur in the first hours or days of trading in stocks that have just reported, with Management giving weak guidance. “But wait!” you say. We just said a fair amount of negative news is already in the stocks. Might they not actually jump on weak but not disastrous guidance? Perhaps, however, at the margin there is always a hair trigger trader or two in a stock with wishful thinking regarding an earnings report. We suspect that many stocks will have initial drops upon weak Management commentary, analyst downgrades (they love to downgrade a stock after the bad news comes out—saves them work on hard forward-looking research) and earnings cuts but that most will recover within a relatively short time—perhaps in some cases the same day. We’ve seen this type of behavior before—most recently in March-April of 2009, which became a signal that all the bad news was in the market. Not that we’re suggesting another 60-70% post-earnings season rally, just that this time around, a nice BOD might just make you some money.

Ramblings of a Portfolio Manager

2010-07-06T05:00:00.000-07:00

'08 or '82?

U.S. stocks plunged last week, giving the Dow first seven-day loss since 2008. The culprits: reports of slower-than-estimated growth in jobs and factory orders and concern that China’s economy has slowed. The Dow, S&P 500 and Russell 2000 are now respectively 14%, 16% and 19% off their April 23rd highs. Another day like Friday and the Russell will be in Bear Market territory for 2010. So far this year, bond returns have exceeded stock gains by the widest margin in nine years. Not exactly how strategists had hoped the first half of the year would unfold.

At the end of last week pessimism in the equity markets was almost as high as it was when Lehman went down in 2008. In fact, the one through 10-year Treasuries ended the week yielding less than they did in mid-late September of 2008, when Lehman failed and AIG required a minimum of $85 billion in government support to stave off a collapse of the entire financial system. Memories of those times are fresh, however, and as investors wonder what will be the next shoe to drop they are dumping equities wholesale and running to the “safety” of US Treasuries, ignoring the perils of that strategy. As one portfolio manager said, “It’s like running under a tree during a thunderstorm.”

Let us say categorically that this is NOT 2008 by any stretch of the imagination although right now the equity markets are acting like it. Back then we had a true credit seizure—banks weren’t lending to other banks, one-month LIBOR rates, currently at 0.35%, exceeded 4% and even GE couldn't roll its commercial paper. We hate to use the phrase but, yes, this time is different…very different. What we have now is a softening in the labor market after a rebound off the bottom which was due in part to Fiscal stimulus. The market, always forward-looking, is ratcheting down its growth expectations—but the expectations are for growth nonetheless. In late 2008 we were staring over a precipice, wondering whether banks would open the next day, let alone how low S&P 500 earnings were going to fall. As of the end of April, S&P earnings expectations were for $100 for 2011, an all time high. Even a drastic cut of 20% would bring them back to late 2005/early 2006 levels when the equity markets were much higher than they are now. The trouble is the uncertainty factor and that is currently depressing multiples on what are declining earnings estimates—a double whammy to stock prices. Unfortunately, the uncertainty comes from our own government. The President and Congress, rather than showing concern for a U6 unemployment number hovering near 17%, are busy punishing Goldman Sachs with 2000 pages of worthless regulation. The only part of the Government that investors trust right now is Bernanke and the Federal Reserve and they are somewhat handcuffed right now given what the fools in Congress are doing. That will change, of course, and the winds are already blowing that way. But no one wants to wait until November to see how many of them get kicked out.

In our opinion, this market looks a lot more like it did in 1982 than 2008. Back in ’82, the Economy was emerging from a deep recession and growth was rapid. The Federal Reserve, seeing the 8%+ growth in GDP and having just come through a terrible period of inflation, started hiking rates too quickly. That move—too much too soon-- sent the Economy right back into recession. The markets followed in lock step and we had two back-to-back bear markets. We don’t expect that to happen this time. We have a Federal Reserve Chairman who is a student of history and not about to repeat the mistakes of the past. One mantra often heard is that the Fed is out of bullets---rubbish! The Fed can still re-instate Quantitative Easing and most likely they will, given that there is no inflation in sight. At current rates homes will sell again and there is a good chance that the home buyers tax credit will come back. Republicans will gain votes in Congress in November and the benefits from European debt-cutting measures will become clear as the year progresses. All this says to us that the markets may be setting up for a strong rally through the end of the year.

Basically we have hit the reset button after a nice run from last year and now have the same opportunities to make money as we did last spring. Investors just need to be patient, wait for the bottom and get back in—psychologically difficult we recognize, but this is where and how fortunes are made. It isn’t often that the markets hand you a second opportunity to make big money but, we believe, they are fast doing so again. No-one knows where and when the bottom will come—any day we could get news that China has taken its foot off the brakes, that the US or Europe is doing Quantitative Easing or some other positive news. Given the state of pessimism, it won’t take much. Frankly, earnings season has such low expectations, even that could initiate the turn. Just a little factoid: the S&P and Dow are now just 10% or less above where they were at the height of the AIG and Lehman crisis yet the situation is clearer, the uncertainty less and we have a strong domestic policy for growth and recovery already in place. Earnings estimates are 50% higher too. The uncertainty is much less yet the markets have barely moved. We like the way things are setting up and even though picking the precise bottom is tricky, we suggest investors begin averaging into the market now, while prices are depressed.

Ramblings of a Portfolio Manager

2010-06-28T04:05:00.000-07:00

To Some, Economics is Just Crap

It has come to our attention that some readers were actually disappointed by the omission of last week’s Ramblings, which was due wholly to our well deserved Father’s Day hiatus. We want you to know that the kids actually encouraged us to publish the piece despite the reverential holiday and even gave us the fodder for the pen. So, out of respect to the young ones, we will publish, at least in part, a commentary on a very sophisticated, insightful and potentially highly useful economic indicator that they stumbled upon while cruising Google Finance (yes, they are that weird).

Now, no doubt many have heard the urban legend of the hemline indicator as a stock market barometer. That old chestnut goes something to the effect that the more affluent and confident Americans feel, the higher women’s hemlines will rise as will, in tandem, the stock market. If true it is, of course, a coincident indicator that probably can be traced back to the roaring twenties when flappers prowled the speakeasies and good old Jack Kennedy Sr. ruled the booze and manipulated the markets. Interestingly, just last week the Chairman of a well-known apparel manufacturer was discussing on CNBC the “heel height” indicator as working in similar fashion (pun intended). In his humble opinion the confidence of Americans can be prognosticated by the height of women’s heels. Not to be outdone, however, our kids have advanced the “toilet paper indicator” as a check on the well-being of the consumer.

Stumbling upon an MSN Money report, they “discovered” what most of us already know; the US economy is dependent upon consumer spending and economists go to great lengths to measure the health of the consumer using the strength of shoppers as a proxy. But what most of the over-educated egg-heads tend to miss is that some of the most obvious and intuitive indicators are sales trends for simple, everyday products--for example, toilet paper. Think about it. Toilet paper is the one consumer product that everyone literally spends money on so they can flush it down the drain. So for consumers to upgrade their toilet tissue, they sure as heck must be feeling confident in their economic status; if they shift from one-ply to two-ply and, gasp, even three-ply they are, in fact, sending a signal on the state of their perceived financial well being. So what does the TPI tell us? According to RISI, a forest products industry research provider, US tissue production is up 13% so far in 2010, due solely to an increase in demand. This is after it plunged dramatically along with the economy and stock market in late 2008 and early 2009. Lending credence to the trend, Procter & Gamble recently reported mid-teens growth for their Charmin Brand (all without Mr. Whipple!) and noted that consumers are moving back toward higher-priced discretionary items after a long focus on value. We confess to not yet having done our research on fashion trends at Christian Dior or Jimmy Choo but from our limited research, to date, it appears to us that the US economy is indeed, still on a roll. [Rimshot]

OK, we actually meant to target this piece on the upcoming earnings season. There has been much handwringing in the financial press over what level of forward guidance companies will give during their second quarter conference calls, which have just begun. Most analysts are quite sure that second quarter earnings will surpass printed expectations on both the top and bottom lines but are becoming increasingly pessimistic about what Management will say about Q3 and beyond. So far we only have a handful of samples, mostly from technology companies, and they have been mixed. Oracle beat expectations, raised guidance and gave an optimistic outlook. Research in Motion barely squeaked by and was fairly dour in their forecast. We have to chalk up both cases to “company specific” issues (gee, it’s fun to sound like a real Wall Street sell side analyst!). In the case of Oracle, they are in the middle of a long-delayed corporate upgrade cycle. As for RIMM, the I-Phone and the mass of smart-phone competitors now crowding the market are stealing their share and putting pressure on prices--as an example, poor old Nokia, with no good offering, was a disaster of an earnings report last week. So what can we expect from the bulk of companies yet to report? Frankly, we have to go with the analysts this time around. It’s hard to imagine any company Management sticking their collective necks out with so much turmoil going on in the currency markets and economies around the world. There is just no upside in being a hero on a conference call—not unless you have 100% certainty that things are going to be rosy and what company ever has that?

So should you run out and sell all your US equity holdings? It’s probably a little late for that. The US equity markets, having corrected nearly 12-15% from their April peaks, are now pretty much discounting a lot of bad news on the forward-looking earnings front. The two and ten-year Treasuries yielding less today than what they did the day Lehman went bust attests to that fact. That’s not to say that individual stocks may not still take a nose dive on really bad guidance, however, in our opinion the equity markets as a collective whole have already priced in a good deal of bad news. Who really expects Alcoa, perennially the cyclical earnings report front-runner, to report stellar earnings (they have whiffed the last two quarters already) or give upbeat guidance? Does anyone think the US multi-nationals with large Euro exposure will say positive things about the next few quarters? Do you believe that the US banks, still parsing through the 1900 pages of regulatory vomit heaved upon them by a soon-to-be Lame Duck Congress, will have ebullient things to say about their earnings future? We sure don’t and neither, we believe, do other investors. Looking at the mutual fund flows, it’s pretty clear that the individual investor has fled equities yet again, so what is left in the stock market are the big institutions who are mandated to be invested. The hedge funds have sold what they want to sell and are short what they want to be short. Every institutional investor is braced for a bad earnings guidance season. There just isn’t a whole lot of optimism in the equity markets right now. We like the odds this scenario presents.

Yes, you could invest your money safely in Treasuries for the next two years and pull down a guaranteed hefty 65bps in annual return (that’s roughly 5/8th of one percent for you English majors). Or you could be a gambler and go out 10 years for a full 3.12% (pre-tax). Yeah, we know that those are guaranteed returns and a damned sight better than what you got out of equities between April 23rd and last Friday. But the lousy returns in equities over the last two months is now rear view mirror stuff. Investing is all about what to expect in and do about the future. For us, with pessimism regarding the economy and equities at an 18-month high and US bond yields at a two-year low (including the 2008 financial crisis) the odds overwhelmingly favor equities going forward. But as the kids say, just take a lot of Charmin with you as it may be a bumpy ride—better yet, 3-ply Quilted Northern as things just aren’t that bad.

Ramblings of a Portfolio Manager

2010-06-14T11:30:00.001-07:00

Changing Course

We’ve been criticized for being overly bullish on equities over the last few weeks, paradoxically by institutional brokers who only make money when stocks are going up and investors are willing to buy. But smart brokers use charts, knowing full-well that they can’t count on their own in-house research to even call the direction of the wind during a hurricane, and the charts always tell you to hate stocks when they are going down and to love them when they are going up. Stocks have been going down of late so who are we to fight the tape with such weak arguments as valuation, fundamentals, and economic growth? That being the case, we bow to the chartists, throw in the towel and present here 10 reasons why you should NOT own stocks.

Gold. It pays no dividend, costs you a great deal to hold, store and insure the physical asset (assuming you have a safe at home) and carries a 20%+ commission each way on trading it. But it’s going up and the chart guys say that means it’s going up. Sell stocks, buy gold. Someday you will be rich.
Obama. His administration is anti big banks, anti business, fond of high taxes, espouses non-growth producing social programs, and has produced no growth in jobs in his 17 months in office. This, of course, is all information that very few are aware of. All these qualities, naturally, are so popular with the voters that he and the incumbents in Congress are virtually assured of a massive sweep in the mid-term and 2012 presidential elections. We even hear talk of suspending term limits so we may have these excellent statesmen in office forever! Sell stocks.
BP. While the environmental impact is saddening, no one is sure if there will be a measurable economic impact from the spill in the gulf. BP isn’t in any US stock index so it can go to zero without affecting the indices here but we get to see that belching oil on TV every day and that has to be bad. Sell stocks.
Uninspiring retail sales. Yup, 70% of our economy is based on the consumer and the latest round of retail sales reports showed only modest growth. So we shall join in with the bears and proclaim the US consumer dead for the 9,378^th time in the last decade. Sell stocks.
Yields on the 10-Year US Treasuries are now a fat 3.28%. That’s almost a hefty 200 basis points above expected inflation according to the current 10-year TIPS. And, of course, we know that the price of gold isn’t saying ANYTHING about expected inflation (just the super-attractiveness of that asset class). Sell stocks, place a penny into Treasuries (not a bank, the Government tells us they are bad) and sit tight in anticipation of the 2020 Bentley (lighter fuse) you will be able to buy with all those guaranteed accrued interest earnings ten years hence.
Portugal. The rating agencies tell us things are bad there and those agencies employ some of the smartest, most forward thinking experts on Wall Street. And Portugal’s GDP is massive-- almost as big as Arizona’s! This is news. Sell stocks.
Italy. The rating agencies haven’t yet told us things are bad there so things are OK. But if they do downgrade Italy, Sell stocks.
Greece. The ratings agencies tell us things are bad there too. This is also news. Sell stocks.
Spain. Ditto
No-one wants to own stocks now. We all know the herd is always correct. Go with the herd. Sell stocks.

By the way, if you decoded our acronym, give us a call for this week’s picks.

Ramblings of a Portfolio Manager

2010-06-01T07:36:00.000-07:00

How to Position Yourself Amid European Turmoil.

According to the databases, the S&P500 just experienced its worst May performance since 1962 while the Dow had its worst May since 1940 and we have Greece, Spain and the rest of the EU to thank for it. Savvy and nimble investors, of course, were able to avoid much of the pain by moving assets to markets less sensitive to the economies of those Sovereign entities, right? Think again. Here’s a little quiz: Now don’t glance at the chart below until you’ve finished reading! In which market would you rather have been invested during the recent ruckus over a potential European debt crisis? 1. The Shanghai Composite—China has the best balance sheet of the developed nations with plenty of reserves and no sovereign debt, however, the EU represents over 20% of Chinese exports. 2. The French CAC-40, which is comprised of companies deriving their earnings principally from the EU, including French banks that would have to write down their book values by over 40% in the event of a Greek and Spanish default. France also admitted at month-end that it would be a challenge to maintain its own AAA debt rating. 3. The S&P500, comprised of multinational corporations receiving only about 10% of their total earnings from the EU. 4. The NASDAQ Composite, made up of high-growth technology and biotech companies earning less than 5% from the EU in total. 5. The US Russell 2000 Index of small cap stocks, which are principally domestic-focused. 6, The German Xetra DAX—Germany is the EU country which will be shouldering most of the burden of pulling its fellow members out of the fire. 7. The Spanish IBEX—need we explain this one? 8. The UK FTSE 100—UK exports to the EU account for about 29% of GDP and the UK Pound has appreciated versus the Euro.

OK, now you can examine the chart below.

The answer, other than the obvious fact that you would have wanted to avoid the Spanish stock market, is that it almost didn’t matter in which developed, Eurozone-affected equity market you invested your money last month—you would have lost a similar amount of money in any of them. The conundrum, however, is that the equity market of one of the most vulnerable countries to a PIGS debacle, France, outperformed almost all of the equity markets in May while stocks in China, with the strongest economy, no debt and the reserves to stimulate, underperformed all but Spain. The FTSE, in a worse position than the US vis-à-vis currency and trade with the EU, outperformed the US. What’s going on? As we see it, there are several countervailing forces at work. First, US hedge fund managers, remembering the debacle of 2008, chose to shoot first and ask questions later—and they tend to be invested more heavily in mid-cap and technology stocks as found in the NASDAQ, the big domestic loser. Secondly, less trigger-happy investors began focusing on the markets where the weaker Euro would be a benefit—the European countries with the largest components of exports in their GDP—and where it would be a detriment—e.g. the US and Chinese multinationals. That’s the reason Germany, with over twice the exports of France, has seen the DAX dramatically outperform the CAC-40 this year and all US and Asian markets last month. Thirdly, the Chinese market is reacting not only to efforts to reign in the property bubble but to the strengthening of its currency versus the Euro, a double-whammy of anxiety. Finally, for the conspiracy-minded, there is the headline timing issue: for the latter part of the month, encouraging comments by politicians tended to come out during the trading day of European bourses (purposefully), allowing them to close higher, while the bad news was saved for “after market hours” (again purposefully) while the US equity markets were still open, sending them lower.. Do that a couple of days in a row (which occurred) and it certainly offers one explanation why the S&P 500 couldn’t put together two back-to-back positive days the entire month while the Euro bourses could. .Fitch’s Friday downgrade of Spanish debt just after the European markets closed but while the US markets were still trading, is a prime example of this.

What to make of this all? Of course this data is all backward-looking but it can give us a clue as to how some markets will perform for the rest of the year. First, we agree with the view that the export-minded EU countries are a buy right now. Several major investment banks have upgraded growth expectations for the stronger, export driven European economies over the past month as did the OECD last week. Secondly, we believe that the sell-off in smaller, US-focused countries is way overdone and that, going forward, they will outperform the large, US multinationals with significant European/currency exposure, especially if the Federal Reserve keeps a rate hike on extended hold, which we think will happen. The stronger dollar will continue to lure overseas investors to our markets and while some of that money will find its way into Treasuries is will also go into perceived “Euro-free” stocks, favoring small caps. Finally, though we have been dead wrong on the Chinese market this year, we have been correct on their economy and we believe that the Central Government will reverse their tightening course as soon as the measures appear to be working (which, as of this morning, they seem to be), especially in light of current world weakness, making Chinese stocks worth a serious look now, after a 20% slide year to date.

Ramblings of a Portfolio Manager

2010-05-24T06:06:00.000-07:00

Street Signs

Our apologies to the folks at CNBC for borrowing the name of their daily segment as our tag- line. It just seems to fit so well with the events that transpired last week. We claim no affiliation, imagined or real, with CNBC or its affiliates but if they wish to sue they know how to find us.

We were going to start this piece with “It was a dark and stormy week…” but that seemed a little cliché and a lot Bram Stoker. Instead, we thought we would share some of our observations, which we believe signal that pessimism has reached a fever pitch and, therefore, perhaps a market bottom has been reached. So here, in no particular order but with some subjective commentary, are the top 10 contrary signs we witnessed from Wall Street last week:

1. CNBC ran a weekly segment entitled “anything but stocks.” It covered potential asset classes from Gold, to fine art, to classic cars. The message: stocks are out, collectibles are in. By the way, the illiquidity, the bid/ask spread, and the unregulated fee/commission structure on these “assets” would make a congressman cringe, however, we didn’t hear any indignant Senators grilling Sotheby’s for selling a Picasso with a 20% seller’s discount and a 10% buyer’s premium, plus a listing fee, or for knowingly shorting a ’71 Hemi ‘Cuda Convertible (35% Bondo) for $2mm to a supposedly “sophisticated” buyer bidding from the complimentary bar.

2. More Greek rioting was splashed across the TV (minus the goat, which we are now sure became Gyros for the rioters). The effect on the capital markets was much, much more muted that the first round. Obviously, the Market is becoming desensitized to such media spectacles.

3. Nouriel Roubini was dragged out, after a year of hibernation, to proclaim that stocks could drop another 20%. Why? Because “they’ve gone up so much.” Now there’s some sophisticated analysis for you. The “broken clock” method always seems to work at least once in a lifetime.

4. Meredith Whitney was also put on screen to admonish us “not to touch any financials.” We’re not sure how Multinational Money Center Banks exposed to EU debt share the same risk profiles as regional banks, private mortgage insurers or consumer finance companies. But Meredith had the right call in 2008 and if the broken clock approach worked for Nouriel, why not also for Meredith. Besides, she is a lot prettier.

5. The volatility index, or VIX, spiked upward around to around 45. For the VIX to stay there would mean that the market’s expectation is for very large changes over an extended time frame. In the 15 years leading up to the VIX’s creation in 2003, price changes of 5% or more in either direction occurred only eight times. It is also interesting that the VIX behaved similarly in 1997, hitting a high of 48.64 during the height of the Asian Contagion. Thus far into the European Contagion, the VIX has hit a high of 45.79.

6. Gary Kaminsky, of CNBC’s fast money, officially declared “the death of buy and hold.” He, and many others, said the same back in March, 2009.

7. Jim Cramer is back to his “buy the accidental high yielders” strategy. He pursued this philosophy all the way to the bottom in March and abandoned it only near the top, when the yields were no longer as high. While that might make sense, he never issued a “sell” recommendation so most of his followers probably still hold the stocks he recommended when they were at high yields; while the yields are now lower, investors are still earning the same (if not higher) dividend stream. Unfortunately, they missed the rapid appreciation of some of the lower yield growth stocks on the way up. Chances are they are smart enough not do so again.

8. At least one prominent analyst admonished eschewing stocks while there was “oil in the water and blood on the streets, which is what we have now.” Warren Buffett tells us those are the best times to start buying. We like Warren.

9. The annual SkyBridge Alternatives (SALT) conference of the “smartest guys on Wall Street” took place in Las Vegas amid heavy media coverage. Mass “group think” ensued, as it often does in these conferences (which is why we avoid them), and fed upon itself, with the emergent consensus being that the world was coming to an end and we all must “de-risk.” That is exactly what all the smartest guys did publicly Thursday on CNBC, as they picked up the phones and called in their sell orders. We note that the heaviest selling and biggest drop in the markets came on that day.

10. A public opinion poll showed that Goldman Sachs and Wall Street enjoy a lower approval rating than Congress. Perhaps Bernie Madoff will replace Lloyd Blankfein and Ted Bundy will replace Nancy Pelosi (the latter certainly being a trade up).

11. OK, we said 10 but we couldn’t resist this one. London pawn shops and bullion dealers reported that they are out of gold to sell. ebay is listing gold coins and ingots at 15-20% premiums over spot prices of the metal (by the way, that’s better than the commission those Good Fellas on TV will charge you) and an ingenious entrepreneur just installed several ATM machines to dispense gold ingots instead of currency. We’re not sure how to buy a Big Mac and Fries with an ingot but when we do we’ll be sure to let you know.

We think you get where we are going with all this. Sentiment is very bad, stocks are down and no one is paying attention to fundamentals, which happen to be good. More often than not, this signals a good time to buy stocks and while it is almost impossible to call the bottom, certainly we must be closer to it now than we were three weeks ago.

Frequent bear and always smart guy Doug Kass turned positive on stocks on Friday. Said Mr. Kass,” The market has every reason to lose steam this afternoon, but it's hanging in there. I think that the action today is bullish and we might have seen a bottom for some time to come.” Doug was right in calling the bottom on March 6^th, 2009 but wrong by calling a top at S&P 1020. If his recent track record is only 50%, why do we even bother mentioning him? Well, to start, he correctly called the mortgage crisis of 2008 back in ’07, well before anyone saw it coming, he declared Fannie Mae and Freddie Mac technically insolvent in 2008, enduring derision, and he correctly picked the stock market bottom in March 2009. Secondly, unlike the broken clocks, he is willing to change his opinion as the facts change and he is willing to admit when he was wrong. His picks now: retailers, private mortgage insurers and China. Coincidentally, that happens to be how our portfolio is positioned. Though it isn’t working well at this moment, we expect Kass to be correct and for significant outperformance to lie ahead.

Ramblings of a Portfolio Manager

2010-05-21T07:35:00.001-07:00

Ramblings End of Week Update

We’re sure many clients are watching the capital markets with concern. We don’t believe things are anywhere near as bad as they were in September of 2008, however, market sentiment is almost as bad. Because we focus on small caps, our portfolio has been positioned in very US-centric companies, which should not be as directly sensitive to a slowdown in Europe or Asia as would large cap, global companies.

Our philosophy has always been to sell euphoria, buy panic. Right now we have a great confluence of negative events, from the debt crisis in Europe to the Financial Regulation Bill in Congress. The result has been that the fear indicators are reaching levels not seen since 2008. Most of this, we believe, is headline risk only and we are, therefore, taking advantage of the sell-off in select areas with a focus on low P/E, quality companies with strong balance sheets, in line with our long-term investment philosophy. We continue to see improving fundamentals in the US and Asia and look at this as a normal sell-off in a cyclical bull market. We are also putting our money where our mouths are and are investing more in the fund, believing that significant opportunities for appreciation lie ahead.

We encourage any investor with questions or concerns to feel free to call us at any time.

Rick and Chris

Ramblings of a Portfolio Manager

2010-05-17T13:45:00.000-07:00

When the Tail Wags the Dog

2% of US GDP. That’s what exports to the entire European Union comprise of our nation’s annual output. Hardly seems worth the volatility that the market put us through last week. Of course, the prevailing fear is the “domino” or “cascade” effect of a weaker EU on the rest of the world and thus, ultimately, the US. We’ve seen this movie several times before. The premier, “Tarp I,” of course, was in September of 2008. The first sequel, “Oh God Obama!,” came in January through February of 2009. The third iteration, entitled “Double Dip,” debuted in July last year. Like all bad movies, the first was better than the sequels—and, as with most movies, it was the “real deal.” The others were just tarted up imposters. Now we have “Contagion IV. The Euro Story.” Is it worth seeing? We think not.

In our little book of investing, E stands for Earnings, not Europe. An excerpt from Ramblings, July 20th 2009:

Anyhow, all we are saying here is that this earnings season should actually turn out to be a good old fashioned one—some beats, some misses, some “in lines.” And that is what makes markets, produces opportunities on both the long and short sides and makes fundamentally-based active money management worth pursuing.

We feel the same way today. Right now the US markets are trading in more or less in direct correlation with the Euro, with exporters getting hit harder than domestically focused companies. We understand the psychology—a strong dollar makes our exporters less competitive vis-à-vis their European competitors and a weak Europe means reduced exports to that trading bloc. But things don’t just work that simply. First of all, as we point out, only 2% of our GDP is based on exports to Europe. Secondly, many of our exporters have no real European competition—think technology and pharmaceuticals. Thirdly, along with a stronger dollar, we have weaker oil (down 20% so far this month), which is like a tax cut for all companies, world wide. Finally, while a weak Euro does mean that European exports to the rest of the world are more competitive, it also means that Europe stands a chance of exporting its way out of an economic slowdown—in fact, UBS upgraded the EU for just that reason today.

We suggest investors turn off the TV and just watch the earnings reports and guidance from the US coming across the tape. It’s a better and more uplifting movie

Ramblings of a Portfolio Manager

2010-05-10T05:42:00.000-07:00

Fat Fingers, Thinner Wallets.

It would have been comical had not the financial anguish been so great or the memories it evoked so painful. There, last Thursday, on the right side of the screen were hundreds of government employees expressing their anger and frustration in a childish temper tantrum at the dilemma that they themselves had caused. On the left side was the Dow, tick by tick, dropping with every Molotov, er Metaxa cocktail let fly. We’re talking, of course, about the Greek Government Union employees rioting at the austerity cuts mandated by the EU bailout package. The would-be comical part was the goat, seen in all the videos, running helter skelter amid the chaos. The not-so-comical part was the close analogy it drew to another scary media spectacle just 19 months earlier. There too, hundreds of childish government employees vented their feigned and hypocritical wrath at a situation that they also caused while the world watched the capital markets fall, tick by tick. That, of course, was the vote on the TARP bailout bill in Congress. Unfortunately, in that scenario the only goat (the “scape” kind) was Hank Paulson, who had to take the blame from grandstanding hypocritical Senators (e.g. Barney Frank) for a situation he certainly didn’t cause but was clearly using all his powers to avert. The Greek goat probably ended up as Souvlaki, roasted over the trash fires by hungry cops (we noted that all the donut shops had already been looted by the other Unions). The American goat, thanks to our more “mature” society, was labeled “damaged goods” and got to write a book that helped augment his stack of T-Bills. It’s a great country.

Amid the televised media spectacle investor panic sent the Dow down almost 1000 points intraday before recovering almost 700 of those points. We’re not qualified to even speculate upon the reasons for the resultant gut-wrenching move, which occurred in just 15 minutes, so we’re not going there…although there is a “grassy knoll” theorist around here who is convinced it was all the work of cyber-terrorists. We’re going to give him some time off to spend with a certain Police Chief we recently had to let go in part due to his conviction that the local nut case who was blowing up porta-potties was in truth an Al Quaeda cell practicing for an attack on the Empire State Building. On second thought, that nut case was released just last week from the hoosegow…hmmmm.

Instead of opining on last week events, we thought we’d give a little test to see who was paying attention. Ready? Here are some headlines from last week. Music please! One of these things is not like the other. One of these things just doesn’t belong. Can you tell which thing is not like the others by the time I sell all my longs?

a. EU Raises 2010 GDP Forecast
b. China’s October Manufacturing Grows at Faster Pace
c. Oct. ISM Factory Index Surges to 55.7%
d. World Equity Markets Lose More Value Than the Combined GDP of the PIGS
e. U.K. October House Prices Gain for Third Month
f. UK Manufacturing PMI at Two-Year High
g. US Employers add 290,000 jobs, Twice the Consensus
h. Australia Increases Benchmark Interest Rate to 3.5%
i. Barrons says “here's a chance to shop for stocks.”

Time’s up! The astute among you noticed immediately that this was a trick question as we all know that Barron’s wound NEVER publish a bullish article on stocks. Right? Wong! Actually, they did. May 8th: “Try not to get rattled by the market rout. Instead, here's a chance to shop for stocks.” Go figure. So the correct answer is “d.” Yes, world equity markets did indeed erase more in value than the entire combined GDP of the PIGS (approximately $4Trillion) in just 4 days last week, which flies in the face of all the positive (in some cases too strong) economic data from around the world. Keeping it all in a Fred Rogers framework: “Over reaction. Can you say that?”

OK, for those of you who missed it, here’s another, easier little test:

Question: Which country is the largest exporter to the EU?

a. United States
b. China
c. Japan
d. Australia
e. Germany
f. The EU

Also a trick question. Yes, the EU is the largest exporter of goods to itself. However, within the EU, Germany is the largest sovereign country to export to the EU and the second largest exporter in the world, after China. The US comes in third in world rankings. Why does this matter? Well, with all the handwringing over the world impact of a European slowdown, one should consider who will be affected first. China, as we all know, is in the midst of a tightening phase due to excessive economic strength. Germany was about to go there before the Greek mess hit and the US is still contemplating tightening after already beginning the liquidity withdrawal. These countries, if beset by export declines due to EU weakness can turn their monetary policies on a dime, as they did in 2008. That, in our opinion, would start the liquidity cycle all over again, driving up stock prices, among other effects. So, while we realize that the story isn’t just Greece but the so-called domino effect across Europe and that all the positive data coming out of countries right now is “rear view mirror” information, we also understand that there is a fair amount of firepower left in the largest economic powers to prevent another financial crisis, which is what the markets fear is happening now.

Oh Oh! As Rosanne Rosanadanna would say, “never mind!”

Timing is everything and as we write this we see that the EU Ministers have approved a $962 billion fund to bolster the Euro and to stave off further debt-crises in member countries. In one fell swoop, this move takes the PIGS off the table. Along with the loan package the European Central Bank will initiate their version of “quantitative easing,” something that last week its president, Jean-Claude Trichet, said the central bank didn't even contemplate. The ECB will go into the secondary market to buy euro-zone national bonds and the Federal Reserve has re-activated swap lines so foreign institutions can get access to loans. It’s an unprecedented move from what here-to-now has been an agonizingly slow, almost constipated, European bureaucratic system. It’s also surprising show of cooperation among central banks. The markets seem to like it and as of this writing Dow futures are up over 400 points.

So as the CNBC junkies cover their shorts in the Euro, let us praise the EU Ministers, mourn the goat and remember that you heard of this first on Ramblings: Special Edition, last Thursday.

Ramblings of a Portfolio Manager

2010-05-03T06:06:00.000-07:00

Greek for Dummies… and PIGS

With all the news surrounding the PIGS last week, particularly Greece, we thought it would be helpful if we provided a little primer to help investors understand some of the more complex Hellenic financial terms flying around the airwaves. So here, in the language of Aeschylus, is the week in review:

hypokrites. n. Gk a stage actor, hence one who pretends to be what he is not. See also oraculum. v. L to plead. ME hypocrite: one who denounces derivatives as “financial weapons of mass destruction” prior to emerging as one of the largest investors in said weapons and criticizing the Government’s plan to regulate such.

amnestía. n. Gk oblivion. See also ME hypocrite. ME amnesia: a group that protests the “cost to taxpayers” of bailing out Wall Street, which paid the Government back in full plus interest, “forgetting” that its own constituency placed taxpayers in the same situation with GM, receiving ownership in the Company in return while being allowed to pay back those taxpayers with their own money ( i.e. TARP funds).

phone. n. Gk sound, voice. See also L senatus, council of elders. See also ME hypocrite. ME phoney: 1: someone who takes money from another and in return puts the donor through a public show trial to enhance the probability of re-election. 2: public criticism of an institution for “adding no value” by an individual who destroys value. See also slang doddism n. cognitive deterioration.

moros. n. Gk foolish, stupid. See also ME worthless. ME moron: 1: one who helps create a global Standard of being Poor. 2: a group or entity paid to opine on the financial health of another and who, having failed spectacularly, downgrades the debt rating of a sovereign entity in obvious financial distress, after the value of that entity’s bonds has already declined 38%, hoping no-one notices.

eirene. n. Gk oil. See also ME double standard, fr. Gk diploos + histanai, to cause to stand twice. ME oil: A value system under which an environmental disaster is never the fault of philosophically liberal politicians or government entities, even when they publicly support the conditions that created the disaster in the first place.

Next week, depending upon which of the PIGS makes the headlines, we will explore the romance languages.

Please call for this weeks highlighted stocks.

Ramblings of a Portfolio Manager

2010-04-26T05:19:00.000-07:00

So Many Worries, So Little Concern.

Riddle: What do volcanoes, Government bureaucrats, oil rigs, nuclear terrorist attacks, Chinese inflation, Greek tragedies and dead comedians all have in common? Hint: they’re all related to the US equity markets. Give up? Answer: despite massive negative headlines regarding the first six items the US equity markets have taken very little notice in the way of profit taking, continuing their slow upward trend and earning a nickname from the seventh: the “Rodney Dangerfield” rally. After a brief sell-off following the news of the SEC fraud case against Goldman Sachs for some probably legal but seemingly unethical behavior just prior to the Financial Meltdown of 2008, which took more in market cap off the US equity markets than the entire value of Goldman itself, the Markets resumed their climb and the S&P 500 and Dow gained 2.1% and 2.5% respectively for the week. The so called “risk trade” was back in fashion as evidenced by the small-cap Russell 2000’s corresponding strong 3.8% gain. Even a 6% slide in the Shanghai Composite on further Chinese Government tightening, it biggest since January, couldn’t pour cold water on the US markets for long. After spiking to near 20 on the Goldman fraud case news, the VIX fell back and remained below 17 for the week.

So with a stock market rally amidst all the negative headlines, a rally that is almost universally proclaimed as “having no respect,” it seems we are climbing the so called “Wall of Worry,” that quaint old Wall Street term for a rising stock market in the face of general pessimism about the economy and Market itself. Well, maybe. According to the Investment Company Institute last month, equity mutual funds consumed their excess cash at the fastest rate in 18 years, leaving them with the smallest reserves since 2007. Cash as a percentage of holdings dropped to 3.6% of assets in March, down from 5.7% in January 2009, the quickest decline since 1991. According to the ICI the last time equity managers held such a small proportion was in September of 2007, a month before the S&P 500 began its 57% drop. This would signal that investors are already fully invested, a sign that optimism, rather than a wall of worry, prevails on Wall Street. However, this ICI data point just measures cash on hand within equity mutual funds, whose mandate is to spend their available cash in the stock market anyhow. Looking at other, non ear-marked, sources of cash, more recent data shows that investors have still have nearly $3 trillion in money-market funds as of the end of last week and although this number is down 25% from a year ago, the year ago number represented the peak in money fund assets during the Financial Crisis. The current money market balance is roughly the same as it was at the beginning of 2008, after the equity markets had already experienced a full quarter of fund redemptions from the markets’ peak in October 2007. In addition to the money market data, ICI shows that flows into equity funds through the end of last week slowed significantly while flows into bond funds continued strong and outpaced that into equity funds at almost a 3:1 rate, in line with its average this year. All this signals that if the markets are rallying due to complacency, euphoria and the so-called “dumb money” rushing in, it sure isn’t supported by the data. The Wall of Worry, then, just might be intact and growing.

A word on Goldman Sachs. We aren’t securities attorneys (thank God!) and so will not pass judgment on the culpability of Goldman vis-à-vis its purported actions. We are, however, market watchers with a background in the analysis of financial services firms. Our only comment on this whole controversy is a reminder that the tangible assets of financial services firms go up and down the elevators each day—that would be the employees—and that the intangible assets are written on air—that would be their reputations. Merrill Lynch, Bear Stearns and Lehman Brothers failed due to leverage and the failure to manage the risk thereof. That isn’t the case here so we look further back in history for guidance on the possible fate of Goldman. Unfortunately, we are old enough to recall Drexel Burnham Lambert, E.F. Hutton and Kidder, Peabody as potential examples. These brokerage firms failed not due to excess leverage or bad financial management, but due to the rapid loss of market reputation and, thus, market clout. In all cases it was the actions of certain employees who set the cataclysmic chain reaction in motion. Whether or not Management was involved was irrelevant as the questionable behavior was seen as symptomatic of the corporate culture of each firm. However it began, the reputational impact was the beginning of the end. We don’t suggest that this fate awaits Goldman but, perhaps more likely, it does await its current Management.

Despite Wall Street being labeled as monopolists by the current Administration, its bread and butter business is, in fact, largely a commodity. This has two implications of which to be mindful: First, if you operate in a commodity business, your only edge is your reputation and that can be fleeting. Goldman Management--and investors in its stock--beware. Secondly, for all other investors, know that in a commodity market, no one firm is indispensable and many participants can come and go without causing harm to the health of the overall market. Despite what they would have you believe, Goldman doesn’t have a monopoly on brains, creativity, innovation or market influence. When Drexel folded the junk bond market remained healthy and vibrant. BBB or lower companies could still access the capital markets and the existing “junk” in investor hands could still be traded. Other firms quickly sprung up to fill the void, many with ex-Drexel employees at the helm. Yes, a Goldman failure (and we aren’t suggesting this) would send ripples through the financial markets but just as ripples in a pond, these will fade with time reestablishing the earlier relative calm. Should Goldman fold or exit certain markets the capital markets will remain liquid, strong and healthy and other firms will emerge to fill whatever void might be created. And if all Wall Street firms are restricted in how they do business in certain products or markets, remember the Wall Street is all about innovation…there is no way a bunch of bureaucrats and regulators can keep up with the new products that will be created. So our word to investors is that while Goldman Sachs stock itself is probably not worth the risk of committing more money at this time, the overall market, should it sell off on any negative news regarding Goldman, certainly is. Just maybe avoid investing in Hamptons’ and Upper East Side pre-War real estate for the time being…

Top 10

2010-04-19T06:26:00.000-07:00

Ramblings of a Portfolio Manager

2010-04-12T10:28:00.000-07:00

The VIX and the “Smart Money Index”

The VIX, or CBOE Market Volatility Index, is an index created in 1993 by the Chicago Board Options Exchange to track market volatility as an independent value, which can be traded on major exchanges. The VIX is calculated based on options prices and activity in the S&P 500 and measures the Market’s expectations of near-term volatility and, thus, many market watchers use it as an indicator of investor sentiment, with high values implying pessimism and low values implying optimism. The VIX itself has been a quite volatile security in recent years, hitting an all-time low of 9.39 in December, 2006 and spiking to 89.53 in October, 2008 at the height of the global financial crisis. Currently, the VIX is trading around 15 meaning that, because mathematically the VIX is expressed as an annual percentage, the market is expecting a 15% change in price (plus or minus) over the next year.

The market has developed a great deal of lore regarding the VIX over the years and it is now often referred to as the "investor fear gauge" because it has a tendency to rise sharply when markets are under stress. Investors, however, tend to be divided over the meaning of the VIX with some seeing it as an indicator of investor confidence and, thus, higher stock prices ahead, while others view it as a contrary indicator of euphoria and complacency implying risk to stock prices going forward. In reality, the VIX is not a measurement of sentiment at all but of implied volatility. Since implied volatility is highly correlated to actual volatility, the rise in the VIX during periods of market turmoil is the result of the increase of volatility itself rather than a change in investor sentiment. Further weakening the VIX usefulness as a sentiment indicator is all the available synthetic methods of hedging risk that have been created over the last decade, which essentially have disenfranchised the S&P options market as the primary source of hedging for many investors.

So what can we make of the fact that the VIX is currently trading at a 52-week low? Well, taking the strict definition of the index, the implication is that investors are not expecting a great deal of market volatility in the near to medium term. Taking the looser “fear” gauge definition, it means that investors are getting comfortable with the levels of the market. By either definition that’s probably good news for individual investors but not so for the “sophisticated” crowd, who make their living hedging and trading off of volatility. This group includes day traders, high frequency traders and hedge funds. In fact, the numbers are starting to bear this out. Through Friday the S&P 500 index was up 7.7% year to date and the Russell 2000 index of small cap stocks was up a whopping 12.8%. With the expectation of volatility along with the “fear” gauge so low, investors are willing to “put on the risk trade,” meaning they are eschewing safer investments for risky assets like small cap stocks. The hedge funds, however, have missed this trade and are showing the impact of the lack of volatility on their returns. Through Friday the HFR Equity Hedge Index was up 1.52%. A more aggressive hedge fund index, the Greenwich Alternative Investments Index, is up only 2.9% year to date. Hedge funds only make the real money for themselves if they make money for their clients and so far that isn’t happening in a big way. So for the hedge funds to have another good year, they need to cover their short positions in hopes the market continues to go up or stay short and pray for a correction. In the first case, that implies further fuel for the “melt up;” in the latter it implies buying support in any pullback. Either way, for individual investors, barring some exogenous event, the VIX is likely to remain low and the slow grind up the “wall of worry” is likely to continue. By the way, has anyone noticed that we stealthily creeped through Dow 11,000?

Ramblings of a Portfolio Manager

2010-04-06T04:21:00.001-07:00

When Will The Individual Investor Return To The Stock Market?

Market strategists like to look at dollar flows into and out of mutual funds as a sentiment indicator for the overall health of the Markets. The Investment Company Institute (ICI), a non-profit organization whose members are the majority of investment companies registered with the Securities and Exchange Commission, publishes a monthly report detailing net flows into domestic and international stock funds, bond funds and money markets. ICI is seen as the Industry standard source of mutual fund trends and tends to be the most reliable. In its monthly report new sales, redemptions and exchanges are netted out to show a "net new cash flow" figure, which can be positive or negative for a given period. Average cash levels at stock funds are also shown in the report. The ICI data is often looked at as a guide to retail investor behavior as institutional money and individual shareholders are excluded from the ICI report.

Many strategists believe that strong flows into stock mutual funds indicate that retail investors have become more confident in the Markets signaling further gains ahead. Some economists, however, view fund flows as indeterminate at best with some seeing them as a contrarian indicator or false positive on the future direction of the markets. In their view, individual investors are always “late to the party,” committing more money to the stock market after it has already run up and has received a lot of positive press and mainstream news coverage. In their view the behavior of the so called “dumb money” should be looked at as a negative sign. They often cite as an example the behavior that occurred in the last few months of the stock market peak back in early 2000. At that time, equity fund flows were at record levels those first few months and, of course, the stock market began a steady decline soon after, with the major indexes dropping more than 50% in the next year.

So what is the individual investor doing with his or her money these days? According to ICI equity funds had estimated inflows of $3.23 billion for the week ending March 24th. This is slightly down from the estimated inflows of $3.51 billion in the previous week. Domestic equity funds had estimated inflows of $1.55 billion, while estimated inflows to foreign equity funds were $1.68 billion. Hybrid funds, which can invest in equities and fixed income securities, had estimated inflows of $990 million for the week, compared to estimated inflows of $1.07 billion in the previous week. While inflows into equity funds slowed week over week, bond funds continued their trend of strong investor appetite with estimated inflows of $9.24 billion, up from their estimated inflows of $8.85 billion during the previous week. Taxable bond funds saw estimated inflows of $8.16 billion, while municipal bond funds had estimated inflows of $1.08 billion.

This fund flow data suggest that mutual fund investors remain in defensive mode, preferring bonds over stocks. The trend is similar to what was seen in early 2009, just after the financial crisis began, and suggests that investors who were burned during the Market downturn of 2008 and early 2009 remain wary about joining this bull market. For the contrarian crowd, this is good news for the equity markets going forward.

Last week, however, we posited that a hiccup in the bond markets, resulting from rising interest rates, would drive investors out of bond funds and into equity funds and clearly that has not yet happened. A possible reason is that “retail investors” are not a uniform class of individuals. They are made up of people from multiple age, ethnic and socio-economic groups all with different investment horizons and risk tolerances. One very prominent investor sub-group comprises the “baby boomers.” The oldest baby boomer is just now retiring while the youngest is half way toward saving for that day. The stock market downturn of 2008 hurt many of these boomers very badly, some just at the exact wrong time. While we question why an individual close to retirement would have a significant portion of his or her net worth in volatile stocks, still even those invested in the relative “safety” of corporate bond funds were hurt in 2008. These near-retirees may now be too scared to ever return to equities or corporate bonds under the philosophy that it is better to have half a slice of pie than none. That’s a big group of retail investors to leave permanently out of the market. The $64,000 question, in our view, is will further market gains entice even these gun shy investors back in with hopes of recouping some of their losses? We think so. Dow 11,000 just may be a headline magnet to this last group of hold-outs, driving fund flows into equities and out of fixed income.

Ramblings of a Portfolio Manager

2010-03-29T06:12:00.000-07:00

Why Treasuries Are Risky

When PIMCO’s Bill Gross speaks, people listen...especially when the subject is bonds. And well they should. As the co-founder of one of the World’s largest fixed income investment management firms, with over $1 trillion in assets under management, he might just know a little something about that asset class. So it was with tuned ears that we listened to his pronouncement last week that, in his opinion, the almost three-decade rally in fixed-income has run its course. Said Gross in an interview with CNBC last Thursday, “Let’s suggest the economy looks good, that risk assets — whether it’s high-yield bonds or whether it’s stocks — have a decent return relative to the potential of declining bond prices... I’ll go with the stock market.” Gross went on to say that he believes stocks may outperform bonds over the next three months. It was a striking statement from someone who makes his living managing bond portfolios and whose PIMCO Total Return Bond Fund has grown to be the largest mutual fund in history, at $214 billion, thanks to fearful investors fleeing equities to the safety of bonds. He reiterated his statement in a later Bloomberg interview in which he stated that “bonds have seen their best days” and that the prospect of a strengthening U.S. economy and rising interest rates makes an “argument to not own as many bonds.” By the way, he’s a man who puts his money where his mouth is as PIMCO announced in December that it would now begin to offer stock funds.

To many investors, that the investment world’s proclaimed “Bond King” is now touting stocks over bonds should be a wake-up call. Since the 2008 financial crisis, investors have fled stock funds and poured cash into US Government bond and other fixed-income funds in search of safety. That trend continued throughout 2009 causing many investors to miss the US stock market’s nearly 74% rise, the biggest rally since the 1930’s. Even thus far in 2010 bond mutual fund inflows are 5 times greater than they were at this time last year. Part of the reason for the rush to bond funds is that investors are reaching for higher returns with money-market funds yielding close to zero, but there is still a large component of fear to the move—fear over the future of the world economy and its potential ill effects on equities. Despite a slew of positive economic and company-specific data from around the globe, investors are still eschewing risk. What most don’t understand, however, is that there are many types of risk--among them inflation risk, and its corollary interest rate risk, are very real, sizeable, and potentially devastating to the unwary investor.

Investors have been making money in bonds for so long they assume that it will continue forever. It can’t. US Treasuries have rallied for almost three decades, pushing the yield on the 10-year Treasury note from a high of 15.8 percent in September 1981 to a record low of 2.03 percent in December 2008 during the height of the financial crisis. Since their December lows, however, 10-year US treasury yields have been creeping slowly upward and last Thursday the bond market got slammed after a poor Treasury auction brought the yield on the 10-year to 3.89%, its highest level since June. Fears of high US debt levels and pending inflation (from stronger economic growth) are making bonds less attractive, pushing down prices and raising yields. Currently, with inflation near zero, both the real and nominal rates of return on US Treasuries is about equal to their current yield--3.9% in the case of the 10-year--and, of course, someone holding a 10-year note to maturity has a very good chance of earning that 3.9%. However, as inflation rises, the real rate of return on that investment will decline and as US interest rates climb (either due to inflation or sovereign risk fears), Treasury prices will drop, giving bond investors a double-whammy of a declining real long-term yield to maturity plus a potential annual loss in their bond portfolios, something many have never seen. Because so many investors have gone so long without losing money in Treasuries, whether they will stay the course and continue to pour money into fixed-income funds is now in question.

According to Morning Star, bond funds almost never outperform equity funds over a decade, as they did in the 10 years ending in March 2009, and they have never done so in two consecutive 10- year periods. That little statistic is striking. Just as “trees don’t grow to the sky” is a wise stock valuation philosophy in equity investing, so too is it true with bond prices in the fixed-income world. If we go through a period where investors realize that they can, in fact, experience annual losses in Treasuries and other “safe” fixed-income investments, we may see an exodus from bond funds. And with inflation and interest rates on the rise it’s a good bet that all that money will find a home in equities.

Ramblings of a Portfolio Manager

2010-03-22T12:28:00.000-07:00

What’s the Next Big Worry?

“The market climbs a wall of worry” is the old saying on Wall Street, meaning stocks rise despite (or perhaps because of) the prevailing level of pessimism about the economy or stock prices themselves. If this old maxim is true then there has been plenty of fuel for the rally we have been having. Between Legislative & Headline Risk: Obamacare, banking reform, Cap & Trade; Liquidity Risk: tax hikes, Bush tax cut expiration, Fed tightening; Global Economic Risk: Chinese and Indian tightening, Greek meltdown, Dubai blowup, the other PIGS, the market has had ample reason to take a long and protracted nose dive. Instead, we are making new 12 month highs daily and the VIX is trading below 17. On the surface one would think investors are either insane or greedily oblivious to the obvious risks. In reality, the Markets are doing what they always do—discounting the noise and focusing on the fundamentals. So far, the fundamentals have been good.

With apologies to FDR, the real fear now is not fear itself but the lack of fear. The VIX (which is NOT a volatility indicator but a fear indicator), while not at ultra historic lows does indicate some complacency on the part of investors. We’ve just made it past Healthcare Reform, which has dominated the headlines for months, and the market is up smartly. If the old adage is to prove correct, then we need another “crisis” for the markets to continue their advance. Alfred E. Newman (of “what, me worry?” Mad Magazine fame) was not a good stock picker. So what should we worry about now? Well, believe or not we still have a lot to fear: We are still looking at potential financial regulatory reform, particularly with a newly emboldened Obama Administration, so we can expect the headlines on that issue to ramp in the coming weeks; we have the November mid-term elections, which though many consider a Republican come-back a positive fait accompli, remain a wild-card; there is the specter of additional weak employment data (this one should be the strongest impetus to new market gains as it will push out further any Fed tightening in investors’ minds); the Obama Administration is now picking a fight over trade policy with one of our largest bankers and trading partners who, arguably, also holds the fate of the Global economic recovery in it’s chop sticks, and, finally, there is the omnipresent threat of another terror attack on US soil. Of course it’s the bullet you don’t hear that is the one that gets you so there are myriad other risks and worries that can crop up, none of which we have yet to contemplate. What other tax and spend plans do the social engineers in Congress have up their sleeves? What other trading partners can we anger with our union-centric protectionist rhetoric? How can Obama’s Green energy policies ramp up to derail the recovery? The list goes on and is as large as your imagination. Heck, around here there is speculation that Elvis will land his Alien spaceship on the Pentagon, accidentally activating NORAD and plunging us into global thermo nuclear war. Could happen. Saw it on YouTube.

The point we want to make is that there are always risks lurking in the headlines but very few of them are truly impactful to corporate earnings and, by extension, long-term stock prices. Most of what we read, hear and see is truly non-impactful noise. But it is this noise that provides us with trading opportunities in a rising market. So the next time you hear the TV talking heads proclaim “this is a game changer” and see the markets react negatively in lock-step, consider the event an opportunity to buy rather than flee. In that situation you truly will have nothing to fear but fear itself.

Ramblings of a Portfolio Manager

2010-03-15T07:23:00.001-07:00

The Consumer is Dead. Long Live the Consumer

The consumer is de-leveraging and will never return to his or her prior level of spending. We are going to have an economic new normal because the consumer has been permanently impaired. The US savings rate will approach that of Japan, crimping consumer spending and any economic recovery. These have been some of the catch phrases of economic doomsayers for the last 18 months. The Media, always looking for a good sound bite, has picked up and repeated these mantras, ad nauseum, to the point that many believe them to be truisms. With nearly 70% of our economy dependant upon the US consumer, such dour sentiment naturally has caused investor concern about the strength of any economic recovery.

This morning Capital One Financial announced that credit card delinquencies fell in February, the first time in over 18 months. Last Friday retail sales unexpectedly rose slightly, versus an expected decline, despite heavy snowstorms that hit the Northeast. A week ago the Federal Reserve released its monthly consumer credit data, which showed that, for the first time in almost two years total consumer credit outstanding rose year over year. It was expected to decline. Consumer discretionary stocks, relegated more or less permanently to the hurt locker for the last two years, have been significant outperformers for the month. What should we make of all this?

Last fall, Jim Paulsen of Wells Capital Management told CNBC “never count out the US consumer.” It wasn’t an original statement but a bold one nonetheless in the face of what has become the newsroom culture of negative sentiment regarding the consumer. We agree with him. Americans love their material possessions. One of our favorite movie lines is from The Jerk: “it’s not the money, it’s the stuff.” To us, that says it all. It would take something just short of Armageddon to permanently cripple the US consumer, in our opinion. Recall that after 911 we also heard a host of market watchers decrying the death of the consumer. Back then we were all going to stay inside and “couchette,” that quaint 90s term for huddling at home and emulating the nuclear family home life glorified in the 50’s. Didn’t happen. In fact, that disaster had just the opposite effect with many consumers, feeling that life was too short, running out and buying that boat, sports car or vacation home they had always dreamed of while others sought out shopping as a comfort food to ease the anxiety of a troubled time. Behavior like that is culturally ingrained and it doesn’t shift overnight—or over a couple of months for that matter.

We now have a few data points supporting the notion that the consumer is not dead or at least is rising from the grave. They are nascent signs but important ones nonetheless and if history is any guide, they will strengthen in the months to come, especially if the unemployment rate begins to drop. And a declining unemployment rate should have a double impact as not only will more people be earning money to spend on consumption, but those with jobs already should be further encouraged to spend by the positive sentiment created by the data. Meanwhile, the market has been on a stealth rally since February 9th, with the S&P 500 climbing 8.8% and the Russell 2000 tacking on an incredible 15.4%, yet the Media tells us daily that we are stuck in a range. That signals to us that no one believes in the economic data or the rally that is has engendered. We like that kind of skepticism. As the consumer data continue to improve investors will come to realize that, perhaps, the Emperor does have clothes and that he just bought them in a high-end retailer…and that’s the sentiment we need to continue the Market rally.

Ramblings of a Portfolio Manager

2010-03-08T14:47:00.000-08:00

The Junk Indicator

Earnings season is winding down, economic data releases are being greeted with almost a yawn, the VIX is holding steady under18 and trading volume is easy to confuse with Google’s stock price on our screen. We’ve had a stretch of spring-like weather in the New York City area over the weekend and forecasts are for the more of same the next couple of days. It’s starting to feel like August on Wall Street except that the calendar tells us we haven’t even reached St. Patrick’s Day.

There’s probably a trading opportunity in here somewhere and we think we’ve found it—the Junk Indicator. No, we’re not talking about high yield fixed income securities we’re talking about junk. Good old used and discarded stuff. Wall Street prognosticators constantly scour the data for indicators of where the market and individual stocks might be going, giving us everything from Astrological indicators to Numerology tables as forecasting tools (there are probably still some entrail readers out there too). So it is without shame that we proffer the used auto and parts market as a leading indicator of the direction of the economy and, ultimately, stock prices.

We know a guy. This guy is in the “recycling business.” That’s PC these days for owning a junkyard. Anyhow, it seems his used auto parts business is just now starting to ramp up significantly after nearly 18 months in the doldrums. His used car lot, quiet for almost two years, is also seeing signs of life. This initially confused us as we’ve tried to track his business as a counter-cyclical indicator ever since the economy entered its current downturn—because that’s what common sense and Wall Street analysts (the gaping contradiction here should have been our tip-off) told us to do. We’ve been frustrated, for our sake and his, that business didn’t really pick up as expected during the downturn. That it is now starting ramp made equally little sense until we combined this anecdotal evidence with what we’ve heard from the automakers and the data from the big auto retailers.

The fact is, our friend’s market is people who cannot afford a new car. And despite what we hear on TV about cuts on Wall Street and Corporate America, these are the people who have really borne the brunt of the current economic slump. The stated unemployment rate of 10% probably doesn’t include these individuals—they are part of the additional 7% who have given up looking for work out of frustration. And amid their despair, they have not been buying cars—used or otherwise—and they have been deferring maintenance on their existing modes of transportation. That is until recently. Now, if we can believe this one data point, this strata of the workforce has either found some sort of work—permanent or temporary—or at least feels confident enough in the future to start laying out cash on their ride and its effects are being seen in the used car and parts business. We realize, of course, that there are alternative explanations to this phenomenon and we also understand that the sample size would make a statistician cringe. But we also know quite a bit about our guy and his business, which gives us confidence that what he is seeing is true evidence of the “green shoots” that Larry Kudlow has been talking about for months. The difference between our green shoots and Larry’s is that ours started much, much closer to the ground and, as a result, have deeper and stronger roots. That’s a gardener’s metaphor for our belief that, finally, the job market may indeed be turning and it is getting its start at the very bottom. If that’s true, then the ripple effects will eventually be felt all the way up the tree trunk. If so we may see the unemployment rate, finally and thankfully, head down and the market, ultimately, head higher.

Ramblings of a Portfolio Manager

2010-03-01T08:11:00.001-08:00

Why must the US Stock Market be a slave to the US Dollar?

Lately, one cannot help but turn on a business news channel and hear, at least a dozen times during the broadcast day, a report on the US Dollar Index (USDX) and its real-time impact on stock prices. More often than not we are presented with an intraday chart of the USDX versus the S&P 500, which explains with near perfect reliability why stocks have strengthened or weakened in the last few moments—always the inverse of the immediate movement of the dollar versus a basket of currencies. We hear and read about this relationship so often now that, in fact, that most newer market participants take it for granted that US equities must always be negatively correlated to the value of the US dollar versus other currencies, a fact that is certain to turn this relationship into a self-fulfilling prophecy for the short run. But does this need to be and has it been so in the past?

The USDX is an index of the value of the US Dollar versus the exchange rates of six major world currencies: the Euro, Japanese Yen, Canadian Dollar, British Pound, Swedish Krona and Swiss Franc. The index started in 1973 and was revised in 2000 with the creation of the Euro. It began with a base of 100 and all movements of the Dollar versus that basket of currencies is relative to this base, so a value of 125 would mean that the U.S. dollar increased in value by 25% since 1973. The index reached a high of over 120 in 2002 and since that time has been in a more or less steady decline. Over the last year the index has declined from a high around 88 during March 2009, at the height of Market fear when the dollar was sought as a safe haven, to a low of 74 in November of 2009. Since November, however, the index has rebounded to around 80 as hopes of a US interest rate rise, combined with a safe haven move on fears of a Greek default, have bid up the Dollar. Over this recent period the Dollar has indeed shown a nearly perfect negative correlation to US stock prices with a coefficient of -0.81 for 2009 and -1.0 (perfect negative relationship) for the last 12 months, meaning US stocks have moved almost in lock step with the dollar but in the opposite direction.

This correlation is atypical, however, and historically a strong dollar was seen as an indicator of a healthy and strong US stock market. A little history: From 1995 to 2000, both the Dollar and the US markets rallied, a positive correlation. From 2000 to 2002, the US markets suffered a big decline and so did the Dollar, also a positive correlation. From 2003 through 2004, however, the markets rallied while the Dollar lost, a negative correlation. In 2005, the Market was fairly flat and the Dollar rose while in 2006, the Market rallied and the Dollar lost. In 2007, the US Market gained but the Dollar suffered a big decline and in 2008, the Dollar initially lost ground while the Market rose slightly but then spiked late in the year when the financial crisis hit and the dollar became a safe haven while the Market sank. The results of this longer term analysis is that the USDX and US equity markets actually have a weak but positive correlation of about +0.35.

So why has the dollar been a strong negative driver of stock prices over the last 18 months? The answer has to do with the absolute level of interest rates in the US. With the drastic Fed easing cycle US rates are near zero and global investors seeking higher returns have been borrowing in dollars to invest in higher yielding instruments such as stocks and commodities--the so called carry trade--leading to a strong inverse relationship between the S&P 500 and the USDX. We’ve seen this pattern before and perhaps there is a history lesson there. In 2004 we also saw a large inverse relationship between the S&P and the Dollar with a correlation coefficient of -0.71. The Dollar Index fell 7% that year while the S&P gained 9%. Back then, as today, interest rates were extremely low during a Fed easing period that led to a Fed Funds target rate of 1%. At the end of the cycle, as the Fed began to raise rates on a strengthen economy, the relationship weakened and as the economy picked up the strength was enough to keep the stock market rising, even with a rising dollar. The current environment feels a lot like the end of 2003 and we suspect that, with Bernanke at the helm of the Fed, future rate rises will be measured enough to allow continued strong economic expansion in the face of rising rates. If that is the case, then history tells us that further gains for both the Dollar and US markets lie ahead.

Rambings of a Portfolio Manager

2010-02-22T11:12:00.000-08:00

Lesson’s from earnings season

Fourth quarter 2009 earnings reporting season is winding down and so far, with 84% of S&P 500 companies reporting, the results have been fairly impressive. According to Thomson Reuters, of the companies that have reported 72% have beaten earnings expectations, 10% met expectations and 18% missed. This result is much better than the historical average of 60% beating analyst’s estimates. Revenues, which have consistently underperformed expectations coming out of 2008’s massive decline, actually surpassed expectations with 71%of companies beating and 29% missing estimates (no revenue reports matched expectations but, of course, that’s somewhat spurious as companies manage to EPS but revenues are harder to manipulate). Earnings growth year-over-year was a whopping 212%, but that was off a very low, recessionary base. Still, for all of 2010, earnings are expected to rise 27% from 2009 levels. All of this positive news, however, was greeted in most cases by selling. Why?

As usual, Alcoa kicked off earnings season with its report, the first of the Dow components to do so. Expectations were high for the company, given what the stock and the price of its underlying commodity had done since the March lows. While Alcoa’s revenues beat expectations investors, however, were disappointed as Alcoa delivered weaker than expected earnings and guidance due to higher costs, something that has not been an issue for reporting companies since Q4 2008. This put the Market on edge and set the stage for a round of “sell on the news” reactions to all future earnings reports, both good and bad. If Alco set the stage, Intel’s report was the catalyst for this trend as the company’s much better than expected report and guidance was greeted with a 3% stock decline and after Intel, the stock of virtually every other reporting company suffered the same fate. Had the whisper numbers (i.e. expectations) gotten ahead of underlying fundamentals? Did the market come too far too fast, as many disgruntled bears claimed? Actually, we believe that some really bad timing on the calendar had much to do with the price action seen during the past reporting season. First, we are into a new year, meaning that funds with big profits in positions from the March lows were more willing to sell and book a taxable gain than they were at the end of last year. The fact that the Bush capital gains tax cuts are due to expire at the end of this year certainly exacerbated this behavior. Secondly, there was the Scott Brown election, the results of which we received two days before Intel reported. President Obama’s attack on the banks, launched the next day in response to that defeat in Massachusetts, put a market already nervous from Alcoa’s report further on edge and started new talk about a potential government-induced double dip recession. The final straw was China’s mandate to its major banks to curb lending, released concurrent with Obama’s speech, which further raised concerns of a double-dip based on a slowing China, if not a business unfriendly US government. Timing is everything and in late January we got a confluence of unfortunately bad news.

Frankly, we’re not concerned by the price action following recent earnings reports and view this as a temporary, short-term trend. Gains that were taken in January and early February are now booked and remaining holders seem to be comfortable waiting for long-term capital gains status. Already we see that the Market is pricing in the risks of China’s actions and Obama, perhaps in reaction to the polls, is looking very much like he is moving toward the center ala Bill Clinton. The combination of the above is probably the reason for the Market’s rally since February 8th. As earnings and economic data continue to come in better than expected, we see a moderation and reversal of the sell on the earnings news trend. If that’s the case, then the Market may be ready to continue its move higher over the next quarter.

Ramblings of a Portfolio Manager

2010-02-16T05:23:00.000-08:00

Let it Snow, Let it Snow, Let it Snow!

The US equity markets just completed their first positive week in five, a welcome relief to most investors but to the dismay of our TV repairman, who was Bentley shopping after we put a series of Diet Coke cans through the screen in vain assassination attempts on the” gurus” postulating that the market is selling off simply because we are 60-70% off the March lows, which we now need to retest according to their detailed analyses (assuming they are holding the chart correct side up). After a strong start followed by much volatility, the indexes are now slightly in positive territory for the month. The recent rally, which began Tuesday after the Dow closed below 10,000 for the first time since November, startled many market watchers who had no idea whence it emanated. Was it the prospect of a resolution to the Greek debt crisis? The strong US economic data hitting the tape daily? A benign CPI in China? Toyota finally recalling their Camry and Prius models? Yes. A more compelling argument, however, is that Washington was deep under two successive snow storms, which had the effect of suppressing any and all toxic rhetoric on the airwaves. No news is good news!

So where are we now? After our “well deserved” sell-off the major US equity averages are all down about 3% year to date. From their January 19th closing high to their February 8th closing low, most indexes lost about 8% or more. Only the Russell 2000 came close to the “classic correction” number of 10%, having fallen 9.7% between those dates. When one looks at the intraday highs and lows, however, the numbers are a little more drastic and in line with guru expectations, with the Russell correcting nearly 11%, the Dow and S&P dropping about 9% and the NASDAQ losing about 10%. So there you go! Correction meted out, weathered and now over, right? Frankly, in our opinion, this is all just number manipulation. Take the Shanghai Composite, for instance--that index was up over 90% from its November ’08 bottom yet it is down in line with US equity indexes during its “correction,” which began at the same time. Is that enough, too little or too much? Heck if we know. Stocks have no memory of their historical trading prices--just ask anyone who owned Cisco Systems or Nortel in 1999--and, collectively, these indexes are comprised of stocks. So, just as it is nonsense to preach the need for a correction after some random amount of upside from a bottom, it is irrational to suggest that any pre-determined percentage move to the downside during that correction is appropriate and to be expected.

We like to think like the fundamental portfolio managers we are and look at the indexes as individual securities, with financial performance expectations and multiples placed by the market on those expectations. Like a stock, the price of an index is determined by a multiple—e.g. price/earnings-- and that what the multiple is measuring—e.g. earnings, sales, book value and cash flow. For portfolio managers, the denominator--earnings, sales, book value, etc.--is fairly easy to calculate and even forecast. The numerator or Price, however, is what we all want to know so it is the multiple (of earnings, book value, etc.) that fundamental portfolio managers spend most of their time trying to solve.

In the case of the S&P 500, the current Price/Book Value multiple is 2.1x , the Price/Sales is 1.14 and the Price/Cash Flow is 10.0x. All of these are well below their pre-2008 10-year averages and near the lows hit over that same period. The Price/Earnings multiple on 12-month trailing earnings is 18.1x, near the high for the pre-2008 decade, but it is only 14.2x on forward (2010) expected earnings, at the lower end seen during that same period. What’s going on? Market multiples are all about sentiment and sentiment is based on expectations of growth. The higher the expected growth (in earnings, book value, etc.), the more the Market is willing to pay for the future in today’s dollars and, thus, the higher the P/E, P/B, etc. In 2009 S&P earnings per share dropped to $68.6, and for 2010 they are expected to be about $75.8, a level last seen at the end of 2005, when the index was trading over 200 points (19%) higher than it is now. The Market, always looking ahead, is willing to pay a higher multiple on what it perceives as “trough” earnings in 2009, expecting higher growth in 2010 and beyond, yet the S&P is not even at the multiples or level where it began 2005. Why not?

In 2011 S&P 500 companies are projected to earn $87.6 per share, roughly equal to what they earned in 2006, their highest level ever. The index at that time was trading over 350 points higher than today. Obviously, the Market saw something in2005- 2006 that gave it more reason to be optimistic and assign higher multiples than it is now. Was it higher expected near-term earnings growth? Not if you believe 2011 numbers. Was it a lower interest rate environment than we have now? Doubtful, given that we are at zero for the foreseeable future and even a series of rate hikes wouldn’t get us to where we were in 2005 or 2006. So why was the Market willing to pay more then for the future than today? There are multiple (pun intended) factors. To be sure there is the uncertainty discount that the current administration carries with it. Whatever history thinks of Bush/Greenspan the truth is that they were seen then as infinitely more business friendly than Obama/Bernanke are now. Then there is the fear factor, carried over from the near meltdown of 2008, which we did not have in 2005 and which recent sovereign events have rekindled. Like someone who has jumped into an icy pool once, investors will be slow to renter the same water as quickly the second time around. Also to be considered is the diminution of the Pax Americana premium, something that will continue as sovereign entities like China and the EU (don’t laugh!) assert their ascendancy in the world. Finally, there is the enormous debt that the Obama administration is piling on, raising the risk level of the US economy vis-à-vis its competitors. This last one is ironic as the Market is almost always willing to pay more for unlevered vs. levered companies due to their lower risk, yet as the Obama administration swaps private debt for public the Market is ascribing the same, if not higher, level of risk to the now less-levered companies in the S&P as it did before—all due to the leveraging up of the US government.

For stocks to go higher in the near term we will need multiple expansion and for that to occur some of the above concerns need to be alleviated in investors’ minds. We believe that the fear factor will dissipate over time and that the American premium will wax and wane with our perceived relative position in the world. The risk discount from the current administration and government borrowing, however, can only diminish if we get perceived stability and fiscal control out of Washington. The Bush administration spent like drunken sailors and Obama, despite his proclivity to blame everything on that policy, is only ramping it up. Perhaps, if we are lucky, the mid-term elections will do more than reduce the power of the anti-business lobby—hopefully, voters will send a message that they have learned their lesson with debt and now it’s Congress’ turn to learn as well. If that happens, then S&P 1400 and Dow 14000 will not be far away.

Ramblings of a Portfolio Manager 2-8-2010

2010-02-08T11:41:00.000-08:00

Bulls Bears & PIGS

The old saying on Wall Street goes bulls and bears will always make money but pigs will get slaughtered. The “pigs” in this little proverb refers the living, sty-resident type and is meant to represent greedy investors, who never succeed by being “hoggish.” The soothe-sayers of old who came up with the adage certainly could not have envisioned that one day the modern day PIGS, Portugal, Ireland, Greece and Spain, would make it a truism. After a dismal market month in January, February’s strong start was abruptly halted by the twin specters of continued debt trouble in Greece and, by extension, Spain.

To put things in perspective, Greece is a country of 11 million people and represents approximately 2% of the combined GDP of the EU. New York City, with a GDP 3x larger, could kick its butt in a rumble. Spain, on the other hand, has a GDP slightly larger than NYC, approaching that of California, with a population of 45 million, slightly less than California and New York City combined. A Sovereign default by Spain would certainly cause a big ripple across the world financial markets and the fear of the Greek contagion spreading to the other PIGS is what rocked world markets last week. By comparison, the tiny Emirate of Dubai, which caused a minor tempest in the markets last fall, is about 13% the size of Greece in GDP.

The possibility of a default by Greece cannot be dismissed. Greece’s total debt stands at over 120% of GDP as compared to California’s indebtedness at 7% and unlike the UAE, EU charter prevents member countries from coming to neighboring states’ financial aid. Any rescue of Greece would have to come from the EU as a whole, possibly in the form of a bond offering, the proceeds of which would be shared with Greece. So far, EU ministers have rejected the prospect of a bailout, as has China, now the World’s lender of last resort. But as we pointed out, Greece is very small and so that begs the question how would Greece bring down Spain? According to the Bank for International Settlements, the majority of Greek Sovereign and private debt is held by French, Swiss and German banks. So a Greek default wouldn’t necessarily harm financial institutions in Spain, however much of the same macroeconomic woes that afflict Greece are also hitting Spain, who’s debt load as a percentage of GDP is a also high, at 66%, and who’s budget deficit is comparable at 9.7% versus 13% in Greece. The sentiment is that if it could happen to one Mediterranean state, it could happen to others (including Portugal) and that fear is hanging over the Spanish currency and thus its bond market, causing the Government to cancel a planned note offering last week.

So is this the buying opportunity that retail investors have been waiting for since the March 6th bottom? Perhaps a lesson from history is in order. The Arab oil embargo of the mid 70’s led to the Latin American debt crisis of ’75-’82, when many countries could not pay the high debt incurred from years of fruitless infrastructure projects. While that crisis played itself out, the US equity markets experienced the “lost decade” of little or no progression. To be sure, much of that lost decade can be attributed to problems at home, also caused by the oil shock, but the LatAm crisis certainly played out on the equities of large US multinational banks and fears of Sovereign default weighed on the US equity markets at the end of the decade. With the resolution of the crisis in 1982, however, the US equity markets staged a stunning decade-long rally although some of that rally could be attributed to the election of Ronald Regan as US President and his subsequent implementation of supply side economics. A more recent and closer analogy is the “Asian Contagion” of 1997, which began with the collapse of the Thai Baht and the subsequent inability of that country to meet its debt obligations. The contagion spread across other South East Asian countries, many of which had Debt/GDP ratios over 100%, as their currencies and stock markets became significantly devalued by global fear. The crisis was eventually resolved by the IMF, which created a series of rescue packages (bailouts) to enable the affected countries to avoid default, tying the aid to promises of drastic economic reforms at the recipient countries. During that contagion the US equity market at first took a dive in mid-1998 but soon recovered and the S&P 500 ended the year up nearly 30%.

In our opinion PIGS issue will eventually be resolved by the coordinated efforts of the EU with some IMF and foreign assistance but that while it works its way through the markets will remain volatile. We are reminded that for half of its time as a Sovereign entity (200 years) Greece has been in default on its debt. So what we are witnessing here has been seen before. Ultimately, we believe that this will present an excellent opportunity to get back into the equity markets and look for the resolution as the catalyst.

Ramblings of a Portfolio Manager

2010-02-01T06:47:00.000-08:00

Stock Ideas from Punxsutawney Phil

Well, so far it seems we got it half right. Earlier this year we posited that good economic data would be taken by the market as negative and that bad news would be taken as good--as this information would signal the timing of the Fed’s pending rate hike--but that individual stocks would trade based on earnings surprises and guidance. Everything is just going down on good news now. There hasn’t been a great deal of bad news in either earnings or economic data but (and this may all be due to timing) for stocks and the market as a whole, bad news seems to be greeted with better price action than good news. Like the Groundhog, investors are running from their own shadows and using positive data as the opportunity to sell.

Is this the long-awaited correction and if so how long and deep will it be? The Dow and S&P are now off more than 6% from their January 19th highs while the NASDAQ and Russell 2000 are down over 7% from their peaks of the same day. That’s a lot of carnage for 8 trading days. According to S&P data the average post-war correction is about 8.5% and lasts 45 days so in magnitude, but not duration, we’re getting close to the long term average pullback. A couple of more days like last week’s and we’ll be there. However, to answer the question on everyone’s lips—if and when to buy or sell--we need to ascertain why stocks are selling off. Certainly some of the price action in individual stocks is “sell on the news” reaction, particularly in technology, which had a great run last year and is thus already discounting a fair amount of good results. And then there is the “noise factor,” which we discussed last week. Some of that noise, such as Bernanke’s renomination and the President’s State of the Union message, is already out of the way and probably discounted. Others, like China’s fate and populist attacks on financial institutions, are still being debated and digested. Noise that we neglected to mention is now coming from technicians who have all sorts of pins in their voodoo dolls in the form of points on the charts at which things are going to either bottom, rebound or fall further. Finally, there is the ever-present fear of a double-dip recession, something the President’s level of noise only serves to amplify. Taking all of the above together, investors would rather just take their dice and go play elsewhere.

Assuming we’re right on the above and that it captures the bulk of the motivation behind the recent sell-off, then we see nothing in it that is based on earnings fundamentals, which, over the long run, are what drives stock prices. The wild card is the last point on the rhetoric coming out of Capitol Hill. Will the anti-business populist sentiment be enough to jawbone us back into recession? On this point we think not for the simple reason than nothing coming out of Washington has changed in tone since the new administration moved in. Was it really a surprise to anyone that Obama would propose anti-Wall Street initiatives? If anything, what is surprising is the level to which even his own confidants disagree with him on that point. So we think businesses are already expecting the worst from DC and at some point will most likely just discount the new pap and move ahead. That being the case, at some point one should one buy, but when? The answer to this is why the technicians are now getting some attention.

When markets are moving on noise and sentiment rather than fundamentals it’s very difficult to pick buy and sell points, which is why investors often turn to charts. Retail brokers often use the acronym DEAD, or Don’t Ever Average Down a strategy with which we don’t always agree. Given the rapidity of the sell-off and the spike in the VIX we have just seen, there is still a good deal of fear in the market so plunging in headfirst probably isn’t the best strategy. We would suggest focusing on companies with good near to intermediate-term fundamentals and slowly accumulating positions over the next month as things sort themselves out. Technology is probably a good place to start after the drubbing it has received in the face of positive information. Non-bank financials are also a good place to look. We don’t agree with the run-up in regional banks on the woes of the multinationals as we expect the yield curve to flatten this year in a rising rate environment. Energy stocks also look interesting to us since they did not keep pace with the prices of the underlying commodities last year yet have sold off along with energy prices this year. In our opinion the groundhog approach taken by institutions over the last two weeks has presented investors who have avoided chasing the market over the last 8 months a good chance to get invested at better prices. Happy Groundhog Day!

Even the Grinch Got Used to Pantookas and Wuzzles

2010-01-25T05:15:00.000-08:00

Ramblings of a Portfolio Manager or Even the Grinch Got Used to Pantookas and Wuzzles

What a week in the equity markets. The market took the triple onslaughts of Chinese monetary policy tightening, Scott Brown’s upsetting (to Democrats) victory, which produced the opposite of the expected effect by spurring Obama’s attempted face-saving attack in the form of plans to dismantle our world-leading financial system and a slew of rats, er Congressmen fleeing the sinking ship of State by backing away from the President by rejecting his preference for the reappointment of Federal Reserve Chairman, Ben Bernanke. As for the later case, when rats flee a sinking ship it is to save their own skins and they typically jump overboard rather than chewing a hole in the hull, hastening the demise of the doomed vessel. But Congressman, like rats it seems, cant read or understand spoken English and our boys on the hill are chewing big holes by ignoring the effect their defection from support of Bernanke would have on our already weakened economy and financial system and, by derivative, the equity markets. But at least they can comfort constituents on Main Street with “I didn’t support that guy who single-handedly brought down our financial system…Oh, so sorry your 401(k) is down 20% as a result.” At least our rats have their own safety net for the capsizing they will cause. Too bad for their constituents. Anyhow, the result of the Trifecta of bad news was the worst three day period in the markets since last February, a time when it wasn’t clear whether or not the Country was going into another great depression. The S&P 500 ended down 3.9% on the week and is now down 2.02% for the month while the Dow dropped 5.2% (552 points), ending down 2.45% for the year, and the Russell 2000 lost 4.53% ending down 1.29% for the year. Thanks, fellas, for working hard for the unemployed and looking out for the savings of the still employed.

Reality check. Is there reason to be concerned over the news and results last week? Is this the long-expected market correction? Our answer is no and no. First of all, everything that happened last week was the result of ever lurking but always surprising headline risk. Occasionally, politicians will say or do something dumb (maybe more than occasionally lately) and the markets extrapolate that information into a virtually certainty and immediately discount the expected results. That’s what markets do, but it doesn’t mean they are always accurate in their predictive power. In any market there is what is called “noise,” which is information that is market moving but non-impactful to underlying long-term fundamentals, and there are long-term policy or structural economic shifts, which are. We put last week solidly into the noise category.

Noise #1, China: funny how all the cynics who claim China is falsely inflating their economic numbers jumped on board with “told you so” when the Central Government tapped on the economic brakes last week. Let’s get this straight—the Chinese are purposely faking monetary contraction to lend credence to their faked economic expansion? Uh huh. Believe it or not, many of the Chinese Central Bankers were educated in Western Capitalist running dog business schools, studying past Fed actions, and understand the value of signaling. That is, it’s not so important what the “Fed” does as what it says in accomplishing its goals. We believe last week’s news release that the Chinese told banks to stop lending for the rest of month was more signaling than fact but, in any case, let’s put it in perspective—will two weeks (that’s all it is—not a permanent change) of reduced credit really derail the expansion of the worlds’ largest population? We don’t think so. Remember, our thesis is that the Central Government has 1.3 billion angry peasants to please. Putting the economy into decline is not going to cause them to put down their pitch forks and torches.

Noise #2, Banking reform: Even Geithner and Frank were surprised by the President’s announcement and subsequently tried to tone it down. In the former case, Turbo Tax Tim may be shown the door but Barney Frank is notoriously difficult to remove. Even that radical Congressman publicly declared the proposal too drastic and sought for a 3-5 year transition period, if the bill ever passes. We think the whole proposal dies an ignominious death either when we get a goodly portion of the democrats out of our Congress in November.or even earlier, when the incumbents get smart enough to realize that a consistent message of scapegoating does nothing for getting their constituents jobs and them votes.

Noise #3, Bernanke. This is a little more disturbing than the previous two as it is based on the unpredicability of panicky politicians. As Warren Buffet said, “let me know if Bernanke isn’t going to get reappointed so I can sell stocks.” We agree with him wholeheartedly. Blaming the prior administration for the current ills is a favorite tactic on Capital Hill and Bernanke is the scapegoat du jour, especially among Senators wishing to distance themselves from the flailing President. In point of fact, even if he is not reconfirmed, Bernanke will still sit on and control the FOMC, which sets rate policy decisions, so we will still have his wisdom and education to guide rate policy, but a weakened Fed is one without great credibility on Wall Street, which is not good. We believe that, ultimately, sanity will prevail and Bernanke will be reappointed (or for no other reason than they don’t have a viable alternative), but it will prove to be a volatile week ahead as rumors, sound bites and polls pollute the airways.

Bottom line: We think the 5% correction we just had is healthy and about as much to expect from the latest round of headlines. Volatility may remain elevated for a time but, ultimately, the markets will continue to grind higher as pending Congressional gridlock draws nearer and companies continue to report stronger than expected earnings.

Ramblings of a Portfolio Manager 1-19-2010

2010-01-19T04:41:00.000-08:00

Hey Lloyd, will you autograph the dashboard of my Chrysler Sebring?

Einstein defined insanity as doing the same thing over and over expecting different results. If that former Nobel Laureate is correct, then a certain recent prize recipient may be overdue for a Rorschach and rubber room. One would think that, having witnessed the greatest slide in fist year/first-term popularity in history, our President might logically conclude that the public was tiring of punish the rich populist rhetoric, craving instead real solutions for the Nation’s stubbornly high unemployment rate, and modify his message. But dot connecting is a skill absent in Washington, DC these days and the White House response to news of an additional 85,000 jobs lost and a stated unemployment rate hovering around 10% (the true rate, which includes workers who have given up looking for a job, is estimated to be 17%) was the same old anger and outrage aimed at those fat cat bankers who, we are told, caused it all.
Last week’s anti-Wall Street message came in the form of a tax, er “Financial Crisis Responsibility Fee,” on large banks with more than $50 billion in assets (10 banks will bear 60% of the burden). The 10-year, $90 billion program is purported to pay back losses incurred under the TARP but it was introduced with the usual anti-wealth creation rhetoric, making its true intent suspect. Nothing about how this “fee” is going to spur loan growth or job creation. Also ignored was the fact that the big banks have all paid back all their TARP loans with interest (Accounting 101 tells us that means they incurred no losses), something the Union-controlled General Motors and Government –controlled Fannie Mae and Freddie Mac—all exempt from the fee--haven’t done. And no word on the vig Barney Frank and Chris Dodd will be assessed for their responsibility in the financial crisis. By week-end the populist harangue hit its latest zenith with Obama’s deal to exempt only union members from the “Cadillac Health Plan Tax” and a Democratic Michigan Representative’s pledge of support for the new bank fees because “Wall Street is solely responsible for all of Detroit’s woes.” Dang, we had forgotten that Goldman Sachs and Lehman Brothers were the saboteurs of the Pacer, Gremlin, Pinto and the remaining long list of Motown masterpieces. Anyhow, amidst all this political noise, its small wonder that the markets ended the week on a sour note.
That’s the “rambling” part. The real subject this week is interest rates. Since at least September the markets have been obsessed with the timing and magnitude of the Federal Reserve’s expected withdrawal of liquidity from the financial system. A key feature of the tapping on the brakes process will be a hike in short term rates—either the fed funds rate, the discount rate or both. The conventional wisdom is that higher rates are bad for the economy as they increase the cost of borrowing, reducing demand for loans while increasing the cost of doing business for virtually all companies, and they typically strengthen the dollar, slowing exports. We can’t argue with this economic theory and, of course, the whole point of a rate hike is indeed to slow down the economy. However, because we are in a political as well as economic Bizzaro Land these days, things don’t always follow the old playbooks. In fact, we posit that a hike in rates, at least in the initial phases, would be good for both the economy and equity markets. How so? To begin with, banks are currently dis-incentivized to lend. The ability to borrow at the Fed’s Discount Window at an effective rate of zero combined with the Government mandates to improve credit quality has motivated bankers to simply play the yield curve for profits. With long-term Treasuries yielding nearly 4% banks can earn a net interest spread comparable to the good old days with no default risk--so why make loans? A small hike in short-term borrowing costs to the banks, if it flattens the yield curve as it generally does, would give them more incentive to take risks in search of returns—i.e. make loans. Since the real problem now is the supply of lending, rather than demand, easier credit at this stage in the economic cycle would likely more than offset the braking effects of a small rise in short term rates.
What about the equity markets? It’s doubtful that the potential benefits to lending of higher rates would be immediately obvious to equity investors, however, since the markets are already discounting a long series of rate increases by the Fed beginning sometime this year (although that date is getting pushed out) the first rate hike, if it is small as expected (say 25bps) and accompanied by the proper “signaling” by the Fed would most likely spark a relief rally. After that, further fuel could come from the fact that retail investor money has been flowing out of equities and into fixed income investments for the last 16 months. A bump up in short term rates will knock down the value of short-term debt instruments, which might just be sufficient to scare that money out of the “safety” of T-bills and Treasuries and back into the equity markets. That’s a move, by the way, that could cause a virtuous cycle for some time as fixed income redemptions further depress the price of those securities while the flow into equities drives up stock prices, attracting more investment.
Of course, for the above scenarios to materialize, the Fed must properly signal its intent—e.g. “3 and done.” An open-ended series of rate hikes will eventually scare investors out of both asset classes (as well as real estate) and overshoot in their braking intent. As a student of the Great Depression, Bernanke is well aware of this. We just hope that the bout of insanity on Capitol Hill is temporary and that Congress will reappoint the Fed Chairman and start making noise about jobs rather than social engineering.

Ramblings of a Portfolio Manager 1-11-2010

2010-01-11T00:01:00.000-08:00

Fair is Foul and Foul is Fair
--Macbeth

The old saying on Wall Street is “as goes January so goes the year.” It’s a quaint little scrap of urban legend that suggests the first week of trading in the stock market—the Dow Jones Industrial Average—foreshadows the remainder of the year. Over the years stock traders, ever an impatient lot, have further distilled the adage into “as goes the first week of January, so goes January” thus avoiding the wait until the 31st to make their asset allocation decisions. Not to be outdone other, equally superstitious, traders have added the Super Bowl Indicator, which suggests a correlation between the winner of the big game and the performance of the equity markets (Dow) in that calendar year (old NFL team wins are good, former AFL team victories are bad). While both myths are good for a chuckle, there is a surprising correlation between them and Dow performance. The Superbowl Indicator has a better than 88% accuracy rate over its life while the so-called January Barometer has demonstrated predictive power 73% of the time when the indicator points up. It’s all spurious, of course, but it gives the tooth fairy believers among us in the markets something to which to look forward during the bleak winter weeks. But we digress.

The US equity markets got a good start to the new year last week. The Dow rose 1.82% while the S&P 500 gained 2.74% and the Russell 2000 Index of small cap stocks bested them all at +3.08%, giving believers in the January Barometer something to cheer. What was remarkable to some, however, is that these gains came amid the release of mixed to weak economic data: Construction Spending kicked off the week coming in slightly worse than expected, down 0.6%, followed by the ISM Index, which was slightly better at 1.1% vs. a forecast of 0.5%. Pending Home Sales were a disaster, down 16% vs. a +2.0% forecast but the 800 lb. gorilla broke the scales on Friday when Nonfarm Payrolls were reported at -85,000 vs. a forecast of flat and some market expectations of a rise. While most of the market gains occurred on Monday, the first trading day of the year, the markets failed to give it back during the rest of the week and actually tacked on slight gains over the remaining trading days even in the face of the weak economic news, especially on Friday. To the market skeptics this behavior was absurd; to us it was predictable.

Market bears have decried the rally since it began on March 9th and they’ve thrown every known investment cliché at it—from “too far too fast” to “not supported by fundamentals” to a cornucopia of chart-speak we don’t understand so will not quote here. Having failed to receive their expected revisit of the Dow to the 6000 region, these same skeptics are now calling for the end to come when the Federal Reserve begins to withdraw liquidity and hike rates, which was expected to occur later this year. Here we cannot disagree with them. While we believe much of the markets’ rise since March has been the result of them doing their job as discounting mechanisms, anticipating the economic rebound we are now seeing, much still has been liquidity-driven. An effective short-term interest rate of zero has made the equity markets look “cheap” in many investment models--not to mention what that implied yield curve has done to bank earnings--and the result has been as remarkable as it has been predictable. Anyone who doubts the rate effect on the markets need only look at the inverse correlation between the dollar and markets over the last year or, more recently, the sideways action of equities amid the increasing belief that the Fed will begin to raise rates sometime in mid-2010. In fact, we were prepared, earlier this week, to call this piece “Sell in May and Go Away,” suggesting that if most market participants expected a June-July rate hike, then the time to get out of equities would be months earlier. Friday changed all that. The weak jobs numbers, we believe, have pushed out market expectations of a rate rise to later in the year. Before the report PIMCO’s Bill Gross was calling for no rate hike at all this year and few believed him—now, many do.

So what do we expect now, as we head into earnings season? Perversely, we believe that for individual equities, bad news will continue be seen as negative and good news good, while for the equity markets as a whole, bad news—in the form of weak economic data--will be positive overall as it will push further out the expected date the Fed will have to take back the proverbial “punch bowl.” Add on top the cynical optimists (like us) who believe that continued weak jobs data will spur the White House into releasing more Fiscal stimulus programs ahead of the mid-term elections and you have a recipe for continued market gains amid lackluster economic reports. Last week we poked fun at investment managers who call each year for a “market of stocks” versus a “stock market” but for the upcoming quarter, at least, that just might be what we will see.

Ramblings of a Portfolio Manager 1-4-2009

2010-01-04T05:16:00.000-08:00

Will China Do it Again?

It’s just about axiomatic on Wall Street that the top-performing market, sector, or asset class from one year seldom retains that title over the course of the next twelve months. Notwithstanding the marketing materials from the momentum or “trend is your friend” style of investing crowd, our research shows the old adage largely holds true when one looks within a particular geographic market. Here in the US one needs only to look at the tech bubble and subsequent wreck of 1999-2000, the real estate and financial services boom and bust of 1989- 1990 and more recently 2006-2007, and the commodities run over 2007-2008. There are many more examples and they all share the same basic life cycle: a catalyst—e.g. interest rates, currency exchange rates, disruptive product innovation, mania, etc., which starts the performance trend--a reaction, which is generally a big run up in prices during the latter stage of which the term “this time it’s different” is often heard--followed by an inhibitor –Central Bank actions, aging product life cycle, valuation concerns, someone standing up and yelling “hey, he’s just a big cockroach” (as in the old Far Side cartoon), which cools the trend or pricks the bubble as it were.

There has been much hand wringing over China, its stock market and economy of late. Many of the pessimistic charges levied against the US market and economy have similarly been aimed at China, often by the same cynics. The Chinese Shanghai Composite index rose over 75% in 2009 and Chinese GDP grew at a rate somewhere north of 8% according to most economists. The GDP growth rate compares to 11.4% and 9.6% in 2007 and 2008. The term “too far too fast” is beginning to be applied to the Chinese stock market while “bubble economy” or “stimulus dependent” are phrases one often hears regarding the Country’s economy. Sound familiar? Of course there is the whole cadre (that’s what Mao would have called them just prior to having them shot) who simply claim that China fakes the economic numbers and that the entire market run-up is a sham.

We can’t argue with the fact that the trend in China’s GDP is for slower growth each year—even we agree with the proverb that “trees don’t grow to the sky” and eventually the law of large numbers takes over—but we take issue with the fact that China is in a falsified or stimulus-induced bubble destined to soon burst. As with the US, government actions are indeed driving the economy in the short term. The 4.0 billion Yuan stimulus package passed by the Chinese Central Government last year is most certainly behind the Country’s impressive growth rate amid a slumping world economy. The State controlled banks kicked off the growth with a lending spree that produced a 30% jump in the Chinese money supply (M2) and this was followed by the spending package aimed mostly at infrastructure projects in the Country. Like the US, together these monetary and fiscal moves have been the catalysts that produced the desired jump-start effect to GDP growth and the stock market has followed. Unlike the US, however, we see no reason for the Chinese Central Government to yank the punch bowl any time soon, either through higher interest rates, spending reduction or higher taxes.

As we write this the Shanghai index has gotten of to a rocky start to 2010 on fears that the Government will cut stimulus spending and remove liquidity earlier than previously expected, cooling growth. Again, sound familiar? At last count there were something like 1.3 billion Chinese living in China. Metaphorically, that is certainly enough that if they all jumped off a chair at the same time, the Earth would indeed move—which means practically that they wield significant “weight” in the World economy. The nominal per-capita GDP of these masses (about $3200 n 2008 according to the World Bank) places them in the lower middle class by world standards yet collectively they comprise the World’s second largest economy after our own. It’s human nature that #2 seeks to emulate or surpass #1 which means all these Chinese want the same or better standard of living that we have—cell phones, cars, televisions, 17 flavors of potato chips, etc--.and that they have a long way to go to get it. And even though they don’t have the same voting or freedom of speech rights as we, they are quicker to carry pitchforks and torches when they don’t get what they want. The Chinese Government, in our opinion, has 1.3 billion reasons not to take its foot off the accelerator anytime soon and unlike the US, with no massive debt balance to cause them concern over spending or contemplate raising taxes to pay for it all, they have the flexibility to keep that foot down. In addition, China is keeping the value of it’s the Yuan pegged to the US dollar at very low levels with no incentive to raise the exchange rate ( due to all the money we owe them—they ain’t stupid, you know). With the greenback depreciating at a record pace over the last year, the trade-weighted value of Yuan is also declining, making Chinese goods cheaper to recovering consumers worldwide. That will spur exports, driving manufacturing and in turn keeping the economic engine running when liquidity is eventually withdrawn. As the Chinese economy begins to demonstrate that it can grow on its own two feet, we expect that its stock market will follow in lock-step. So even the Shanghai was fine in 2009, we can see it do it all again in 2010.

Ramblings of a Portfolio Manager 12-28-2009

2009-12-28T05:18:00.000-08:00

Ramblings of a Portfolio Manager, Predictions for a New Year.

“Daddy, what’s a stock?” was the question from my six year-old the other day. As the son of a portfolio manager he needed to know even if his eyes blurred and wandered toward the TV set showing Sponge Bob during the excessively lengthy answer. After he had returned to the travails of Squidward and Patrick, I got to thinking how I might have answered the same question had he asked it 20 years hence. In a similar vein, would I have even been mad at him if he were 20 years older and asked the same question now?

There used to be an urban legend on Wall Street that there were more mutual funds than common stocks traded on US exchanges. According to the Investment Company Institute, however, there were 8,022 open-ended mutual funds as of the end of 2008 compared to approximately 9,800 common stocks (our count excluding closed-end funds) traded on the NYSE, AMEX, NASDAQ, OTCBB and Pink Sheets combined. As you can see that the old saw was indeed just legend…but it was close. Wall Street, branded as a horde of greed heads and “fat cats” by our loving government, is, in reality, just a big marketing machine. We now have mutual funds that seek to emulate just about any asset class, market, strategy, sector, industry, philosophy, stock price or you-name-it sub-segment of an asset class you can imagine. And the list is growing.

Each year at this time we hear from a raft of portfolio managers calling out their investment predictions for the upcoming year. By and large, these predictions are self-serving—bond managers tell us that fixed income will outperform, equity managers tell us that stocks will be the place to be, etc. The prediction that always tickles us is the annual forecast by equity managers that “next year will be a stock picker’s market,” meaning that active managers will outperform the passive market indices. We hear that one every year. Our favorite is the catch phrase “it will be a market of stocks rather than a stock market.” Dang if we know what that means, but we do observe that every year, equity managers as a collective group underperform the major market indexes. The reason for this phenomenon is well known and simple: fees, commissions and trading friction from cash flows create a huge hurdle for the individual manager targeting a market index and, collectively, equity managers are the market. So the result is easy to predict.

In the “if you can’t beat them seek to emulate them” approach, Wall Street has created a whole new class of investment vehicles, Exchange Traded Funds (ETFs), to address some of the shortcomings of mutual funds but further complicating investors’ choices. ETFs trade as individual listed securities and seek to do what sector or asset-class specific mutual funds do but with lower cost, fewer capital gains, better tracking and simpler investing. At last count there were approximately 925 ETFs traded on US exchanges and the number is growing so if you combine them with mutual funds, indeed there just about as many “funds” as there are common stocks. There are now ETFs which track equity indices at 1x, 2x or 3x the returns of the underlying index. There are ETFs which track fixed income, real estate and just about every other asset class and sub-seqment thereof. Just to keep things interesting there are now mutual funds of ETFs (we can’t envision why someone would pay a manager for that service). Recently, we witnessed the launch of several faith-based ETFs: the FaithShares Islamic, Catholic, Christian and Methodist ETFs. Arriving soon is the Lutheran ETF. The purpose of these is to allow investment in only companies with “values consistent with the targeted religion.” For the life of us we can’t fathom how the structure of the underlying portfolios of the last four will differ. As of this writing they all hold shares of Nike, a company who’s principal spokesman hardly lives up to the Christian ideal of family values. Perhaps the Lutheran ETF will distinguish itself by purchasing the old Davy and Goliath film library and selling it to Bill Gates at a profit…

With such choices, does anyone buy individual stocks anymore? It’s clear that Wall Street, despite last year’s setback and the stream of rancor emanating from the White House, hasn’t died as a marketing powerhouse but in our opinion the product innovation is starting to get excessive. Carrying the trend to its logical extreme conclusion, one can envision a market where the only trading in individual company stocks is the result of rebalancing among the passive indexes, ETFs and sector/asset-class specific funds. Such a scenario is admittedly extreme but at the margin declining interest in individual stocks isn’t good for both Wall Street and companies trying to raise capital in the equity markets—and ultimately bad for Main Street. So here’s our not-so-self-serving prediction for next year: The equity markets will rise, active managers will once again underperform the major market indices, more ETFs will be launched and more will be closed. Here’s our self-serving prediction: good managers will continue to outperform the indices, investors will grow to realize that they can’t yell at an ETF for losing them money and that ETFs don’t buy them lunch, give them tax and investing advice or hold their hands during rough markets. ETFs will prove themselves to be high maintenance (one still has to research and track them) so for individuals without too much time on their hands, choosing a good manager will be more rewarding than locating an fund that tracks their individual tastes, religion or political affiliation.

Happy New Year to All!

Ramblings of a Portfolio Manager 12-21-2009

2009-12-21T03:32:00.000-08:00

Ross Perot Had the Hoover in Reverse

As another quarter of corporate earnings reports winds down with another poised to ramp up, we anecdotally observe that Corporate America is beginning to sound like a broken record. Companies, on average, met or exceeded Wall Street’s earnings expectations last quarter but, once again, their “success” was largely due to cost containment with tepid sales growth. This marks the 4th consecutive quarter of the trend and Management conference call commentary of “cautious optimism” does not portend any change over the near term, auguring poorly for job growth. Despite the Obama Administration’s collective self back-patting after the November Jobs Report, which showed that companies “only” eliminated another 11,000 jobs and that the employment rate actually fell to “only” 10% (largely due to discouraged workers who stopped looking for jobs), the reality is that Corporate America is just not yet ready to begin hiring. If the financial crisis is well in the rear view mirror, why are managers acting so cautiously? Typically, in past recessions the faster and harder the economy has fallen, the quicker and steeper has been the snap-back. That isn’t happening this time around.

Rep. Paul Ryan (R., WI.), ranking Republican member of the House Budget Committee, was on CNBC last week echoing what many business people feel but have been too cowed by fear of special interest groups and other zealots to admit publicly—that Capital Hill policies and rhetoric are creating uncertainty, which is holding back business growth. Now, as a member of the minority party, Ryan may have an agenda but analyzing the Gestalt of Management Discussion and Analyses over the last year, we also read that the triple uncertainties of pending Health Care Reform legislation, continuing government spending, and the tax hikes needed to pay for it all, along with an overt and omnipresent hostility toward Wall Street and Corporate “Fat Cats” (you know, the people who create businesses, jobs and, thus [gasp!] wealth), have fostered reluctance among companies to invest in productive capital, both physical and human. Like any good forecasters, US managers base their hiring and capital spending budgets on a set of assumptions and if we and Ryan are correct lack of business confidence, due to the dour noises coming out of Washington, is muting those assumptions. Lower confidence in the future leads to lower economic forecasts by managers, reducing spending on personnel and equipment, which, in turn, retards economic growth and so on.

How do we break the vicious cycle of pessimism rife in American business? The answer is fairly simple and it doesn’t even involve a shift in Administration policy: Washington needs to cut the rhetoric, get to work and end the uncertainty. As we write this the Senate is rushing to vote on Obama’s Health Care Reform bill before Christmas. The cynic in us says the hurry is to achieve passage while America is otherwise focused with little time to review the details—as it was with the Economic Recovery and Reinvestment Act—but the pragmatist tells us it’s to allow for reconciliation with the House version in time for the President’s State of the Union Address in January, allowing him to declare a “victory” to the Nation. OK, maybe that’s cynical as well but whatever the reason we just hope for a conclusion, no matter the outcome—and the same for Cap and Trade. Just as a condemned man finds inner peace right before the lever is pulled US managers will have confidence that their assumptions are no longer subject to radical change with the lifting of the political cloud. Furthermore, if the Obama Administration’s contention that Health Care Reform and Cap and Trade are job creators is correct, that fact will eventually find its way into higher corporate forecasts; if not, then the 2010 mid-term elections will doubtless give us “gridlock” in Washington, which will also lead to higher corporate forecasts. Either way, managers will have greater confidence in those forecasts and that’s a good thing for the economy.
Although we don’t share the Obama Administration’s enthusiasm over the November Jobs Report we did see one silver lining: More than 50,000 temporary workers were hired--the first surge in months--and employees worked more hours, raising the average weekly wage by nearly two-thirds of a percentage point in a single month, to $622. This signals to us that worker productivity has improved to the point where companies can no longer extract more work from their existing workforce and to grow further they must add employees—but right now they are taking the conservative approach and hiring temporary workers. This is a crucial inflection point in the economy and if Washington can get its act together, giving companies the confidence and outlook for stability they require, then we just may get a “giant sucking sound” in the labor market…but in this case it would be from the ranks of the American unemployed into the ranks of the American employed.
We’ve had a two-week run of losers in our weekly stock focus. We remind readers that ideas highlighted are stocks in the portfolio that we think may have reason to outperform in the upcoming week. Some times that reason fails to materialize and we exit those positions before the week is over. So it was with Zale Corp, which we sold after speaking with Management following its terrible same store sales report, fortunately before it fell further over the next two weeks. Anyone interested in our weekly picks should recognize that we offer an active management strategy and that such portfolio changes can occur at anytime without warning and should call for further information before investing. Oh Christ, we sound like a Cramer Disclaimer now!

Ramblings of a Portfolio Manager 12-14-2009

2009-12-14T20:36:00.000-08:00

In this present crisis, government is not the solution to our problem; government is the problem. From time to time we've been tempted to believe that society has become too complex to be managed by self-rule, that government by an elite group is superior to government for, by, and of the people. Well, if no one among us is capable of governing himself, then who among us has the capacity to govern someone else? All of us together, in and out of government, must bear the burden.
-Ronald Regan

Ahh, how we (and, doubtlessly, most similarly-aged capital market participants) miss the Great Communicator. We try to remain politically neutral, as opposed to apolitical, in our Ramblings since the issues of politics and financial markets are inexorably intertwined--unfortunately, more so, these days, than we would like. So we’ve been fairly quiet on much of the rhetoric spewing from the current administration as it has been just that and has called for social engineering with tangible but peripheral predicted effects on the capital markets. Now, however, the populist sentiment on Capitol Hill is being aimed squarely at Wall Street in the form of legislation that, we believe, will result in very negative, unintended consequences for both Wall Street and Main Street.
On Friday the House narrowly passed sweeping “reform” legislation to restrict the operations of large banks and narrow the powers of the Federal Reserve. The bill, which still faces major scrutiny and modification in the Senate, advances a major initiative of the Obama Administration to close what it perceives as loopholes that caused the financial crisis of 2008. It was written in large part by Rep. Barney Frank (D., MA.), who, as House Financial Services Committee Chairman, was “shocked, shocked” to hear that there was “financial gambling” going on at major Wall Street banks. Said Speaker of the House Nancy Pelosi (D., CA.), "We are sending a clear message to Wall Street. The party is over. Never again." The details of the bill are too large to list here but the key, and disturbing, elements, are: 1) Stripping nearly all of the Federal Reserve's powers to write consumer-protection laws and creating an arm of Congress to audit the Fed's monetary policy decisions, once considered a necessarily a politics-free zone. 2) Creating a new Consumer Financial Protection Agency, which would write rules and examine large banks for compliance with (existing and soon-to-be-enacted) consumer protection policies on a host of financial products, from credit cards to mortgages. Small banks, which presumably have no impact on consumer credit or the financial system in general, are exempt from the CFPA’s examination. 3) Granting an advisory vote on executive compensation to shareholders of public financial institutions. The legality of this is one unclear if indeed the power is granted exclusively to the shareholders of banks and other financial companies.
It could have been worse. In one victory for banks, Republicans and more than 70 Democrats defeated an amendment that would have allowed bankruptcy judges to rework the terms of mortgages. Of course all this new legislation and the additional bureaucracies created to over see it aren’t free. It’s unclear exactly how much the annual tally for it’s enactment and supervision will be but the costs are expected to be passed on to the banks in the form of additional fees and taxes. This will be on top of an additional $150 billion in fees that will be collected by the FDIC from the large banks to pay for future failures.
Why are we sounding alarmist here? Is not the government’s attempt to reign in those big banks and “help” the little guy consumer a good thing? One need only like at the financial system of our European friends to answer that question. Decades of stifling regulation on financial institutions has driven out smaller firms, leading to a highly concentrated banking system with high fees and little product innovation—that’s why their banks are all so eager to do business here. Our legislators, who daily rail against the evil, monopolistic empire of “Big Oil” are now posing legislation that will create “Big Buck,” an oligopoly of banks large enough to survive wielding similar market power. Regardless of the theories expounded in business school, oligopolies do keep prices higher than a system of perfect competition with virtually no motivation toward product development Think the few banks remaining wont pass the higher costs of doing business on to business and the consumer? Think consumer and business credit, the current “tightness” of which is being blamed for slowing job growth and economic rebound, will get easier with all the new regulation? What about the scariest proposal, politicalization of Federal Reserve policy, which is all promulgated under the House bill? Think it will ensure the continued autonomy and flexibility of that body to stave of financial disasters and reign in inflation, especially when there is a political agenda in Congress or personal angst, as there was between Rep. Frank and Alan Greenspan?
As we write this House Economic Advisor Larry Summers is saying that President Obama will tell bankers that they have an obligation to restart lending. Uh huh. Bankers, like most business people in a free capitalist society, operate on the basis of profit motive, not moral obligation. Unless, of course, as Ayn Rand warned (maybe foretold), they are legally compelled by government. We hope the Obama administration will take time to read the text of President Regan’s fist inaugural address and that, in the meantime, Atlas keeps his shoulders level.

Ramblings of a Portfolio Manager 12-7-2009

2009-12-07T04:43:00.000-08:00

Ramblings of a Portfolio Manager or It’s December, Time For The January Effect

The so-called January Effect, observed since the 1920s but not academically recognized until the 1980s, describes the phenomenon where the equities of small companies (small-cap stocks) tend to not only increase in price but outperform the stocks of larger companies in the month of January. Much scholarly research and speculation have been directed at the anomaly with the most commonly accepted explanation now being that year-end tax-loss selling pressure of less liquid securities, which small-cap stocks tend to be, is reversed in the new calendar year when those same securities are re-purchased by investors. This rationale seems quite intuitive except for one small quirk: Wall Street, in its never-ending search for profitable advantage, has front-run this somewhat reliable observation and in the process moved it from January to December or even earlier. So while the original motivation behind the effect may well have been taxes it has, of late, become a self-fulfilling, self-sustaining prophecy of sort.

The January Effect (really now the December Effect) doesn’t always manifest itself but tends to be fairly consistent and we observed it even during last year’s financial market meltdown when the Russell 2000 index of small-cap stocks rose 5.8% in December versus 1.5% for its large-cap brother, the Russell 1000, and a small decline for the Dow Jones Industrial Average. It’s no surprise, then, that this year small-cap stocks are so far outperforming large-cap equities by a margin of almost 3:1 in the month of December. The outperformance actually began in the middle of November, not surprisingly just about 30 days after small-caps started getting disproportionately hard-hit in mid-October, so arguments for a tax-loss selling basis may be valid. We have a different explanation.

According to Hedge Fund Research Inc., US Equity Hedge Funds returned approximately 20% on average through the end of October. Hardly a barn-burning snap back from last year’s almost universal decimation, but a return sufficient to place most funds squarely ahead of the major market index averages year-to-date as of month-end. Additionally, for some unknown reason, 20% seems to be a targeted return for many hedge funds. In any case, our humble opinion, having observed October’s rapid and brutal sell-off in small cap stocks (the equity asset class that led the market’s rise from the March lows), followed by a period of calm and a declining VIX, is that many hedge fund managers found themselves nicely in positive territory after last year’s drubbing and simply decided to take the rest of the year off and went to cash. Tax loss selling, while a conveniently-fitting explanation, really doesn’t apply this year as so many funds have loss carry-fowards from 2008 that may well last them the rest of the decade.

Our view might explain October’s dramatic underperformance but why, then, have small-caps once again reasserted themselves since mid-November? Well, while many hedge fund managers may think 20% is a good number and are able to sit in cash and play computer solitaire for the last two months of the year, many plain-vanilla funds are mandated to remain invested and perform relative the indices. Others just plain missed the rally and haven’t enjoyed the same level of returns. So for a large segment of the asset management industry, not only is the year not over but there is a fair amount of last minute catching-up to do. And we can’t think of a better way to gain ground on the averages than to pick up some high beta small-cap stocks that have been severely marked down for non-fundamental reasons. Also, with the broader averages now up more than the mid 20% range, a 20% YTD return no longer seems so special so we suspect that many hedge funds are now getting back in the game. So, although there is no empirical way to test our theory, if we are right then December may hold more good news for small company stocks in its remaining weeks.