Ramblings of a Portfolio Manager 12-28-2009

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

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

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

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.

Friday Rambling

Ramblings of a Portfolio Manager 11-30-2009

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

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

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

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

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

Ramblings of a Portfolio Manager 11-23-2009

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

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

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

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

Ramblings of a Portfolio Manager 11-16-2009

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

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

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

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

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

Ramblings of a Portfolio Manager 11-9-2009

Ramblings of a Portfolio Manager or Hello Goldilocks?

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

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

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

Ramblings of a Portfolio Manager 11-2-2009

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

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

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

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

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

Ramblings of a Portfolio Manager 10-26-2009

Ramblings of a Portfolio Manager

Nouriel Roubini, perpetual bear a.k.a. Dr. Doom, was on CNBC early this morning doing a fair amount backpedaling and sounding (for him) positively bullish. His thesis: things somehow changed in government policy back in March (huh?) and so the market rally is justified. As he sees it, the market is now at fair value! Sharp-eyed contrarians instantly brought the early Dow futures down 30 basis points. We note that a broken clock is only correct twice a day as long as no-one fiddles with the hands or mechanism. Clearly, the negative feedback loop of rising stock prices fiddled with Dr. Roubini’s inner workings so we no longer trust this clock and decline to take the contrarian bet just now.

Third quarter earnings season is about two-thirds over and the results have been fairly good, despite the market’s apparent lack of interest. Experienced portfolio managers, however, are already looking at 2010 and have been doing so since at least July, which explains much of the market’s rise since then. The media has made much hullabaloo about Dow 10,000 since we crossed that psychological barrier and the “too far too fast” crowd has used the milestone to bolster their case. In their view, the market is expensive and the earnings don’t justify the levels. In our view, they have missed two very important points: First, consolidated Dow Jones constituent earnings are now projected to be 22% higher in 2010 than in 2009, which represents only an 8% decline from 2007 earnings, when the index was 40% higher. Doing the math, assuming we get to the same trailing multiple as we had in 2007 (and remember the housing crisis started in that year) we get, roughly, Dow 12,700 by year-end 2010 (that’s a 27% return!). Secondly, in the same vein, looking at 1999 when the Dow last crossed 10,000 on the way up, actual constituent company earnings were 24% lower than actual 2008 earnings (viewed another way, earnings are 31% higher now!) and 26% lower than 2010 expectations (which represent 36% growth from 1999). So much for the valuation argument!

Of course all of this is a simplistic analysis involving just the Dow Jones index and we remind investors that, back in 1999, we were in a different world—one in which that new-fangled thingy called the internet, coupled with Y2K spending, were going to drive US earnings growth at double digit rates well into the next millennium. Clearly, that bullish outlook on our economy had a big influence on the multiple investors were willing to place on forward-looking earnings at the time. By the same token, however, we now have that not-so-new-fangled thingy called a global economy in which very large (China, India) population centers are growing rapidly in wealth and, thus, consumer demand. If we need to remind you which country is king at developing and delivering products for consumers, first go to your local supermarket and count the varieties of potato chips available, then move up the value-added chain and browse the Apple Store. And that’s just consumer products. Where else does one find the likes of Caterpillar, IBM, Boeing, etc., all of whom produce things growing economies need? Rising global demand for the diversified base of US products, we believe, is a much more robust and sustainable underpinning to future domestic earnings growth than a new distribution and information system. That underpinning will give us higher US company earnings over the next decade and for multiple expansion on those earnings, all we need is for folks like Dr. Roubini to recognize it.

Ramblings of a Portfolio Manager 10-19-2009

Ramblings of a Portfolio Manager or You have to take the bitter with the sweet -Diana Ross

Well the “most crucial earnings season in decades” went into full swing last week, largely following the pattern we predicted. That is, technology, having become part of the whisper number gang, performed like any high expectation, momentum driven group and sold off on earnings reports--even when the reports (and guidance) surpassed expectations. Banks and financials, solidly in the low expectations camp, didn’t disappoint in their ability to disappoint and, so, also sold off on in-line to worse than expected news. Uh-oh? Summarizing earnings season to date, then, we’ve gotten some really good reports that resulted in a sell-off and some so-so reports that also ended up with profit taking. Have stocks truly run too far ahead of fundamentals and are their reactions signaling the end of the bull-run, as so many bears have predicted? We remain unconcerned for now as a little profit-taking is a necessary function of a healthy market. Frankly, we are less concerned with the implications of the reaction to earnings reports than with what the reports themselves are saying.

In our humble opinion, this earnings season is already over in terms of economic signaling. Now, consultants and anyone else trained in statistics and nothing else will criticize our sample size, conclusions and extrapolations. Fine--we like it here on the other side--but hear us out. So far this bull-run has demonstrated an almost classic pattern. That is, early cycle stocks like technology, transports and even some financials have led the way off the bottom. We say “almost” because many mid to late cycle stocks such as producer durables and basic materials have also been strong leaders (we wont even touch gold) while some traditional early cycle sectors like consumer cyclicals (principally retailers and many bank and non-bank financials) have been laggards. All this, however, is quite explainable given the weakness in the US dollar. Early cycle technology and late cycle producer durable manufacturers share one common trait—they are, largely, multinational exporters. The weak US dollar has made their products more attractive overseas and sales are expected to follow. Similarly, dollar-denominated commodities like oil, precious and industrial metals (mid-late cycle) have also benefited from the greenback’s weakness and stocks in those sectors have also been market leaders in anticipation of greater global sales. Missing from this entire equation are the early-cycle consumer cyclicals—specifically, retailers and, to a large degree, non-bank and regional-bank financials. To be sure these two sectors have performed well off the bottom but they have lagged the later-cycle groups significantly of late. The reason is simple. These sectors are pegged more to domestic than international growth.

This earnings season, so far, is demonstrating the implications of that narrow dependence. Management at Intel, IBM, Alcoa and Caterpillar, all multinational industrials, had good things to say about the quarter past and those to come. Citibank, BofA and American Express Management were less sanguine. Though they have a good deal of international exposure, their domestic consumer franchises are holding them back--and with 70% of our domestic GDP tied to the consumer and unemployment nearing 10%, that is hardly a surprise. One thing we do agree on with the pundits is that employment is a lagging indicator so expect regional banks and consumer finance companies to say much the same things over the coming weeks. We anticipate more of the same as the reports roll in and so, from our point of view, this earnings season has already said all it needs to about the health and direction of the economy. Regardless of what market reaction we receive during and following this earnings season we are more concerned with a set of data points further down the road…specifically, Black Friday and beyond. That, more than “the most crucial earnings season in decades,” will be a bigger “tell” on whether that lagging indicator will continue to be a drag on earnings and whether we have, in fact, come too far too fast.

Ramblings of a Portfolio Manager 10-12-2009

Ramblings of a Portfolio Manager or Sometimes it pays to be a fish

When at a loss for words, just add superlatives. That’s what CNBC is doing this month. Having already declared last earnings season the “most important ever” it has found itself needing to one-up its own pronouncements for the third quarter. So now we have the “most crucial earnings season in history” before us. To avoid embarrassment to the anchors, they aren’t even allowed to refer to it as such. Instead, “Jay in the booth” makes the announcement during commercial breaks. Lampooning all this is way too much of a lay-up so we’re not going there this week.

Instead, we thought we would take the opportunity to talk about what we are doing amid the media’s Halloween Hysteria. We’ve rambled about analyst expectations and media hype for several months now so a fair question to ask is how we are positioning ourselves. Our philosophy has always been to sell hype, buy pessimism. But before you dub us contrarians, realize that we’ve been in this business for over 25 years now and, perhaps, that means we’ve (hopefully) learned a few things. To use an allegory, we recognize that salmon swimming upstream strengthens the breed and ensures the perpetuation of the species--but we also recognize that only a very small percentage of the fish embarking on the journey actually live to achieve their goal. Remaining at sea, they would all survive the year but would eventually become extinct. John Maynard Keynes said it another way—the market can stay irrational a lot longer than you can stay solvent. No investment discipline (discipline being the operative word), rigorously applied, works in all market environments. So, using a mixed metaphor, even though following the herd too long often leads you off the cliff, there are times when you need to swim with the current. Flexibility is the key to survival in this business.

In the last 10 months the market has gone from extreme pessimism, to moderate doubt, to mild optimism. We responded, using the animal analogy, by starting off as salmon (not an easy thing to do, especially when at least one client called on March 6th to lambaste us for having ANY exposure to equities). This strategy unintentionally evolved us into herd animals as the market caught up to where we already were. Now, however, we are intentionally devolving ourselves back to the fish. In investment terms, early this year we recognized the extreme pessimism and bought the out of favor, low expectation cyclical stocks while everyone else favored the defensive and higher expectation growth names. As this strategy began to pay off we stuck with it, knowingly swimming with the current, as we believed that the levels of pessimism, although abating, were still quite high meaning our strategy had room to go. Now that we have returned to whisper numbers and analysts expecting companies to “beat expectations,” we are concentrating again on low expectation stocks. This doesn’t mean we have gone defensive—we believe that those stocks themselves have high expectations –but rather are lessening our exposure to technology and soft-cyclicals that have appreciated significantly over the past several months. We still think cyclical and commodity stocks, despite their recent run, still have very low expectations and will be given a “pass” on their earnings reports and so remain there. Technology, on the other hand, is fully within the whisper number realm and we are treating them with caution.

And for those who think China is a fraud (we get those calls too), we have increased our exposure to that part of the world, especially as their market has pulled back. Just remember that there are 3 times more Chinese than there are of us. So even if they were to eat, drive or yap on the cell phone 1/3rd as much as we do they would be, as a consumer group, equal to us. And their aspiration is to emulate us. Think about the potential growth ahead.

Ramblings of a Portfolio Manager 10-2-2009

Ramblings of a Portfolio Manager or Blame it on Rio.

The American Heartland was dealt a psychological blow last week when the IOC eliminated Chicago in the first round for consideration for the 2016 Summer Olympics. The winner, Rio de Janeiro, will become the first country in South America to host an Olympiad.

While the IOC ostensibly chose a Latin American country due to the dearth of Olympic games held in that part of the Southern Hemisphere, it strikes us as a little more than coincidental that each Summer Olympic venue chosen over the last several decades has tended to be where the economic action was occurring (2004 excepted, with Athens being a nostalgic choice). Sydney in 2000 in many ways signaled the passing of the economic growth torch from the US to Asia. Likewise, Beijing 2008 symbolized the rise of China in international economic status. So now we have Rio. Is Brazil where the economic now action lies? Well, the Bovespa is up 63% year-to-date versus, a paltry 8.1% for the Dow Jones (last year they were down similarly at 39% and 32% respectively). There is a not-so-subtle irony in Chicago’s loss to Rio. Barely three decades ago, Latin America was known as the deadbeat of the world. Over leveraged and unable to repay the mountains of debt piled up during their industrial and infrastructure growth phases, Brazil, Argentina, Mexico, Chile and other commodity-dependent South American countries threatened to topple the world’s (particularly US) banks. Lending was cut off and their economies sunk into recession. Any of this sound familiar?

Fast-forward 25 years and Latin America looks to be the hot place to invest (and play Olympic beach volleyball). How did this happen? A combination of sovereign debt forgiveness, currency devaluation and strong (commodity-based) economic growth, which helped the region catch up to their debt payment burden. A resumption of lending by international banks contributed to that strong economic growth. So now that the US is piling on huge amounts of debt is there a potential historical parallel? Perhaps. But it is important to remember that in the early 80’s the Latin American “deadbeats” were (and still are) emerging economies with much of their economic potential still ahead of them, leaving them headroom to outgrow their troubles. The US in 2009, by contrast, is a very mature economy with a population growth near zero. While productivity gains and technological innovation may yet contribute to positive GDP gains here, it’s going to take some significant growth to catch up to the obligations we are now incurring. As Speedy Gonzales would say, Arriba! Andale!

Ramblings of a Portfolio Manager 9-28-2009

Ramblings of a Portfolio Manager or Shocked, Shocked to Find That Gambling is Going on in Here!

That should have been the headline on the left column of page C1 of the Wall Street Journal today. In case you didn’t accidentally do a face-plant into the paper this morning, as we did while jogging, let us paraphrase: The column heading was “Profits Poised to Surprise Again.” Basically, the thrust was that an Investment Strategist of a well known (and still surviving!) white shoe investment firm went from extremely bearish to bullish over the weekend. His rationale: he expects third quarter earnings to be “better than expected.” Now, having been on Wall Street for 25+ years we have NEVER heard anyone question the inherent paradox of this phrase. We’re not sure but think that is why sell-side analysts rarely survive on our side of the Wall Street Chinese Wall and why Louie probably never made a dime outside of Rick’s.

What we are sure of is that this strategist is smart and, no doubt, well educated. So are a lot of politicians. But that doesn’t stop either from succumbing to the group think of the profession. In either case one eventually becomes desensitized to the fact that you are the cause of the problem you are trying to solve. It’s like perpetual amnesia in which you keep forgetting that itchy rash was caused by your scratching of the itchy rash. So let’s pretend we aren’t English majors and dissect the phrase “better than expected.” Obviously, “expected” is what Wall Street analysts have in print for earnings estimates. “Better” than those estimates means companies will report earnings and/or sales that are higher than those estimates. So why don’t analysts eliminate the paradox by raising their expectations for sales and earnings when they expect those numbers to be beaten? Safety in numbers. Period. Sticking one’s neck out is risky in this business—if you are aggressive and right, you get little credit. If you are aggressive and wrong, well, Mme. Lafarge is ready with the Guillotine. If you stay with the herd and the Company beats expectations, investors are too happy to notice your original conservative mistake; wrong and you are in very good company. Reversion to the mean is a powerful force in the investment game.

This behavioral characteristic once was a very exploitable artifact of the market and generated some very successful investment models employing earnings revisions. Good analysts willing to step out from the crowd, however slightly, usually signaled a larger-than-expected earnings surprise and, thus, stock under or out performance. Over the years, analysts’ behavior eventually produced what is known as the “whisper” number (you’ve heard that phrase on TV before, no doubt.), which arbitraged away the advantage of earnings revision analysis. So now that we are on the second derivative of “better than expected” companies have to beat the “whisper number” for their stock prices to move ahead.

What does this all mean for the upcoming earnings season? Well, first of all, the tail turning of the last holdout bear gives us reason to be nervous. So does the comment just released on CNBC: “is buy and hold back?” What do they think has been working since March?!?! More significantly, however, the fact that expectations have moved beyond the numbers in print means we have a pretty lofty set of whisper numbers to meet or beat. Another quarter of “beat on the bottom line, miss on the top” will most likely not be tolerated this time around. With every economic sage telling us that the recession is over, investors no doubt will be seeking confirmation—and that confirmation will have to come in the form of rising sales that beat the Street whispers.

Ramblings of a Portfolio Manager 9-21-2009

Ramblings of a Portfolio Manager or What to expect when you are expecting?

We’re probably guilty of some sort of copy write infringement here. No, no-one here is expecting a new family addition. We’re speaking specifically of the much anticipated market correction and corporate earnings season. Having failed as of yet to receive the first, we are fairly confident of delivery of the second. Will they perhaps coincide?

The thesis of the “too far too fast” crowd is that stocks are now discounting a V-shaped recovery (yes, we know we promised no more consonants) to economic conditions that will not materialize. While we do accept that markets are discounting mechanisms we disagree as to what they are, in fact, discounting. As we write this, an incredulous TV talking head is complaining “how dare the stock market forecast the economy?” Well, Madame, that’s what it’s supposed to do!

Using the widely tracked S&P 500, stock prices right now are slightly ahead of where they were on Election Day 2008 and 11% below where they were on
September 15th, when Lehman Brothers declared bankruptcy. The index is still 32% below its peak, achieved in October of 2007. For our purposes we assume that we are more or less back to where we were on Election Day. Well, if one can remember that far back, we had already witnessed the collapse of Fannie Mae, Freddie Mac, Bear Stearns, Washington Mutual and Lehman Brothers. The Federal Reserve was forced to guarantee money market funds as some had already “broken the buck,” Congress had reluctantly approved $700 billion for the TARP and the 30 day T-Bill sported a negative yield (yes, you paid Uncle Sam to hold your money). We would argue that those were some fairly dire conditions with a correspondingly extreme negative market sentiment. Of course, things did get worse for stock indices, much of which can be attributed to deleveraging of hedge funds and headline risks from the opening shots of the Geithner Treasury. Nevertheless, despite the rapid ascent from March 6th, we are no better off stock-price-wise than we were when Obama was ahead at the polls on Election Day. That says to us that stocks are hardly discounting a rosy scenario; certainly not a return to pre-Lehman economic conditions.

So far September hasn’t lived up to its reputation (it’s not over yet) but a reminder that October is when most big crashes occur. So what can we expect as earnings season rolls around? Are investors expecting (and stock prices discounting) significantly improved earnings? Well, that’s a big debate around here. So far Fed Chairman Bernanke has declared the end of the recession, the Purchasing Managers Index has crossed 50, signaling growth, and we have the 4th consecutive monthly positive set of Leading Economic Indicators. One would think, then, that investors will be expecting earnings to follow the positive economic news…or will they? Now that it is confirmed that we have hit bottom and are on the mend, there is still the potential that investors will give companies a “free pass” for missing expectations on the promise of better numbers to come. So, perhaps, what we should expect is not so much earnings reports as earnings guidance. Any downplaying of expectations, whether based on fact or well-intentioned sandbagging, may well engender the market swoon we have all so long come to expect.

Ramblings of a Portfolio Manager 9-14-2009

Ramblings of a Portfolio Manager or Every Rally Has a Golden Lining?

We published no Ramblings last week as we took Labor Day off to roast a pig and to ruminate on the state of the capital markets. While cooking our tasty ruminant we found a number of things to chew upon but, in particular, we noted that the Calendar placed us solidly in September while the market indices showed us solidly in the black! What about the doomsayers’ daily history lesson regarding September’s evil legacy and it’s strong correlation to the omnipresent “too far, too fast” market indicator? And, if the market is truly going up on positive sentiment, why is Gold soaring, the dollar sinking and interest rates dropping? Are we are in economic Bizzaroland?

Actually, these seemingly contradictory moves in asset classes make sense and say a great deal about where the market sees the economy 6 months to a year out. Let’s start with Gold, as the move in this asset class is intertwined with the others. There are usually 3 reasons why investors like to hold Gold: 1. as an inflation hedge; 2. as a safe haven to hedge against the risk in other asset classes (like stocks and bonds) and 3. due to weakness in the US Dollar. Taking each in turn, Inflation: currently, most credible forecasts see tame inflation (deflation is off the table for now) over the next 6-12 months as the economy is expected to recover slowly, keeping wage growth in check, and these expectations have not been increased in the last month. This outlook is buttressed by the lack of movement in 10 year treasury inflation spreads and the still historically low velocity of money (meaning banks still aren’t lending). The lack of significant inflation outlook is also one reason why US interest rates have been coming down. Safe Haven: the volatility index, or VIX, a measure of fear in the stock market, has been trending down and is now at a one-year low—almost to pre-crisis levels—as are credit default spreads, suggesting that fear of shocks to other asset values is not significant. By the way, although it has been positive lately, the long-term correlation between Gold and stock prices is pretty much zero, debunking the pretty metal as a safe haven in a stock market storm. Weak dollar: Gold’s correlation to the US dollar is inverse and much stronger than its correlation with stock prices. The same holds true for Oil, which has also been climbing in price as of late. Weakness in the dollar, we believe, is behind the asset class paradox we have been seeing this month. The US Dollar has been taking it on the chin as of late as inflation fears remain muted and a huge supply of US debt is expected to hit the market. Lack of fear has also reduced the demand for US currency as a safe haven, driving down its price relative to other currencies. Of course, the Fed has signaled no expected increase in interest rates in the near future, thus dampening demand for the dollar.

So why are rates dropping and stocks rising? Rates, as we have discussed, are trending lower as inflation outlooks have been downsized and the Fed remains on hold. There is also a growing sense that Obama’s $Trillion Health Care package is on the ropes, suggesting smaller than originally expected future US borrowing. Stocks, on the other hand, are following simple Graham and Dodd fundamental analysis: lower rates increase the present value of earnings and dividend streams, thus making stocks more valuable In addition, a weak dollar means that US exports are more competitive in the global market, signaling greater future international demand and higher revenues for our multinationals. It’s no surprise, then, that industrials have been the best performers this month. In the absence of any negative information, thus, stocks are trending higher. Really, it is as simple as that.

Ramblings of a Portfolio Manager 9-1-2009

Ramblings of a Portfolio Manager or Is China History?

A good technician will tell you that the trend is your friend…until, of course, it isn’t. That helpful advice is now being delivered in shiploads with respect to the Chinese stock market. Now down over 23% from its July peak, the Shanghai Index took a nearly 7% hit on Monday. Smelling blood, the technicians and other skeptics came out in droves to proclaim all sorts of doomsday scenarios both for the Shanghai as well as the Dow, complete with detailed sets of new support and resistance levels. We note more than a few of these chartists enjoyed the ride up and now, having missed calling the top, are frenzy-feeding on the blood scent of a chart that has rolled over.

Forgetting the entrail readers for a moment, the real issue upon which to focus is whether the direction of the Shanghai has any direct relationship to the state of the underlying Chinese economy and if the well-used but largely debunked phrase of decoupling can be (hopefully) applied to the US market. As always, the answer to the first question largely dictates the answer to the second. A brief background is in order: The Chinese economy went into a “slump” before the US officially hit the skids. “Slump,” however, is a relative term. The big run in Chinese equities came to an end on October 9^th, 2007, after a nearly 5-fold rise in a little over 20 months. Much of the rise was declared to be at the time, and in restrospect truly was, based on speculation by domestic retail investors. Of course, those speculators got started somewhere and the massive Chinese infrastructure build ahead of the Olympics certainly gave them a reason. The ensuing double-digit GDP growth only fanned the speculative flames. When the torch went out and the country was no longer in the global spotlight, the window-dressing spending stopped, things softened and the market followed accordingly. 11 months later our economy experienced its AIG/Lehman hangover and the Shanghai continued its slide along with the US markets.

Hind-sight is always 20/20 and looking back, it is easy to see that the Chinese market was overly optimistic about the long-term growth prospects of the underlying economy during the bull run of 2005-2007 (remember the NASDAQ in 1999??). But hindsight also tells us that Chinese stocks got overly pessimistic late last year as our economy headed into the toilet. How can we say that? Well, unlike the US, China has vast currency reserves, no crippling national debt, a government body that can act swiftly without endless partisan and special interest debate (they shoot dissenters you know) and a strong motivation to keep the economic boom intact (farmers rioting in the streets doesn’t play well on the BBC). And the Chinese Government put all these advantages to work in a much more stimulative set of initiatives than our borrow, spend on pork and tax program, with much more favorable expected outcomes. So much of this year’s climb in the Shanghai, in our humble opinion, has been warranted. But did Chinese investors get overly optimistic once again? Probably. Trees don’t grow to the sky, is a favorite saying of old-timers on Wall Street., meaning that no market goes straight up forever. So, now that we have a fairly sizeable sell-off in Chinese equities, are they now overly pessimistic in their assessment of the future state of the economy? Most likely. The Chinese Government, as we mentioned, has the means and motivation to keep the spending tap open and there is no reason to suspect that they will turn it off any time soon (they’ve got no Milton Friedman-types sounding inflation alarm bells over there). So the Chinese engine of growth, we believe, still has at least ¾ a tank full of gas. What about the relationship to our markets? Here again, history can be a guide. When China tanked in 2007, the pundits decried a decoupling of our economies and markets. Didn’t happen. When the Chinese economy and markets started to turn ahead of those in the US earlier this year, the same pundits once again rang the decoupling bell. Didn’t happen. And in the early stages of the Chinese market sell-off in July/August, the optimistic “decouplers” came out once again. Not looking like that is going to hold true either. So, if, as we believe, the dip in Chinese equities is the pause that refreshes and has more to do with investor sentiment than the actual future of Chinese GDP growth, then we humbly suggest taking advantage of the decoupling myth, when it proves itself as such, over the next few months.

Ramblings of a Portfolio Manager 8-24-2009

Ramblings of a Portfolio Manager or “No Mr. Bond, I expect You to Die”
Auric Goldfinger

It was unfortunate that we had to pen last week’s Ramblings prior to seeing the full results of the Monterey Classic Car auctions. Scanning the full data, we noted that a 1965 Aston Martin DB5 coupe sold for $341,000. Not even close to sharing the rarified atmosphere with the likes of original Shelby’s and one-off Ferraris, the Aston owns its own pedestal for having been 007 James Bond’s ride of choice in several bond films, most notably the iconic Goldfinger, released in 1964. We are unaware of any machine guns or ejector seats in the $341k recent sale but what we do know, if our HP12-C is correct, is that an owner of the vehicle, had he/she purchased it new and held it 45 years, would have gotten approximately an 8% annual return on that “investment” ignoring insurance, maintenance and storage costs. Not so spectacular for a car once named “The Most Famous Car In The World.” 007’s nemesis, Auric Goldfinger, would have scoffed at such meager returns…or would he? Americans were not allowed to own gold for investment or speculative purposes in 1964, when Bond thwarted the destruction of Fort Knox, but at the time the US Government had fixed the price of gold at $35/ounce. Plugging that number into our trusty HP and using today’s price of roughly $943/oz, we get, hmmm, about an 8% annual return, also ignoring storage and insurance costs! Over the same period, using the Dow Jones Industrial Average, the US stock market returned, a slightly better 9% including dividends but excluding taxes.* US retail price inflation for the last 45 years was half the return of these assets at 4%. The conclusion: over the long run stocks aren’t such a bad place to put your money. However, as we have noted, you can’t wear your portfolio or show it off on Main Street on a hot August night.

What prompted this simple analysis is a perpetual gold bug/market bear’s appearance on CNBC touting the yellow metal as the “best investment” over the long run. His thesis was simple: in his opinion, gold prices are perfectly negatively correlated with the US dollar and perfectly positively correlated with the inflation rate. He further forecasts that massive Government spending is pushing us into a period of hyper-inflation, which will erode the purchasing power of the dollar thereby making gold the perfect investment. In his world, Mr. Bond (US, that is) truly must die and Auric will prevail. Without commenting on his dire prediction, we do note that, as an inflation hedge, the data does support the attractiveness of gold as an investment. However, the storage and insurance costs of holding the physical asset cannot be ignored and we estimate that these would have eaten up close to half of your annual return over the last 45 years, based on current costs, meaning at best you would be tied to slightly ahead of inflation. In addition, physical gold does not trade like stocks in that there is no liquid market where bid and ask prices are readily available. That means your purchase price, even today, is subject to the retail markup of guys like those you see on TV and that you will pay more than the spot price quoted in the Wall Street Journal on the way in and will have to accept a discount to the reported spot price on the way out. Putting it all together, you would be lucky to keep even with inflation in a buy and hold strategy employing gold as a physical asset. Luckily, today we have a gold ETF that is supposed to track the spot prices of the metal, without the direct costs of illiquidity and physical storage. The ETF, however, incorporates all the costs associated with holding the physical commodity (someone has to hold it—there is no free lunch) so the security doesn’t track the spot price of gold exactly. Since the returns we reported above include periods of high inflation as well as stagflation (there hasn’t been a period of deflation since 1964) and even before transaction and holding costs gold still underperformed stocks, we suggest investing in paper rather than metal…unless, of course, your metal of choice is an aluminum-bodied DB5 with Pussy Galore as your chief mechanic. But, of course, there are other costs associated with that form of investment…

Ramblings of a Portfolio Manager 8-17-2009

You Can’t Cruise Main Street in 500,000 Shares of GE

The annual classic car auction at Monterey, CA was held last weekend. Few records were set but the sales numbers were impressive, as they have been for the last decade. One car enthusiast paid more than $7mm for a 1965 Shelby Cobra Daytona race car while another plunked down $2.75mm for a 1958 Ferrari California Spyder. Yet, as we write this the world equity markets are in full sell-off mode. The Chinese Shanghai Index closed down nearly 6% and is now down over 17% from its August 4^th high while Japan’s Nikkei index closed down 3% and the S&P 500 has fallen over 3% since Thursday. Fears over the health of the US consumer are driving the sell-off, according to market pundits. Huh?

Actually, this seeming paradox makes quite a bit of sense and says a great deal about market psychology and the current state of the capital markets. Since the 1980’s, classic cars have morphed from fun toys held by car nuts with too much money and/or time on their hands to a serious asset class for investors. We won’t comment on the advisability of investing in old motor vehicles as a retirement strategy, however, we will examine the reason for the car market’s transformation. There have been two significant periods during which classic cars were treated as assets rather than playthings. The first was immediately preceding and following the stock market crash of 1987. Back then, cheap money had fueled both the US real estate and Japanese stock markets and the beneficiaries of those booms plowed a portion of their new found wealth into high end “collectibles” such as art, and then cars. When the stock market crashed in 1987, the classic car market boomed further as money came out of stocks and sought a “more stable” return. Again, art and old cars were the targets since their values had already been rising and—presto!--cars became an asset class. That house of cards tumbled in 1989 along with real estate and the Japanese economy. The current boom in classic car prices traces back to the Barrett Jackson Car Auction of January, 2002. Immediately following the attacks of 9/11, many baby boomers, wealthy after years of a strong economy and a rising stock prices (sound familiar?), began to feel that life was too short and that it was time to buy “the cool car I always wanted in high school but couldn’t afford.” The market sell-off following 9/11 and the Enron and WorldCom scandals further solidified the asset class status as once again money sought a stable asset whose values were rising. The car market’s boom was then further fueled and perpetuated over the ensuing years by real estate wealth (again, sound familiar?) and although it has weakened in the last 12 months it has not crashed in the true sense

Can we draw any conclusions from this history lesson? The strongest message we take is that the classic car market needs to correct, if history is any guide, and the fact that it has yet to do so signals that, perhaps, money is still seeking returns uncorrelated to the stock market. That, we view, as a longer term positive for stocks as it means investors most likely still doubt the recent rally and that skepticism, which is healthy to any market longer-term, still abounds.

Ramblings of a Portfolio Manager 8-10-2009

Summer has finally arrived on the East Coast!

No joke—last week we had our first 5 day stretch without rain here since Memorial Day. The mushrooms growing under the Ark we constructed in the office parking lot are in danger of shriveling. Might this favorable stretch of weather have any implications for the direction of the capital markets the rest of the year? Before you think we have gone off the deep end and are beginning to employ astrological charts in our investment process (and you still might be right here), hear us out.

Earlier this year we commented on the “sell in May and go away” myth. That quaint notion, borne of a simpler time before cell phones, laptops, wifi and DSL in the Hamptons, had its place in the white-shoe days of Wall Street, when market participants mutually made an unspoken, passive pact to do no harm during the summer months, when everyone’s attentions were focused elsewhere and communications with the office were slow and infrequent. The strength and volume associated with this current summer rally attests to the fact that the old gentlemen’s agreement regarding summer break is long dead. Still, with many of the near-term potential market catalysts such as quarterly earnings reports and significant monthly economic data now behind us and, most importantly, with congress on vacation (meaning fewer dangerous trial balloons) we may yet get our summer doldrums—they just may occur all in the month of August.

The market’s recent rally has many an “expert” calling for a pullback, retracement, profit-taking session or any number of other terms suggesting a reversal of the uptrend. We don’t disagree with the need for time to digest. Our anecdotal evidence is that a good deal of this rally can be attributed to short covering, in that many of the best performers are low quality, high short interest stocks trading under $5. We also note that retail investors are starting to belly up to the trough, judging from the volume and trade size in some of these higher flying issues, although the money market data and funds flow data have yet to bear this out. Both data points are classic causes for concern. Yet “digestion” doesn’t mean that stocks have to fall back to some technical preordained level to allow the rally to advance further. Treading water (now there’s a good old Wall Street technical term for you) sometimes works just as well to relieve the gas pains. True, the ownership profile of stocks may change in a sideways movement phase, but that isn’t necessarily bad. We disagree with the notion that retail investors being last to the party is a bad thing—especially if they help the “smart money” out of their positions during a flat spot in the market. All that would be happening there is that the cash horde changes hands from individuals to institutions—and we would strongly take the contrarian point of view as to which side is the “smart money”—and retail investors can be much stronger hands than institutional holders for any number of reasons. So, putting this thesis together with our August doldrum theory from above, we have good reason to believe in a small market sell-off at best and a boring (amen!) few weeks ahead of us.