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.