Ramblings of a Portfolio Manager

The Culture of Pessimism

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

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

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

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

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

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