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.