Fair is Foul and Foul is Fair
--Macbeth
The old saying on Wall Street is “as goes January so goes the year.” It’s a quaint little scrap of urban legend that suggests the first week of trading in the stock market—the Dow Jones Industrial Average—foreshadows the remainder of the year. Over the years stock traders, ever an impatient lot, have further distilled the adage into “as goes the first week of January, so goes January” thus avoiding the wait until the 31st to make their asset allocation decisions. Not to be outdone other, equally superstitious, traders have added the Super Bowl Indicator, which suggests a correlation between the winner of the big game and the performance of the equity markets (Dow) in that calendar year (old NFL team wins are good, former AFL team victories are bad). While both myths are good for a chuckle, there is a surprising correlation between them and Dow performance. The Superbowl Indicator has a better than 88% accuracy rate over its life while the so-called January Barometer has demonstrated predictive power 73% of the time when the indicator points up. It’s all spurious, of course, but it gives the tooth fairy believers among us in the markets something to which to look forward during the bleak winter weeks. But we digress.
The US equity markets got a good start to the new year last week. The Dow rose 1.82% while the S&P 500 gained 2.74% and the Russell 2000 Index of small cap stocks bested them all at +3.08%, giving believers in the January Barometer something to cheer. What was remarkable to some, however, is that these gains came amid the release of mixed to weak economic data: Construction Spending kicked off the week coming in slightly worse than expected, down 0.6%, followed by the ISM Index, which was slightly better at 1.1% vs. a forecast of 0.5%. Pending Home Sales were a disaster, down 16% vs. a +2.0% forecast but the 800 lb. gorilla broke the scales on Friday when Nonfarm Payrolls were reported at -85,000 vs. a forecast of flat and some market expectations of a rise. While most of the market gains occurred on Monday, the first trading day of the year, the markets failed to give it back during the rest of the week and actually tacked on slight gains over the remaining trading days even in the face of the weak economic news, especially on Friday. To the market skeptics this behavior was absurd; to us it was predictable.
Market bears have decried the rally since it began on March 9th and they’ve thrown every known investment cliché at it—from “too far too fast” to “not supported by fundamentals” to a cornucopia of chart-speak we don’t understand so will not quote here. Having failed to receive their expected revisit of the Dow to the 6000 region, these same skeptics are now calling for the end to come when the Federal Reserve begins to withdraw liquidity and hike rates, which was expected to occur later this year. Here we cannot disagree with them. While we believe much of the markets’ rise since March has been the result of them doing their job as discounting mechanisms, anticipating the economic rebound we are now seeing, much still has been liquidity-driven. An effective short-term interest rate of zero has made the equity markets look “cheap” in many investment models--not to mention what that implied yield curve has done to bank earnings--and the result has been as remarkable as it has been predictable. Anyone who doubts the rate effect on the markets need only look at the inverse correlation between the dollar and markets over the last year or, more recently, the sideways action of equities amid the increasing belief that the Fed will begin to raise rates sometime in mid-2010. In fact, we were prepared, earlier this week, to call this piece “Sell in May and Go Away,” suggesting that if most market participants expected a June-July rate hike, then the time to get out of equities would be months earlier. Friday changed all that. The weak jobs numbers, we believe, have pushed out market expectations of a rate rise to later in the year. Before the report PIMCO’s Bill Gross was calling for no rate hike at all this year and few believed him—now, many do.
So what do we expect now, as we head into earnings season? Perversely, we believe that for individual equities, bad news will continue be seen as negative and good news good, while for the equity markets as a whole, bad news—in the form of weak economic data--will be positive overall as it will push further out the expected date the Fed will have to take back the proverbial “punch bowl.” Add on top the cynical optimists (like us) who believe that continued weak jobs data will spur the White House into releasing more Fiscal stimulus programs ahead of the mid-term elections and you have a recipe for continued market gains amid lackluster economic reports. Last week we poked fun at investment managers who call each year for a “market of stocks” versus a “stock market” but for the upcoming quarter, at least, that just might be what we will see.
Monday, January 11, 2010
Monday, January 4, 2010
Ramblings of a Portfolio Manager 1-4-2009
Will China Do it Again?
It’s just about axiomatic on Wall Street that the top-performing market, sector, or asset class from one year seldom retains that title over the course of the next twelve months. Notwithstanding the marketing materials from the momentum or “trend is your friend” style of investing crowd, our research shows the old adage largely holds true when one looks within a particular geographic market. Here in the US one needs only to look at the tech bubble and subsequent wreck of 1999-2000, the real estate and financial services boom and bust of 1989- 1990 and more recently 2006-2007, and the commodities run over 2007-2008. There are many more examples and they all share the same basic life cycle: a catalyst—e.g. interest rates, currency exchange rates, disruptive product innovation, mania, etc., which starts the performance trend--a reaction, which is generally a big run up in prices during the latter stage of which the term “this time it’s different” is often heard--followed by an inhibitor –Central Bank actions, aging product life cycle, valuation concerns, someone standing up and yelling “hey, he’s just a big cockroach” (as in the old Far Side cartoon), which cools the trend or pricks the bubble as it were.
There has been much hand wringing over China, its stock market and economy of late. Many of the pessimistic charges levied against the US market and economy have similarly been aimed at China, often by the same cynics. The Chinese Shanghai Composite index rose over 75% in 2009 and Chinese GDP grew at a rate somewhere north of 8% according to most economists. The GDP growth rate compares to 11.4% and 9.6% in 2007 and 2008. The term “too far too fast” is beginning to be applied to the Chinese stock market while “bubble economy” or “stimulus dependent” are phrases one often hears regarding the Country’s economy. Sound familiar? Of course there is the whole cadre (that’s what Mao would have called them just prior to having them shot) who simply claim that China fakes the economic numbers and that the entire market run-up is a sham.
We can’t argue with the fact that the trend in China’s GDP is for slower growth each year—even we agree with the proverb that “trees don’t grow to the sky” and eventually the law of large numbers takes over—but we take issue with the fact that China is in a falsified or stimulus-induced bubble destined to soon burst. As with the US, government actions are indeed driving the economy in the short term. The 4.0 billion Yuan stimulus package passed by the Chinese Central Government last year is most certainly behind the Country’s impressive growth rate amid a slumping world economy. The State controlled banks kicked off the growth with a lending spree that produced a 30% jump in the Chinese money supply (M2) and this was followed by the spending package aimed mostly at infrastructure projects in the Country. Like the US, together these monetary and fiscal moves have been the catalysts that produced the desired jump-start effect to GDP growth and the stock market has followed. Unlike the US, however, we see no reason for the Chinese Central Government to yank the punch bowl any time soon, either through higher interest rates, spending reduction or higher taxes.
As we write this the Shanghai index has gotten of to a rocky start to 2010 on fears that the Government will cut stimulus spending and remove liquidity earlier than previously expected, cooling growth. Again, sound familiar? At last count there were something like 1.3 billion Chinese living in China. Metaphorically, that is certainly enough that if they all jumped off a chair at the same time, the Earth would indeed move—which means practically that they wield significant “weight” in the World economy. The nominal per-capita GDP of these masses (about $3200 n 2008 according to the World Bank) places them in the lower middle class by world standards yet collectively they comprise the World’s second largest economy after our own. It’s human nature that #2 seeks to emulate or surpass #1 which means all these Chinese want the same or better standard of living that we have—cell phones, cars, televisions, 17 flavors of potato chips, etc--.and that they have a long way to go to get it. And even though they don’t have the same voting or freedom of speech rights as we, they are quicker to carry pitchforks and torches when they don’t get what they want. The Chinese Government, in our opinion, has 1.3 billion reasons not to take its foot off the accelerator anytime soon and unlike the US, with no massive debt balance to cause them concern over spending or contemplate raising taxes to pay for it all, they have the flexibility to keep that foot down. In addition, China is keeping the value of it’s the Yuan pegged to the US dollar at very low levels with no incentive to raise the exchange rate ( due to all the money we owe them—they ain’t stupid, you know). With the greenback depreciating at a record pace over the last year, the trade-weighted value of Yuan is also declining, making Chinese goods cheaper to recovering consumers worldwide. That will spur exports, driving manufacturing and in turn keeping the economic engine running when liquidity is eventually withdrawn. As the Chinese economy begins to demonstrate that it can grow on its own two feet, we expect that its stock market will follow in lock-step. So even the Shanghai was fine in 2009, we can see it do it all again in 2010.
It’s just about axiomatic on Wall Street that the top-performing market, sector, or asset class from one year seldom retains that title over the course of the next twelve months. Notwithstanding the marketing materials from the momentum or “trend is your friend” style of investing crowd, our research shows the old adage largely holds true when one looks within a particular geographic market. Here in the US one needs only to look at the tech bubble and subsequent wreck of 1999-2000, the real estate and financial services boom and bust of 1989- 1990 and more recently 2006-2007, and the commodities run over 2007-2008. There are many more examples and they all share the same basic life cycle: a catalyst—e.g. interest rates, currency exchange rates, disruptive product innovation, mania, etc., which starts the performance trend--a reaction, which is generally a big run up in prices during the latter stage of which the term “this time it’s different” is often heard--followed by an inhibitor –Central Bank actions, aging product life cycle, valuation concerns, someone standing up and yelling “hey, he’s just a big cockroach” (as in the old Far Side cartoon), which cools the trend or pricks the bubble as it were.
There has been much hand wringing over China, its stock market and economy of late. Many of the pessimistic charges levied against the US market and economy have similarly been aimed at China, often by the same cynics. The Chinese Shanghai Composite index rose over 75% in 2009 and Chinese GDP grew at a rate somewhere north of 8% according to most economists. The GDP growth rate compares to 11.4% and 9.6% in 2007 and 2008. The term “too far too fast” is beginning to be applied to the Chinese stock market while “bubble economy” or “stimulus dependent” are phrases one often hears regarding the Country’s economy. Sound familiar? Of course there is the whole cadre (that’s what Mao would have called them just prior to having them shot) who simply claim that China fakes the economic numbers and that the entire market run-up is a sham.
We can’t argue with the fact that the trend in China’s GDP is for slower growth each year—even we agree with the proverb that “trees don’t grow to the sky” and eventually the law of large numbers takes over—but we take issue with the fact that China is in a falsified or stimulus-induced bubble destined to soon burst. As with the US, government actions are indeed driving the economy in the short term. The 4.0 billion Yuan stimulus package passed by the Chinese Central Government last year is most certainly behind the Country’s impressive growth rate amid a slumping world economy. The State controlled banks kicked off the growth with a lending spree that produced a 30% jump in the Chinese money supply (M2) and this was followed by the spending package aimed mostly at infrastructure projects in the Country. Like the US, together these monetary and fiscal moves have been the catalysts that produced the desired jump-start effect to GDP growth and the stock market has followed. Unlike the US, however, we see no reason for the Chinese Central Government to yank the punch bowl any time soon, either through higher interest rates, spending reduction or higher taxes.
As we write this the Shanghai index has gotten of to a rocky start to 2010 on fears that the Government will cut stimulus spending and remove liquidity earlier than previously expected, cooling growth. Again, sound familiar? At last count there were something like 1.3 billion Chinese living in China. Metaphorically, that is certainly enough that if they all jumped off a chair at the same time, the Earth would indeed move—which means practically that they wield significant “weight” in the World economy. The nominal per-capita GDP of these masses (about $3200 n 2008 according to the World Bank) places them in the lower middle class by world standards yet collectively they comprise the World’s second largest economy after our own. It’s human nature that #2 seeks to emulate or surpass #1 which means all these Chinese want the same or better standard of living that we have—cell phones, cars, televisions, 17 flavors of potato chips, etc--.and that they have a long way to go to get it. And even though they don’t have the same voting or freedom of speech rights as we, they are quicker to carry pitchforks and torches when they don’t get what they want. The Chinese Government, in our opinion, has 1.3 billion reasons not to take its foot off the accelerator anytime soon and unlike the US, with no massive debt balance to cause them concern over spending or contemplate raising taxes to pay for it all, they have the flexibility to keep that foot down. In addition, China is keeping the value of it’s the Yuan pegged to the US dollar at very low levels with no incentive to raise the exchange rate ( due to all the money we owe them—they ain’t stupid, you know). With the greenback depreciating at a record pace over the last year, the trade-weighted value of Yuan is also declining, making Chinese goods cheaper to recovering consumers worldwide. That will spur exports, driving manufacturing and in turn keeping the economic engine running when liquidity is eventually withdrawn. As the Chinese economy begins to demonstrate that it can grow on its own two feet, we expect that its stock market will follow in lock-step. So even the Shanghai was fine in 2009, we can see it do it all again in 2010.
Monday, December 28, 2009
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!
“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!
Monday, December 21, 2009
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!
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!
Monday, December 14, 2009
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.
-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.
Monday, December 7, 2009
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.
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, December 4, 2009
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