Quarterly Commentary October 2009

Animal Spirits

I cannot procrastinate any longer.  After all, a quarterly report must be written every three months.  But for weeks now, I have been deliberating how to explain why I have been mostly in cash, and hedged the few long positions I do have, while the S&P 500 has risen 50%.

The markets certainly looked ready to roll over in July.  But every dip has been met with buyers, and virtually every tradable asset class has marched upward in tandem.  Theory follows price, and in the aftermath, every market pundit has rushed to proclaim that a new bull market is evidence of a v-shaped recovery.  Of course, markets are a discounting mechanism, looking over the valley to the dawn of a new beginning.  And as prices continued to rise, I have (daily) peered into the darkness, looking for the light that everyone else seems to see, at times almost inventing some reason to follow the herd.  But as I look past the talking heads, I cannot help but to keep stumbling on the facts:

• The Wall Street Journal has run several articles recently on the state of commercial real estate.  Office buildings, apartments, and retail centers all have rising vacancies, at levels not seen in decades.  I consult for several real estate management companies, and know firsthand that EVERY category of commercial property has been adversely affected.  In addition, commercial lenders have vanished, struggling with their own mounting defaults and non-performing loans.

  If you consider the combined statistics on commercial mortgage debt, equity, and future rental cash flows, you must conclude that the value of many REITs is permanently impaired. Even if a core group of higher-quality REITs escapes bankruptcy, their equity will still be impaired because lenders will only refinance properties on very tight terms: strict covenants, high interest rates, and requirements of hefty equity infusions into upside-down properties. This is a transfer of wealth from REIT shareholders to creditors. This wealth transfer is occurring through many channels, but the most important one relates to claims on future rental cash flow, which will be bleak regardless of who owns it:

  REIT shares have increased almost 40% in the last three months.

• Bank failures are at levels not seen since the savings and loan crisis.  Georgian Bank, the second-largest Atlanta-based bank, which the FDIC deemed to have plenty of capital in June, failed last week.  The FDIC estimates the collapse will cost its insurance fund $892 million, or 45 percent of the bank’s assets; the highest among the 10 largest bank failures.  How many other seemingly healthy multibillion-dollar community banks are out there waiting to implode?

  The FDIC is out of money, finishing the third quarter with a deficit, and must collect $45 billion in advance payments from the banking industry to remain solvent.  The $70 billion of additional losses forecast in May, has just been revised to $100 billion.

  Banking stocks have risen in excess of one hundred percent since March.

• The world is awash in natural gas.  In the last three years, thanks to the new “fracting” technology used in oil shales, we have discovered a one-hundred year supply of natural gas sitting under the US, and the producers have not been able to cut back fast enough. There is a supply glut, and we are almost out of storage.

  Natural gas prices have doubled in the last two months.

• High yield loan defaults continue to climb past multi-decade records.   I have been consulting for several prominent bond mutual funds, as a work-out specialist for problem deals.  I can personally attest that bonds worth perhaps 20 cents on the dollar are on the mutual fund books for the full dollar.  Assets are inflated, losses are understated.

  High yield bond fund returns have exceeded the return of the S&P 500, as interest rates plummet and investors discount the “inevitable” recovery.

• It is widely believed that the liquidity supplied by the Federal Reserve and Treasury bail-out actions is the fuel for the current rally.  However, M2 money supply has actually decreased in the last three months, documenting that banks are hording the stimulus funds, which threatens to choke off a recovery by withholding credit

I could go on, but you get my point.  The buy and hold, all-in investor is doing great.  In fact, the retirement accounts I manage, in which I apply a basic asset allocation approach, are performing much better than my discretionary accounts.  And contrary to media reports, many other active managers are struggling, or have held cash throughout the past three months.  The endowments of Harvard, Yale, and MIT have just reported their second fiscal year of double-digit losses.  The hedge fund industry, in the aggregate, is up 14% year to date.  In particular, there was an article on Peter Thiel (co-founder of Paypal) on the front page of the Wall Street Journal.

The following chart is food for thought, for all those who believe in the sustainability of the rally.

Financial stocks have rebounded in the greatest dead cat bounce and short-covering rally of all time.  The market risk was low in March, but not so low in June, and is even greater now.  The P/E multiple on the S&P 500 has just jumped from 10 to 20 in six months.  Historically, a 20 multiple is a terrible time to enter the market.  The market has priced in a V-recovery, which we are not going to get.

After a 50% run, I am largely in cash, waiting for better opportunities.  And it is a little early to play the short side, because it is a nightmare trying to short a liquidity driven market with interest rates at zero. There is no return on low risk investments now. Capital always moves to risky assets when interest rates are zero. Artificially low interest rates boost asset prices to artificially high prices. It always ends in tears, but can play out for a while. You want to have an asymmetric risk reward metric in your favor, as we did in March of this year. Now, we don’t have that.

Bigger Picture

While it is easy to dismiss the markets as insane or manipulated, there is in fact an honest, ongoing debate:  is there a recovery or will there be a relapse; is there pending inflation or deflation.  Rising unemployment, falling housing prices, huge Treasury bond auctions that continue to sell at low interest rates, manufacturing utilization below 70%, mounting stockpiles of commodities; all currently define a deflationary environment.  Without a doubt.  But there is universal suspicion that zero percent interest and stimulus funding, administered by a lead-footed government, will inevitably lead to inflation.  All eyes now are on the falling dollar.  At some point, the reaction must be an increase in interest rates.  The issue is timing.  And, like the point spread on the Super bowl, shifting bets by investors have, and will, continue to cause the markets to careen from one collective perception to the next.

In other words, there is a lot of money sloshing around that honestly does not know where to go.  And as economic events unfold, I think we will have sequential bubbles, as market players rush to anticipate the next play.   So, while the markets are currently ignoring all bad news, at some point that will become impossible.  

Perspective for the Fourth Quarter
In the short term, my focus is entirely on the short side of the market.  The markets may have some additional upside, given the residual strength, but everything is collectively overbought, and I believe the next big move, the surprise, is down.
Sector Thoughts

• Gold and silver are like beanie babies to me.  I don’t get it.  The demand, and price, is artificially contrived.  There is no yield, no industrial demand, no scarcity, just some historical believe in precious metals as a store of wealth.  As a hedge against inflation, I’d rather have copper or oil.
• China and the BRIC emerging economies:  China, it is said, will lead the world out of the recession.  Copper, zinc, and other commodities prices have risen to meet the growing demand.  However, 12% of the world’s inventory of cargo ships sit empty in harbors outside Singapore, Hong Kong, and other Asian ports, neither importing raw materials, nor carrying out manufactured exports.  And copper stockpiles grow, as Chinese pig farmers speculate in copper as a store of wealth.  China has enacted a stimulus program much larger than the one in the U.S., and the resultant speculation has prompted one Chinese central banker to comment that he “sees bubbles everywhere.” 

  China, in the short run, has problems.  It is a country built on vast manufacturing capacity, and its primary client (the U.S. consumer) is tapped out.  China has no middle class, just a few wealthy and many poor, and thus has no substitute purchasers for its manufactured goods.  It is hard to game their economy, because so much is manipulated by the Chinese government.  But the Shanghai stock exchange is up 80% this year, and banks have been recently told to restrict lending.  I currently see little upside in China.

• The Australian economy, and dollar, has rallied tremendously as the country follows along in the China slipstream.  However, if China stumbles, the Australian markets can fall hard.  I am watching their dollar, bond market, and country ETF for a potential short.
• Bonds have rallied sharply in the last few months, and I strongly believe it is time to sell.  The combination of a falling dollar, and massive Treasury bond sales, will at some point push interest rates much higher.  At current yields, bonds offer all risk, no reward.  As a speculation, bond prices have been too high to buy, but too low to sell short.  I have been watching TBT, an inverse bond exchange traded fund that rises as long-term Treasury rates rise.
• Oil certainly marches to its own drummer.  There is currently an oversupply, and prices dip down again into the low 50’s; but oil may hold its own in a falling dollar environment.  My primary oil position has been Prudhoe Bay Royalty Trust, because of the dividend, but it is thinly traded, and can be a bit volatile.  I’ve sold a little lately, but it continues to be my largest single holding
• Commodities have done well in spite of rising inventories, due to the falling dollar.  Any hint of dollar strength, and I think commodities can easily fall.  In particular, I think copper is an interesting short.  Southern Peru Copper, a favorite holding, cut its ample dividend almost completely due to poor conditions, and yet the stock has doubled in the last few months, pricing in a rapidly improving world economy.  Short of an utter collapse in the dollar, I can see a round trip.
• Agriculture has the most promising fundamentals, particularly in light of the tremendous droughts occurring in various part of the world; but stock prices remain suppressed.  Mosaic and Potash just reported earnings that declined 90+%.  I’ll continue to watch.
• Real Estate is dead money for the next ten years.  The bottom is nowhere in sight.  Historically, markets overshoot on the downside just as much as they overshoot on the upside.  As such, real estate will bottom when it gets downright cheap.  Until then, there are myriad variables that will knock the legs out of any signs of stabilization.