Quarterly Commentary: January 2010

A Bull Market in Government Intervention

Bloomberg: Buffett Ends 2009 Trailing S&P 500 by Most in Decade

Investing in 2009 involved an all-or-nothing bet on the anticipated results of massive government intervention. Bonds rallied based on the perceived rescue of the banking system; stocks rallied on the hopethat cheap money and a depressed dollar will ignite a V-shaped economic recovery; and commodity prices leaped on the certainty that all this debt and money printing must lead to inflation. As such, almost every asset class rose in unison, offering little opportunity to hedge or diversify. All other fundamentals have been irrelevant. On the contrary, the weakest asset classes performed the best, even while economic conditions have steadily deteriorated. Stocks I sold with declining (even collapsing) fundamentals laterdoubled in price. To have hesitated, blinked, hedged, or otherwise questioned these market assumptions was to substantially underperform the indices this year. I obviously blinked; so much so that my eyes are watering. As such, this was perhaps my most challenging year for actively managed accounts, amidst one of the greatest stock market rallies in seventy years.

The brevity of the decline, and the speed and size of the rally is astounding when compared to any other historical period, especially given the pervasive effect of a bursting credit and real estate bubble. Financial stocks account for about 40% of the S&P 500, and their collective 170% rise was a major contributor to the overall market bounce. During the dotcom crash, which arguably affected a far smaller portion of the
economy, the S&P 500 took about two years to bottom, and over four more years to rebound 65%. After the bear market of 1973-1974, the S&P 500 took 23 months to rise 78%. The current rally exceeded 65% in nine months. Even the most casual observer must question whether prices have risen too far too fast.

My investors are interested in making money, not an economics lesson. But market conditions have sodiverged from (what I would deem) rather extreme economic conditions, that some discussion is essential to shed some sanity on my behavior. I will reference a headline where appropriate; and if anyone wants to read the source article, let me know and I’ll send it. I am attaching An Empire at Risk by Niall Ferguson, aprominent Harvard historian who also hosts a fascinating documentary, The Ascent of Money.

The “betting” versus the facts

As will come as no surprise to clients and other readers, I am solidly of the opinion that the worse is yet to come, especially since the unfolding news and data seems to directly contradict the market consensus. The elephant in the living room, of course, is the world-wide governmental attempt to borrow our way out of debt. Markets seem temporarily fooled by this because, in the past, it has always (eventually) worked. Barton Biggs, a legendary money manager in his late seventies, has remarked that he is a child of the bull market; suggesting that, over the career of virtually any living money manager, easy money has always led to growth. But there have been profound contradictions. Japan; entering a third decade of stagnation. Our own dotcom bust, when government intervention simply created another bubble. Money managers and policy makers have never faced such a pervasive debt bubble overhanging almost every world economy;but there is still the expectation that familiar solutions will result in a predictable outcome.

• “Asset prices have risen due to the flood of liquidity from emergency measures of the Federal Reserve and the Treasury.” The Federal Reserve bought $1.5 trillion of toxic assets from financial institutions, while pushing interest rates down to zero. Such tremendous liquidity, multiplied by fractional reserve banking, must be the reason for the rise of stock and bondmarkets. Or is it? The most obvious manifestation would be a direct increase in money supply. During the credit bubble of mid-2005 to early 2008, money supply soared, attesting to the gusher of liquidity. However, money supply is now shrinking in real terms. How is that possible? Banks have literally zero borrowing cost, and can lend many times their newly enhanced capital reserves,providing an overwhelming profit incentive to lend. But anyone who has applied for a loan, or has had their credit card limit arbitrarily reduced, knows that banks are simply not lending. Since lending is crucial to their salvation, there can only be two possible explanations. The first is that there are few viable borrowers. That may be true in, for example, real estate, but the banks are not lending to industries with rising product demand either, i.e. farmers and mining companies. The only other explanation is that the banks cannot lend due to overwhelming problem loans still on the books. Evidence the record number of bank failures this year, the insolvency of the FDIC, and the $17.5 billion decline in consumer credit, the largest drop since record keeping began in 1943.

  Note: A shrinking money supply in real terms has happened only four times before last November, and each time it signaled either the onset of a major recession or a sharp deterioration in a contraction already underway.

• “Stocks are rising due to the falling dollar.” Maybe. But the dollar was lower a year ago, when the stock market was crashing.
• “All this debt and money printing will lead to inflation and high interest rates.” Actually, that is what the Federal Reserve is counting on: high inflation to lessen the real cost of all this debt. However, inflation and interest rates are always discussed as an inseparable unit, as if they must move together in the same direction. Rising inflation generally does lead to rising interest rates, as lenders attempt to maintain their purchasing power. But the reverse is not always true: rising interest rates do not necessarily lead to high inflation. Interest rates will almost certainly rise as the Treasury auctions more and more debt to a static pool of buyers. But high unemployment, low manufacturing capacity, and shrinking money supply point to deflation. High interest rates coupled with deflation is the worst of all possible scenarios, historically seen in the depressionary environment of over-leveraged economies.
• “Gold is a safe haven from inflation.” Gold appreciated 25% in 2009. Copper appreciated 140%. If inflation truly becomes a concern, industrial commodities would appear to be a much better hedge.
• “Asia will continue to finance our debt.” A friend of mine is over leveraged, and is afraid that if he misses a credit card payment, the interest rates on all his cards will spike. So he has taken out a large cash advance again his one card with some credit line left, and is making minimum payments on all his other cards. His total debt is now ballooning at a much faster rate. That is exactly what our government is doing.

  Last year, the U.S. Treasury issued $2 trillion new debt to finance the deficit. Total foreign purchases were $300 billion. Of that, China purchased $100 billion. The largest purchaser: the Federal Reserve, at over $800 billion, to create the illusion of demand and to keep interest rates low. Since almost 50% of all U.S governmental debt is in the form of short-term bonds that mature within one year, our federal budget is extremely sensitive to any increase in interest rates. And as U.S. consumers purchase fewer Asian goods, Asians have fewer U.S. dollars to recycle into our bonds.

• “Emerging economies will lead the world’s recovery.” Emerging markets, by definition, are thin, single purpose economies that fall into one of two broad categories: they either supply China with raw materials; or they are China, who supplies the U.S. with consumer goods.
• CNBC: Chinese Overcapacity is Worsening, EU Chamber Warns
• Bloomberg: China Property Bubble May Lead to U.S.-Style Real Estate Slump
• Bloomberg: Dueling Chinese Bubbles
• Bloomberg: Shanghai residential property gains 60% in 2009.

U.S. per capita income is $48,000; in Asia, $5,800. No economy in the world (including China)can replace U.S. demand for Chinese products. The Chinese have enacted a stimulus package proportionately far in excess of the U.S.; and since the government there can force banks to lend, money supply has increased by 30% this year. As such, the Chinese are gearing up for manufacturing demand that does not exist. The State Council acknowledged in August that overcapacity was blighting many industries and that local governments were expanding capacity "blindly". It is estimated that 95% of GDP growth in 2009 is a direct result of governmental spending on infrastructure projects and forced bank lending. Remaining stimulus is pouring into stock and real estate speculation. As such, the Chinese government (and every Chinese supplier, such as Australia, New Zealand, Canada, and most of South America) is explicitly betting on U.S. consumer demand returning to pre-crisis levels.

“Copper, oil, and other commodities are rising due to a falling dollar and the recovery of Chinaand other emerging markets.”

 

 

 

 

 

 

 

 

 

 

 

Note in the graph that copper prices and warehouse inventories (excess supply) are inversely related, which is logical: as demand rises, prices rise and inventories fall. However, since spring, 2009, LME global warehouse inventories for copper and other industrial metals are skyrocketing along with rising prices. This suggests that demand is waning as copper prices rise, and that prices continue to rise due to speculation rather than actual industrial demand. Recent news articles giveweight to such evidence:

• Bloomberg: China’s imports of refined copper dropped by 35% in the fourth quarter.
• Bloomberg: Chinese Pig farmers amass copper, nickel

The markets are beset by a series of contradictions. They are dependent on extraordinary amounts of government stimulus. But that stimulus is in turn ultimately dependent on the willingness of lenders to continue to finance exploding government debt at extremely low rates. They should be willing to do so only if they believe that growth prospects are poor and inflation will stay low. But if they believe that, investors should be unwilling to buy equities and houses at above-average valuations. Markets are utterlyreliant on unsustainable government stimulus. Something has to give.

Perspective for the First Quarter

Sentiment indicators are positively giddy. An Investors Intelligence poll shows stock-market optimism at levels not seen since just before the market peaked in October 2007. Only 23% of individual investors are pessimistic about the upcoming year, the lowest level since January, 2006. 15.6% of investment newsletters are bearish, the lowest level since April, 1987. Thomson Reuters reviewed all analysts' recommendations, across the Standard & Poor's 500-index group of major stocks, for 2010. Fewer than 7% are negative. And most of those are merely "underperform" calls. Just 2% are outright "sell" recommendations. The most optimistic argument I have heard is that bubbles can last longer than anyone imagines. What’s interesting is that, in reading many professional investment reports, the bullish managers
are very concerned about the unfolding fundamentals but continue to be bullish for the moment because, well, everyone else seems to be.

Analysts were similarly bullish at this point 10 years ago, at the start of the worst decade for U.S. investors in recorded history—as they were two years ago, just before the biggest crash in living memory. At the start of 2008 ( a terrible year) , according to Thomson Reuters, even fewer recommendations were bearish—a mere 6% were either a "sell" or an "underperform," while 49% were "buy" recommendations, of
which 21% were a "strong buy."

 

 

 

 

 

 

 

 

In the last nine months, the price of almost every asset class has risen to pre-crisis levels; as if the credit crisis never happened, and economic growth will pick up right where it left off. Most asset classes are now priced for perfection. The S&P 500 is selling at 28 times earnings; and is anticipating, and fully
discounting, a sustaining V-shaped economic recovery. Junk bond rates and spreads to treasuries are extreme, as if the default rate has vanished. Commercial real estate is at pre-crisis prices, reflected by caprates in the 4-4.5 range, amidst rising vacancies and refinancing risk. Municipal debt issuance is exploding as state revenues decline the most since 1963.

• Financial Times: Default rate for U.S. commercial mortgages climbed to fresh 16-year high.
• Wall Street Journal: Junk-Bond Rally Loses No Steam

Sovereign debt risk is spreading. In 2010, our federal budget, and the budget of the State of California, will have the same debt-to-GDP ratio as the collapsing sovereign debts of Greece, Iceland, Spain, Ireland, Italy, and most of the Baltic countries. And, as a sign of things to come, the President of Iceland refused to sign a bill to repay $5.5 billion in debts to Great Britain and the Netherlands.

Our political process has collapsed. The State of California required $8 billion in federal stimulus funds to balance the budget, and needs $21 billion this year. There appears to be no political attempt to manage the State, other than run to Washington for a bail-out. Last year, the Federal Reserve dropped interest rates to zero in an emergency measure. The emergency is over, evidenced by the money center banks’ repayment of $200 billion of TARP money. And yet interest rates will remain at zero “for an extended period of time.” The $200 billion in repaid TARP funds will not be used to reduce the federal deficit, but recycled insome political-derived emergency. Since 2010 is an election year, and both parties feel vulnerable, financial discipline is likely out of the question.

Tactics for the First Quarter

I started 2009 with a portfolio of high-yielding stocks. I sold most of these stocks as every one of their dividends was substantially cut or eliminated due to poor business conditions. For most of the year, I held cash and a position in the Prudhoe Bay oil field, which still paid an 8+% yield. I initiated a small positionin an S&P 500 inverse exchange traded fund as a hedge for the BPT position, to minimize price
fluctuations and lock in the yield.

In October, when the market looked weak and valuations reached an extreme, I took a much bigger positionin several inverse ETF’s for commodities, real estate, and the Russell 2000 (small companies that generally do poorly in a recession). Inverse ETF prices go up when the underlying stock price goes down; i.e. it is a technique to short a market sector. Inverse ETFs have a well-publicized tracking error; i.e. they do not perfectly inversely track the respective index. However, they seem to work fine for me, and a crude tool suits our purpose. Any meaningful correction and the price of these ETFs can easily rise by two to fivetimes our basis.

Since bull markets always end before we are ready, and because markets fall much faster than they rise, itis very hard not to be early when shorting the market, or a specific sector. And I am too early. The market did not rollover, but has moved incrementally higher. As such, I am taking heat (sitting on unrealized losses), hedged somewhat by cash and the BPT position, which has risen steadily higher. The market has started the year almost exactly like the start of 2009 (and we all know how that quarter ended), ignoring a steady stream of disappointing economic news. I may attempt to hedge a little better as the market fluctuates, but given my expectations, will continue to be prepared for a market decline.

Sector Thoughts

Since all asset classes have moved in unison, cuing off the stimulus, the direction of interest rates and the dollar, there has been little need for subtly or extensive research.

• The world is watching the results of the 2010 Treasury auctions. If the Federal Reserve ends their buy program in March as announced, and foreign purchases remain constant, then every conceivable argument points to interest rates rising this year. Since the world markets of almost every asset class are held aloft by essentially free money; well, it should be an interesting year. The only possible delay of a substantial rate increase is if another economic crisis occurs, and there is a rush from risk assets to the safety of U.S. government bonds. Every hedge fund manager has been very vocal about shorting long-term treasuries, but they really haven’t moved much in a year. Frankly, virtually every class of bonds has a disproportionate risk to reward.
• I am reconsidering my dismissal of gold and silver. I still do not understand them, but byd efault, they may prove at some point to be the most advantageous store of value. Gold and silver are very hard to trade, and theoretically, I still prefer other industrial commodities as a hedge against inflation.
• China, other emerging markets, and commodities: These three sectors, for all investment intents and purposes, are currently the same market. And I see each of these markets as currently grossly overbought, if not in an actual bubble. Any hint of U.S. dollar strength (quite likely this year) and this entire complex can easily fall.
• Oil, natural gas, and most industrial commodities have had rising inventories along with rising prices for most of the year, as market participants play for a recovery in the second half of 2010.The last time copper inventories were this high was in July, 2008; copper prices subsequently fell 65% in the following five months. My only long commodity position has been Prudhoe Bay Royalty Trust, because of the dividend, but it is thinly traded, and can be a bit volatile. I amcurrently short commodities via the inverse exchange traded fund, symbol SMN.
• The most promising emerging markets have been those natural resourced-based countries that supply China. All have rallied tremendously this year, all have very strong currencies. Since I am bearish on China, I have not explicitly traded emerging market securities, except in the retirement accounts. I am personally short the China ETF, but have elected to avoid this sector with actively managed funds.
• Agriculture has the most promising fundamentals, but the ETFs have barely moved this year. The most successful participation of some rising soft commodities has been in the futures market,which we do not participant in with client funds. Agriculture has been affected this year by bumper crops in some markets, and by the farmers’ inability to obtain bank loans for fertilizer and seed. Mosaic and Potash continue to report terrible earnings. I’ll continue to watch.
• Commercial real estate investment trust shares have continued to climb, while the underlying fundamentals steadily decline. I am short the commercial real estate sector, through the ETF symbol SRS.
• Small capitalization companies grow fastest in an economic upturn, and decline the furthest in a downturn. I am currently short the sector through the ETF symbol TWM.