No economic law is more immutable than, "there is no such thing as a free lunch!" Actually, a more immutable law (at least in my mind) is you can't spend more than you make (at least not for very long). Not surprisingly, the two laws are related. And the truth be told, there are such things as free lunches, but they usually come with strings attached (which is the usual application of the idiom). But in the economic realm, there is a simple reason why there is no such thing as a free lunch and relatedly why you can't keep spending more than you make. It is because the production of a lunch costs something. Whoever is handing out free lunches is limited by how much capital they have. Ergo, there are limits to free lunches (and deficits), and the economic law holds true.
And so it seems with the massive government and monetary interventions we have experienced in the post-GFC world. We have become desensitized to the scale and the scope of the operations, and don't think twice anymore about new initiatives or new "solutions," largely because we have not seen too many deleterious effects. It seems that because none of these actions have led to immediate calamity, then maybe they are alright (perhaps even a free lunch). People who would traditionally and historically have been aghast at the actions proposed and undertaken, are now much less squeamish about each new initiative. We are becoming more comfortable with and more complacent about government interventions. And if that doesn't sound familiar, you may like to remind yourself of the pre-conditions to a bubble* (comfort and complacency are important ingredients).
There is a cost to artifice, and there is a price to be paid for attempts at muting the laws of economics. You can't simply wish new liquidity into existence, or make interest rates whatever level you want, without some cost. We have yet to see or feel the full effects of those costs, and therein lies the danger. The bigger the cause, the greater the effect. Ultimately it will be the encroachment of the previously contingent liabilities that sink us (unless we make the necessary painful changes). Rather than smoothing over the effects, the passage of time may in fact accelerate our day of reckoning.
*Bubble is being used here in the sense of something that is isn't sustainable, and for which there is a rude awakening.
Friday, December 23, 2011
Friday, November 18, 2011
Global Socio-Politico Trends
Post the Great Depression the global socio-economic trend among political elites was toward greater government involvement in the economy. That trend finally came to an end, shipwrecked on the rocks of the 70s recession. But by the time it had run its course, it had blended opposing socio-economic ideologies into indistinguishable political forms. Turning, so-called "conservatives," such as Richard Nixon, Edward Heath, Helmut Schmidt, Valery Giscard d'Estaing, Malcolm Fraser, and Robert Muldoon into quintessential socialists. Such is the pressure of a trend and a supportive ideology (Keynesianism).
The natural backlash to the expanding Statism of the 50s, 60s, and 70s, was the countermove toward deregulation and financial liberalization in the 80s and 90s, led by Margaret Thatcher and Ronald Reagan (supported incidentally by ideological liberals Francois Mitterand, Bob Hawke and David Lange in France, Australia, and New Zealand respectively). This trend now appears to have run its own course, shipwrecked on the shoals of the Global Financial Crisis, with Tony Blair and Bill Clinton the best examples of political actors who melded their opposing ideological disposition to the dominant ideology of the time (monetarism). Whether Democrat or Republican, Labour or Liberal, the times and the culture might change, but the dominant political parties seem to move symbiotically together.
Interestingly, the role that President Carter played (serving in the transitional flux between periods) might serve as a template for the role that President Obama is playing, as socio-political forces work out a new direction.
"plus ça change, plus c'est la même chose"
The natural backlash to the expanding Statism of the 50s, 60s, and 70s, was the countermove toward deregulation and financial liberalization in the 80s and 90s, led by Margaret Thatcher and Ronald Reagan (supported incidentally by ideological liberals Francois Mitterand, Bob Hawke and David Lange in France, Australia, and New Zealand respectively). This trend now appears to have run its own course, shipwrecked on the shoals of the Global Financial Crisis, with Tony Blair and Bill Clinton the best examples of political actors who melded their opposing ideological disposition to the dominant ideology of the time (monetarism). Whether Democrat or Republican, Labour or Liberal, the times and the culture might change, but the dominant political parties seem to move symbiotically together.
Interestingly, the role that President Carter played (serving in the transitional flux between periods) might serve as a template for the role that President Obama is playing, as socio-political forces work out a new direction.
"plus ça change, plus c'est la même chose"
Thursday, November 10, 2011
Sovereign Debt Crises Have A Long Fuse
About the only thing Greece* has shown us is that sovereign debt "crises" have a long fuse. The Greek crisis erupted in early 2010 and has yet to reach its ultimate zenith.
In recent days, Italian bond yields have risen above 7%, throwing into question the sustainability of Italy's fiscal position, and the potential collapse of efforts to bailout the eurozone.
Equity markets have appeared to ignore the current "crisis." I suspect it is because they see it as a long term problem, with only a small likelihood of a catastrophic collapse any time soon. With Greece as the blueprint for this thinking. This may, or may not, prove correct, but it has frustrated the bears no end. They have been betting upon a rapid conflagration, and are perplexed by the market going up in the face of supposedly rising risks. The greater possibility is for more "can kicking" and the prospect of a long dripfed erosion in confidence. Periodic fires (aka crisis of confidence) are likely break out, but the system can go on for a long period of time before the piper ultimately comes calling.
The real problem in this whole equation is structural fiscal/current account imbalances co-mingled with massive long term contingent liabilities due to generous promises made at various points in the past. In the absence of any serious address of those problems, we know how this story will end. Even when the market is signalling the ultimate end, a bankrupt country can make interest payments on its debt for a long period of time before it eventually calls it quits.
*And let's not forget Japan.
In recent days, Italian bond yields have risen above 7%, throwing into question the sustainability of Italy's fiscal position, and the potential collapse of efforts to bailout the eurozone.
Equity markets have appeared to ignore the current "crisis." I suspect it is because they see it as a long term problem, with only a small likelihood of a catastrophic collapse any time soon. With Greece as the blueprint for this thinking. This may, or may not, prove correct, but it has frustrated the bears no end. They have been betting upon a rapid conflagration, and are perplexed by the market going up in the face of supposedly rising risks. The greater possibility is for more "can kicking" and the prospect of a long dripfed erosion in confidence. Periodic fires (aka crisis of confidence) are likely break out, but the system can go on for a long period of time before the piper ultimately comes calling.
The real problem in this whole equation is structural fiscal/current account imbalances co-mingled with massive long term contingent liabilities due to generous promises made at various points in the past. In the absence of any serious address of those problems, we know how this story will end. Even when the market is signalling the ultimate end, a bankrupt country can make interest payments on its debt for a long period of time before it eventually calls it quits.
*And let's not forget Japan.
Friday, October 28, 2011
2Q11 Comments 7/15/11
Excerpt from 2Q 2011 commentary. Always interesting (and sometimes insightful) to go back and see what one has said in the past. Dated 7/15/11.
“Hey, Let’s Be Careful Out There”
Despite a rather anemic recovery, and a distinct soft patch, the consensus is holding out that the economy will get back on track later this year. Markets have held up surprisingly well, especially given all the negative headlines (debt ceiling debate, eurozone crisis, austerity), but they are somewhat bifurcated with a few high growth names receiving super-multiples, while megacaps trade at a discount to the average. In spite of the potential for systemic risk as a result of global deleveraging from the debt supercycle, equity markets have been underpinned by solid earnings, attractive valuations, and low interest rates. Negative real interest rates make equities the best looking house in a bad neighborhood. In the wake of the Fed’s exit from QE2, it has indicated a watch ‘n see approach, while retaining the Bernanke put. The task for investors is to determine the likely path forward as cyclical tailwinds smack into secular headwinds. Will it be policy mistakes and blunders, or will it be political solutions and renewed confidence? Are we in a secular bear market, or the early days of a new bull market? In the relative vacuum of the Fed’s exit from the market, it will be interesting to see whether the market tests the downside to gauge the Fed’s resolve.
Amid significant structural problems, political decisions and policy choices need to be feasible and effective in order to put to rest concerns. That requires strong, decisive leadership. Something that has been missing, not only in the US, but also in Europe and Japan. The authorities are doing everything they can to kick the can down the road. There is an end of the road somewhere. We just don’t know where it is, or when we’ll get there. The market has not really been spooked by the lack of decisiveness, but at some point it may have no choice but to respond to whatever crisis du jour washes up on the doorstep. Everyone knows that the solution to our problems is growth (productivity based growth). But knowing the solution and reaching a solution are two different things. In the absence of real change, the likely result is more “can kicking”, and ultimately either inflation, deflation, or some kind of burden-sharing restructuring. The longer we go without resolving a number of fundamental problems, the greater the likelihood that the market will get caught out and we’ll be facing a lost decade for the economy. With the authorities almost out of bullets in both the fiscal and monetary realms, good options are fast diminishing.
Given the potential severity of the risk backdrop, there are relatively few signs of stress in global equity markets. Credit spreads across the spectrum have expanded, but are within bounds, the VIX volatility measure has increased recently, but is reasonably tame by financial crisis measures, and perhaps most amazingly, government bond yields show few signs of alarm (the obvious exception being peripheral Europe). Given the potential for contagion, this is hard to fathom. Not only that, but there has been an apparent disconnect between corporate earnings and the economy, which leaves one scratching their head. The essence of the current dilemma is knowing that there is an elevated level of risk at a macro level, but also knowing from history that there is a good chance we’ll muddle through. A consequence of this juxtaposition is a positive skew for equity markets, but with the possibility of binary outcomes. In the absence of a strong conviction related to better times ahead, and in deference to the large macro risks overhanging the markets, it seems most prudent to proceed with some degree of caution.
The problem when facing a binary outcome of unknown magnitude, direction, or proximity is that you can become paralyzed with fear. Even if you don’t like the economy, you don’t like current policy(ies), and you don’t like the outlook, when you take a step back and factor in low interest rates for an ‘extended period,’ then it is hard to resist the temptation to deploy capital. There is a huge opportunity cost to sitting on the sidelines and waiting for the big one to hit. In the longer term it may be the right move, but in the shorter term it is incredibly painful and frustrating. The potential pitfall here is that the authorities are forcing you back into the market, largely based on a monetary illusion. When the punchbowl is taken away, and/or one of the major landmines explodes, then the mask may get ripped off and reality laid bare. Easy money distorts reality through perverted incentives, leading to the misallocation of resources, and ultimately the destruction of capital. Like too much honey, it tastes good at first, but leaves you with a stomach ache. Contrarily, there is a tendency to be too sensitive to risk(s), especially in the wake of a financial crisis when our attitudes are anchored by our experience in the recent past. Overcoming psychological as well as real barriers is one of the tasks at hand.
There are many good reasons to be concerned with the current global economic environment, but there are also many positive factors outstanding as well. To list a few: a normalizing of megacap and financial sector valuations; highly accommodative monetary policy; ongoing economic recovery; strong emerging market demand; solid earnings; decent long term expected returns; a recovering banking system; the eventual bottom and rebound in property and construction, and lending. In addition, the outstanding reservoir of negativity lends itself to a market climbing the wall of worry. Renewed confidence of any form will propel the market higher. Investors should look through the overwhelming doom and gloom, and allow for the possibility of positive resolutions to some of the nation’s long term problems. And the fact that there are a lot of things that are weak, means that when they improve, good things will ensue. And let us not forget two other important factors. Firstly, we have already experienced a lost decade for equities, and within the scope of history another is unlikely. Secondly, human progress and advancement often take place in the midst of financial turbulence and economic difficulty. On a relative basis, with interest rates near zero, equities don’t look so bad.
“Hey, Let’s Be Careful Out There”
Despite a rather anemic recovery, and a distinct soft patch, the consensus is holding out that the economy will get back on track later this year. Markets have held up surprisingly well, especially given all the negative headlines (debt ceiling debate, eurozone crisis, austerity), but they are somewhat bifurcated with a few high growth names receiving super-multiples, while megacaps trade at a discount to the average. In spite of the potential for systemic risk as a result of global deleveraging from the debt supercycle, equity markets have been underpinned by solid earnings, attractive valuations, and low interest rates. Negative real interest rates make equities the best looking house in a bad neighborhood. In the wake of the Fed’s exit from QE2, it has indicated a watch ‘n see approach, while retaining the Bernanke put. The task for investors is to determine the likely path forward as cyclical tailwinds smack into secular headwinds. Will it be policy mistakes and blunders, or will it be political solutions and renewed confidence? Are we in a secular bear market, or the early days of a new bull market? In the relative vacuum of the Fed’s exit from the market, it will be interesting to see whether the market tests the downside to gauge the Fed’s resolve.
Amid significant structural problems, political decisions and policy choices need to be feasible and effective in order to put to rest concerns. That requires strong, decisive leadership. Something that has been missing, not only in the US, but also in Europe and Japan. The authorities are doing everything they can to kick the can down the road. There is an end of the road somewhere. We just don’t know where it is, or when we’ll get there. The market has not really been spooked by the lack of decisiveness, but at some point it may have no choice but to respond to whatever crisis du jour washes up on the doorstep. Everyone knows that the solution to our problems is growth (productivity based growth). But knowing the solution and reaching a solution are two different things. In the absence of real change, the likely result is more “can kicking”, and ultimately either inflation, deflation, or some kind of burden-sharing restructuring. The longer we go without resolving a number of fundamental problems, the greater the likelihood that the market will get caught out and we’ll be facing a lost decade for the economy. With the authorities almost out of bullets in both the fiscal and monetary realms, good options are fast diminishing.
Given the potential severity of the risk backdrop, there are relatively few signs of stress in global equity markets. Credit spreads across the spectrum have expanded, but are within bounds, the VIX volatility measure has increased recently, but is reasonably tame by financial crisis measures, and perhaps most amazingly, government bond yields show few signs of alarm (the obvious exception being peripheral Europe). Given the potential for contagion, this is hard to fathom. Not only that, but there has been an apparent disconnect between corporate earnings and the economy, which leaves one scratching their head. The essence of the current dilemma is knowing that there is an elevated level of risk at a macro level, but also knowing from history that there is a good chance we’ll muddle through. A consequence of this juxtaposition is a positive skew for equity markets, but with the possibility of binary outcomes. In the absence of a strong conviction related to better times ahead, and in deference to the large macro risks overhanging the markets, it seems most prudent to proceed with some degree of caution.
The problem when facing a binary outcome of unknown magnitude, direction, or proximity is that you can become paralyzed with fear. Even if you don’t like the economy, you don’t like current policy(ies), and you don’t like the outlook, when you take a step back and factor in low interest rates for an ‘extended period,’ then it is hard to resist the temptation to deploy capital. There is a huge opportunity cost to sitting on the sidelines and waiting for the big one to hit. In the longer term it may be the right move, but in the shorter term it is incredibly painful and frustrating. The potential pitfall here is that the authorities are forcing you back into the market, largely based on a monetary illusion. When the punchbowl is taken away, and/or one of the major landmines explodes, then the mask may get ripped off and reality laid bare. Easy money distorts reality through perverted incentives, leading to the misallocation of resources, and ultimately the destruction of capital. Like too much honey, it tastes good at first, but leaves you with a stomach ache. Contrarily, there is a tendency to be too sensitive to risk(s), especially in the wake of a financial crisis when our attitudes are anchored by our experience in the recent past. Overcoming psychological as well as real barriers is one of the tasks at hand.
There are many good reasons to be concerned with the current global economic environment, but there are also many positive factors outstanding as well. To list a few: a normalizing of megacap and financial sector valuations; highly accommodative monetary policy; ongoing economic recovery; strong emerging market demand; solid earnings; decent long term expected returns; a recovering banking system; the eventual bottom and rebound in property and construction, and lending. In addition, the outstanding reservoir of negativity lends itself to a market climbing the wall of worry. Renewed confidence of any form will propel the market higher. Investors should look through the overwhelming doom and gloom, and allow for the possibility of positive resolutions to some of the nation’s long term problems. And the fact that there are a lot of things that are weak, means that when they improve, good things will ensue. And let us not forget two other important factors. Firstly, we have already experienced a lost decade for equities, and within the scope of history another is unlikely. Secondly, human progress and advancement often take place in the midst of financial turbulence and economic difficulty. On a relative basis, with interest rates near zero, equities don’t look so bad.
Wednesday, October 26, 2011
All Blacks win Rugby World Cup...NZ may never be the same
There are many reasons not to host the Rugby World Cup in New Zealand, but there are no comparable places in the world where rugby is so embraced and is such an integral part of the culture. It may be some time before the RWC ever returns to New Zealand, but the country will be forever marked by a sparkling six week period known as the Rugby World Cup 2011, culminating in the All Blacks victory. History is always hard to gauge at the time, but it is quite possible that the Rugby World Cup 2011 will leave an indelible mark upon the New Zealand psyche and the identity of the country.
And so, after years of RWC disappointment and heartache, it was not only appropriate, but fitting, that the All Blacks exorcised those demons in front of their home support.
And despite being the best team in the world over the past four years (and twenty four years since they had last won the cup), the x-factor of home field advantage may have been the telling factor in a match where the French won in virtually every facet, except for the one that counted, the scoreboard.
Pick me out of the crowd:
http://gigapixelfancam.com/fancams/rugby/2011worldcup/20111023/?slug=4263942-share-view&ref=nf
And so, after years of RWC disappointment and heartache, it was not only appropriate, but fitting, that the All Blacks exorcised those demons in front of their home support.
And despite being the best team in the world over the past four years (and twenty four years since they had last won the cup), the x-factor of home field advantage may have been the telling factor in a match where the French won in virtually every facet, except for the one that counted, the scoreboard.
Pick me out of the crowd:
http://gigapixelfancam.com/fancams/rugby/2011worldcup/20111023/?slug=4263942-share-view&ref=nf
Wednesday, October 12, 2011
Apple the new Microsoft
Apple has benefited greatly from peoples dislike of Microsoft's dominance and penchant for marginal upgrades. The seemingly constant need to update to new versions of the operating system or Office has hacked alot of people off.
Apple, in its present pursuit of monopolist profits, has now picked up the same playbook and will no doubt become persona non grata in a few years once people get sick and tired of paying more for the newest, latest, greatest, or even worse, getting stuck with some of their orphaned software and/or systems.
You've been warned!
Apple, in its present pursuit of monopolist profits, has now picked up the same playbook and will no doubt become persona non grata in a few years once people get sick and tired of paying more for the newest, latest, greatest, or even worse, getting stuck with some of their orphaned software and/or systems.
You've been warned!
Thursday, October 6, 2011
Steve Jobs passing is a milestone and a chance for reflection
I was saddened to hear of Steve Jobs passing. I heard it at tennis last night, and it was the first thing I passed along to H when I got home. He has touched my life with his products and has left a mark upon modern society and culture. A modern day Thomas Edison. It is amazing to see the outpouring of emotion today. A milestone.
We had a discussion with the kids at breakfast this morning regarding his impact upon our lives and his legacy. In going through his history (Pong, founding Apple, getting fired, NEXT, Pixar, and then rejoining Apple and transforming the modern consumer technology landscape), he is a testimony to perserverance, dedication, vision, and giftedness.
It was somewhat appropo because Emma asked about Henry VIII, and that got us into a discussion about the reformation and how people leave their impact upon society and culture, oftimes with us not even knowing the source.
We had a discussion with the kids at breakfast this morning regarding his impact upon our lives and his legacy. In going through his history (Pong, founding Apple, getting fired, NEXT, Pixar, and then rejoining Apple and transforming the modern consumer technology landscape), he is a testimony to perserverance, dedication, vision, and giftedness.
It was somewhat appropo because Emma asked about Henry VIII, and that got us into a discussion about the reformation and how people leave their impact upon society and culture, oftimes with us not even knowing the source.
Friday, September 16, 2011
The Markets Are Like Doctor Who
The markets are like Doctor Who (or Flash Gordon, or Lost in Space, or any of the other serials from the 50s, 60s, and 70s), in which the audience is left waiting till the next week to find out whether the Doctor dies or not.
Apart from the pantomine of the political actors, the matters are serious, and they are eroding confidence the longer they are left unresolved. Band-aids provide short term salve, but no long term solution. As a result, it seems we go into each weekend wondering what the outcome will be on Monday.
Till Monday. See you then!
Apart from the pantomine of the political actors, the matters are serious, and they are eroding confidence the longer they are left unresolved. Band-aids provide short term salve, but no long term solution. As a result, it seems we go into each weekend wondering what the outcome will be on Monday.
Till Monday. See you then!
Tuesday, July 19, 2011
Denial vs Reality
Some meanderings on denial and reality.
It seems to me that we are in a period of denial.*
A period where we're acting as though everything is okay, and when something bad pops up, we respond to it appropriately, but we are able to look beyond the present negative to a better time in the future. Perhaps it is more simply optimism than it is denial. But the word denial generally carries negative connotations. It implies a reality worse than the perception.
Q. Where does optimism begin and denial end, and vice versa? Ans. I don't know. Perhaps it depends upon the issue and the zeitgeist of the time.
Denial can be both conscious and/or unconscious. It may be closely tied to hope and/or optimism. It is generally pretending or believing that something isn't true, that is true. In many ways it is like the childish impulse to simply close ones eyes (mind) and hope that something goes away (or isn't true).
The question at hand is whether the underlying structural problems/imbalances are sufficiently large to cause another crisis. An. Probably, ceteris paribus.
Q. Is the market in denial about the size and scope of the global economy's long term structural imbalances? Ans. Yes and No. Since no one knows the future, it is merely an opinion or speculation.
If size and scope of the global economy's long term problems is not great enough to cause another crisis, then the market is not in denial, it is simply reflecting that reality.
Q. What is reality? Ans. Belief, perception, opinion. Reality is what happens. Speculation on the future is reality in the present, but it does not necessarily reflect the reality that takes place in the future.
Q. How long can a market ignore reality before it responds? An. A long time. Imbalances take a long time to accumulate, before they reach a destabilizing point.
Q. Is denial reality? An. Yes. If the consensus is happy with ignoring an issue or problem, then that is reality.
*Actually, we are always in a period of denial, if you define denial as a present opinion/belief regarding the future that ends up wrong.
It seems to me that we are in a period of denial.*
A period where we're acting as though everything is okay, and when something bad pops up, we respond to it appropriately, but we are able to look beyond the present negative to a better time in the future. Perhaps it is more simply optimism than it is denial. But the word denial generally carries negative connotations. It implies a reality worse than the perception.
Q. Where does optimism begin and denial end, and vice versa? Ans. I don't know. Perhaps it depends upon the issue and the zeitgeist of the time.
Denial can be both conscious and/or unconscious. It may be closely tied to hope and/or optimism. It is generally pretending or believing that something isn't true, that is true. In many ways it is like the childish impulse to simply close ones eyes (mind) and hope that something goes away (or isn't true).
The question at hand is whether the underlying structural problems/imbalances are sufficiently large to cause another crisis. An. Probably, ceteris paribus.
Q. Is the market in denial about the size and scope of the global economy's long term structural imbalances? Ans. Yes and No. Since no one knows the future, it is merely an opinion or speculation.
If size and scope of the global economy's long term problems is not great enough to cause another crisis, then the market is not in denial, it is simply reflecting that reality.
Q. What is reality? Ans. Belief, perception, opinion. Reality is what happens. Speculation on the future is reality in the present, but it does not necessarily reflect the reality that takes place in the future.
Q. How long can a market ignore reality before it responds? An. A long time. Imbalances take a long time to accumulate, before they reach a destabilizing point.
Q. Is denial reality? An. Yes. If the consensus is happy with ignoring an issue or problem, then that is reality.
*Actually, we are always in a period of denial, if you define denial as a present opinion/belief regarding the future that ends up wrong.
Tuesday, July 12, 2011
1Q11 SMID Market Commentary
***Forgot to post this at the time.
First Quarter 2011 Quarterly Commentary
The Stewardship Partners US SMID Cap BRI strategy composite (gross) returned 3.94% in the first quarter 2011.
SMID Market Review
The “QE2” rally that began in September carried over to the first quarter 2011, propelling SMID cap equities to new all-time highs. Not even rolling revolutions in the Middle East, higher oil prices, earthquake/tsunami/nuclear catastrophe in Japan, or prospective default by Ireland or Portugal could upset the SMID cap apple cart. It may be cliché, but we truly live in historic times. What remains to be seen however, is which events leave an indelible mark on history. For the quarter, mid caps outperformed small caps (9.36% vs 7.71%), and growth again beat value. The strongest performing sectors were energy, staples and healthcare, while telecom and financials were notable laggards. It should be noted that the telecom sector is a small segment of the SMID universe, and as such, underperformance by the consumer discretionary sector contributed an even greater drag on the index. The SMID cap segment of the equities market once again outperformed large caps, with much of that attributable to outsized gains in the energy sector.
The Teflon Market
The market weathered an enormous amount of bad news over the quarter, only to come through relatively unscathed. Much was thrown at it, but nothing seemed to stick. The resilience, evident in the price action, belied a growing confidence in the future. However, it doesn’t necessarily follow that the market will continue to go up at the rate it has been appreciating. The S&P 1000 is up more than 140% from its nadir in 2009, and 40% from its lows in 2010. At this point in the cycle, it is not unreasonable to assume that as the economy normalizes, the market will normalize. A more normal market might be one where the rate of appreciation is lower, and volatility is higher. The main underpinnings of the rally thus far have been relatively attractive valuations, strong earnings, an improving economic outlook, and negative real interest rates. Getting to this point however, required a lot of borrowing from the future, with the govt/Fed providing the bridge.
At some point, the economy (and the market) will have to wean itself from its dependence upon fiscal and monetary stimulus. To date, the market has shown surprisingly little interest in the matter. Perhaps it is the hyper short term nature of the market today, or an inspired insight to the future. Whatever the case, eventually the market will have to confront the exit strategy. And when it does, the focus will likely shift from the tailwinds of massive stimulus and a cyclical recovery, to secular headwinds in the form of rising interest rates, lower government spending, and higher taxes.
Underneath the current robustness is a fragility due to the inability to make hard political decisions to solve structural imbalances, and the legacy of a decrepit international monetary system. It would be a little surprising to see another crisis of the magnitude of the 2008-09 financial crisis so soon after the event. Crisis have a large psychological dimension, but they are also predicated upon an accumulation of excesses somewhere in the system, and an increasing comfort with those excesses. Those things are building, but they are probably not here yet.
That is not to say there aren’t risks. There are still significant risks that remain. However, nearer term, the main factor that could trip the market is a faltering economy. There have been a few signs of a decline in growth this quarter, but with employment on the mend and confidence improving, the market seems comfortable with the outlook. Shorter term risk emanates from the weak housing market, the sapping effect of higher oil/commodity prices on consumers, concerns surrounding Fed exit from QE2, and questions over the sustainability of corporate profit margins. Any infusion of uncertainty could bring about a reappraisal of future perspectives, but to this point the market has run roughshod over any fear or uncertainty, and picking when that attitude will change is hard to do. The real cause for concern could come when the Fed backs off from its zero interest rate policy and the government seeks to address its fiscal affairs.
Portfolio Review
The Stewardship Partners US SMID Cap BRI strategy composite (gross) returned 3.94% in the first quarter, compared to 8.86% for the S&P 1000. During the quarter, the strategy exited two positions in healthcare that were the target of takeovers: Martek Biosciences (MATK) and Genoptix, Inc. (GXDX). Proceeds from those sales were reinvested in cash. Cash holdings rose to 21% in regular SMID cap strategies, and 6% in SMID cap tactical strategies (tactical strategies have a 12% position in the ProShares Short Russell 2000 ETF (RWM) reducing equity exposure to 70% in the portfolio).
The persistence of the trend in the market and the amount of inertia in the system has been somewhat surprising. As fundamental-based, bottom-up investors it is incumbent upon us to keep our eye on the goal. And the goal is to find and invest in quality companies that can produce above average returns for shareholders over the long term. Easier said than done. In adopting a more conservative position in deference to macro risks, we have missed opportunities with individual companies. Consequently, the situation is all the more difficult today, because the market has risen 40% in the last six months. Stock returns are a function of earnings growth, dividend yield, and the multiple the market is willing to pay for those earnings. A rising market is factoring in higher future cash flows and/or a higher multiple attached to those earnings. In so doing, expectations rise implying, ceteris paribas, lower future expected returns (because a greater portion of future profits have been incorporated into today’s prices). In addition, the odds of a correction increase as a market moves higher, for the simple reason that there is less room for disappointment. As a market participant, it is hard to like artificial imposts upon the market such as QE2, because they create distortions that lead to misallocated resources. We subscribe to the adage that there is no such thing as a free lunch. There is a cost to any artificial impost. However, by focusing on the risks associated with pump priming, we have misjudged the strength, carefree nature, and resilience of the market. Many a bomb has gone off only to be repelled by surging momentum and a buy the dip mantra. The market has been climbing the proverbial wall of worry, and instead of a possible black swan derailing things, it could just as easily be a piece of seemingly innocuous news that becomes the straw that breaks the camel’s back. That having been said, SMID cap valuations are not overly excessive relative to their long term averages, and have been supported by strong earnings growth (although questions surround the sustainability of future profit margins). There is nothing one can do about missed opportunities, and even though the market may be indicating that it is safe to get back in the water, most of the big gains have already been had. In that circumstance, jumping on the bandwagon may be deleterious to your wealth and your psychological well-being. It continues to be our contention that SMID caps are overvalued relative to large caps, and that a reversal of that relationship will occur at some point in the future. We are defensively positioned in our SMID cap strategies relative to our benchmark, and continue to believe that caution is the more prudent way to approach things at this point, given the cloudiness of the future and the size of the risk factors in play.
Outlook
It is remarkable how much has happened, but how little things have changed. The market seems to be caught in a kind of Groundhog Day loop where the outlook every quarter appears the same - cloudy with a chance of rain, but the market rallies anyway. The price action implies that valuations (both absolute and relative to bonds) are reasonable, and this reasonability provides reinforcing. The lion’s share of the gains have already been had, however waiting for the market to start worrying about the stimulus exit feels like waiting for Godot. The complexion of a market can change in the blink of an eye. Discerning what the cause is, or will be, can be like chasing after the wind. In the present environment stresses and fear are much reduced. Earnings are strong. Interest rates are low. Growth is positive. The general skew is positive and could quite possibly remain that way for some time - at least until the bill comes due. IPO and M&A activity is expected to pick-up providing additional support for investor confidence. Equities are under-owned and, in conjunction with low interest rates, are pulling investors back in. The economy continues to recover pointing to a real possibility that it may move from recovery to expansion this year. However, a rising market embeds rising expectations, leaving less room for positive surprises. Countering the positive notions are structural imbalances that continue to overhang the economy and the market, and no real solution at this point. Caution, in our opinion, continues to be the better part of valor, with the preservation of capital more important than eeking out a few extra returns. It has been a trying time over the past two to three years, and at times has felt like the slough of despond, but those who have stayed the course have been rewarded with the return of capital. It is our hope that good fortune is also just around the corner with continuing positive returns for the SMID cap strategy. Thank you for the opportunity and the privilege to manage your funds, and it is our hope that over time we can reward that trust and confidence.
This commentary represents the opinions of its author as of 4/15/11, and may change based on market and other conditions. The author’s opinions are not intended to forecast future events, guarantee future results, or serve as investment advice.
First Quarter 2011 Quarterly Commentary
The Stewardship Partners US SMID Cap BRI strategy composite (gross) returned 3.94% in the first quarter 2011.
SMID Market Review
The “QE2” rally that began in September carried over to the first quarter 2011, propelling SMID cap equities to new all-time highs. Not even rolling revolutions in the Middle East, higher oil prices, earthquake/tsunami/nuclear catastrophe in Japan, or prospective default by Ireland or Portugal could upset the SMID cap apple cart. It may be cliché, but we truly live in historic times. What remains to be seen however, is which events leave an indelible mark on history. For the quarter, mid caps outperformed small caps (9.36% vs 7.71%), and growth again beat value. The strongest performing sectors were energy, staples and healthcare, while telecom and financials were notable laggards. It should be noted that the telecom sector is a small segment of the SMID universe, and as such, underperformance by the consumer discretionary sector contributed an even greater drag on the index. The SMID cap segment of the equities market once again outperformed large caps, with much of that attributable to outsized gains in the energy sector.
The Teflon Market
The market weathered an enormous amount of bad news over the quarter, only to come through relatively unscathed. Much was thrown at it, but nothing seemed to stick. The resilience, evident in the price action, belied a growing confidence in the future. However, it doesn’t necessarily follow that the market will continue to go up at the rate it has been appreciating. The S&P 1000 is up more than 140% from its nadir in 2009, and 40% from its lows in 2010. At this point in the cycle, it is not unreasonable to assume that as the economy normalizes, the market will normalize. A more normal market might be one where the rate of appreciation is lower, and volatility is higher. The main underpinnings of the rally thus far have been relatively attractive valuations, strong earnings, an improving economic outlook, and negative real interest rates. Getting to this point however, required a lot of borrowing from the future, with the govt/Fed providing the bridge.
At some point, the economy (and the market) will have to wean itself from its dependence upon fiscal and monetary stimulus. To date, the market has shown surprisingly little interest in the matter. Perhaps it is the hyper short term nature of the market today, or an inspired insight to the future. Whatever the case, eventually the market will have to confront the exit strategy. And when it does, the focus will likely shift from the tailwinds of massive stimulus and a cyclical recovery, to secular headwinds in the form of rising interest rates, lower government spending, and higher taxes.
Underneath the current robustness is a fragility due to the inability to make hard political decisions to solve structural imbalances, and the legacy of a decrepit international monetary system. It would be a little surprising to see another crisis of the magnitude of the 2008-09 financial crisis so soon after the event. Crisis have a large psychological dimension, but they are also predicated upon an accumulation of excesses somewhere in the system, and an increasing comfort with those excesses. Those things are building, but they are probably not here yet.
That is not to say there aren’t risks. There are still significant risks that remain. However, nearer term, the main factor that could trip the market is a faltering economy. There have been a few signs of a decline in growth this quarter, but with employment on the mend and confidence improving, the market seems comfortable with the outlook. Shorter term risk emanates from the weak housing market, the sapping effect of higher oil/commodity prices on consumers, concerns surrounding Fed exit from QE2, and questions over the sustainability of corporate profit margins. Any infusion of uncertainty could bring about a reappraisal of future perspectives, but to this point the market has run roughshod over any fear or uncertainty, and picking when that attitude will change is hard to do. The real cause for concern could come when the Fed backs off from its zero interest rate policy and the government seeks to address its fiscal affairs.
Portfolio Review
The Stewardship Partners US SMID Cap BRI strategy composite (gross) returned 3.94% in the first quarter, compared to 8.86% for the S&P 1000. During the quarter, the strategy exited two positions in healthcare that were the target of takeovers: Martek Biosciences (MATK) and Genoptix, Inc. (GXDX). Proceeds from those sales were reinvested in cash. Cash holdings rose to 21% in regular SMID cap strategies, and 6% in SMID cap tactical strategies (tactical strategies have a 12% position in the ProShares Short Russell 2000 ETF (RWM) reducing equity exposure to 70% in the portfolio).
The persistence of the trend in the market and the amount of inertia in the system has been somewhat surprising. As fundamental-based, bottom-up investors it is incumbent upon us to keep our eye on the goal. And the goal is to find and invest in quality companies that can produce above average returns for shareholders over the long term. Easier said than done. In adopting a more conservative position in deference to macro risks, we have missed opportunities with individual companies. Consequently, the situation is all the more difficult today, because the market has risen 40% in the last six months. Stock returns are a function of earnings growth, dividend yield, and the multiple the market is willing to pay for those earnings. A rising market is factoring in higher future cash flows and/or a higher multiple attached to those earnings. In so doing, expectations rise implying, ceteris paribas, lower future expected returns (because a greater portion of future profits have been incorporated into today’s prices). In addition, the odds of a correction increase as a market moves higher, for the simple reason that there is less room for disappointment. As a market participant, it is hard to like artificial imposts upon the market such as QE2, because they create distortions that lead to misallocated resources. We subscribe to the adage that there is no such thing as a free lunch. There is a cost to any artificial impost. However, by focusing on the risks associated with pump priming, we have misjudged the strength, carefree nature, and resilience of the market. Many a bomb has gone off only to be repelled by surging momentum and a buy the dip mantra. The market has been climbing the proverbial wall of worry, and instead of a possible black swan derailing things, it could just as easily be a piece of seemingly innocuous news that becomes the straw that breaks the camel’s back. That having been said, SMID cap valuations are not overly excessive relative to their long term averages, and have been supported by strong earnings growth (although questions surround the sustainability of future profit margins). There is nothing one can do about missed opportunities, and even though the market may be indicating that it is safe to get back in the water, most of the big gains have already been had. In that circumstance, jumping on the bandwagon may be deleterious to your wealth and your psychological well-being. It continues to be our contention that SMID caps are overvalued relative to large caps, and that a reversal of that relationship will occur at some point in the future. We are defensively positioned in our SMID cap strategies relative to our benchmark, and continue to believe that caution is the more prudent way to approach things at this point, given the cloudiness of the future and the size of the risk factors in play.
Outlook
It is remarkable how much has happened, but how little things have changed. The market seems to be caught in a kind of Groundhog Day loop where the outlook every quarter appears the same - cloudy with a chance of rain, but the market rallies anyway. The price action implies that valuations (both absolute and relative to bonds) are reasonable, and this reasonability provides reinforcing. The lion’s share of the gains have already been had, however waiting for the market to start worrying about the stimulus exit feels like waiting for Godot. The complexion of a market can change in the blink of an eye. Discerning what the cause is, or will be, can be like chasing after the wind. In the present environment stresses and fear are much reduced. Earnings are strong. Interest rates are low. Growth is positive. The general skew is positive and could quite possibly remain that way for some time - at least until the bill comes due. IPO and M&A activity is expected to pick-up providing additional support for investor confidence. Equities are under-owned and, in conjunction with low interest rates, are pulling investors back in. The economy continues to recover pointing to a real possibility that it may move from recovery to expansion this year. However, a rising market embeds rising expectations, leaving less room for positive surprises. Countering the positive notions are structural imbalances that continue to overhang the economy and the market, and no real solution at this point. Caution, in our opinion, continues to be the better part of valor, with the preservation of capital more important than eeking out a few extra returns. It has been a trying time over the past two to three years, and at times has felt like the slough of despond, but those who have stayed the course have been rewarded with the return of capital. It is our hope that good fortune is also just around the corner with continuing positive returns for the SMID cap strategy. Thank you for the opportunity and the privilege to manage your funds, and it is our hope that over time we can reward that trust and confidence.
This commentary represents the opinions of its author as of 4/15/11, and may change based on market and other conditions. The author’s opinions are not intended to forecast future events, guarantee future results, or serve as investment advice.
Wednesday, March 16, 2011
Truly Historic Times
It may be cliche, but recent events are likely to warrant mention in future history books.
Only time can provide a true perspective.
It remains to be seen the full importance and implications of the revolutions in the Middle East and the Japanese earthquake/tsunami/nuclear crisis. Both have the potential to leave a lasting mark upon the course of human history.
These are indeed interesting times.
***Of even greater interest will be the events of the times that end up being the most important marks on history.
Only time can provide a true perspective.
It remains to be seen the full importance and implications of the revolutions in the Middle East and the Japanese earthquake/tsunami/nuclear crisis. Both have the potential to leave a lasting mark upon the course of human history.
These are indeed interesting times.
***Of even greater interest will be the events of the times that end up being the most important marks on history.
Wednesday, February 16, 2011
We're All Momentum Chasers Now
The constancy and consistency of the move higher is leading many to re-evaluate their fundamental beliefs.
Gone are the 'new normals,' the balance sheet recessionistas, and the perma-bears, and in their place are newly minted momentum 'guys.'
It is easy to rationalize the market, to find data to support a particular contention, and ultimately to justify a position. It is hard to run against the herd, to fight the forces that be, and to be handed a beat down by the market.
It speaks to something deep within us. The acknowledgment that we are wrong.
We are all momentum chasers now! (or, is it Game of Chicken players, or Musical Chairs participants).
Gone are the 'new normals,' the balance sheet recessionistas, and the perma-bears, and in their place are newly minted momentum 'guys.'
It is easy to rationalize the market, to find data to support a particular contention, and ultimately to justify a position. It is hard to run against the herd, to fight the forces that be, and to be handed a beat down by the market.
It speaks to something deep within us. The acknowledgment that we are wrong.
We are all momentum chasers now! (or, is it Game of Chicken players, or Musical Chairs participants).
Friday, February 11, 2011
A Back of the Envelope on the Pullback
I've been concerned that the mega caps haven't participated in the rally, and their playing catch-up will in fact drive the market higher (even as we get a rotation out of smid caps).
Consequently, when you look at the Naz and S&P 500 I'm not expecting them to fall too much. Doing a back of the envelope of the major indexes:
* 50%+ of each index is comprised of stodgy mega-caps trading at an average of about 15x forward earnings (even when you include Apple and Google and Amazon).
* It seems obvious to me that the large caps are undervalued relative to the smid caps. Smid caps are trading at roughly 18x forward earnings (and that might be understating it).
* When the "risk on" trade expires and the "risk off" trade returns, it is easy to see a little pullback and rotation along the following lines. Large cap multiple compression from 15x to 14x (6%-7% decline), smid cap multiple compression from 18x to 15x (16%-17% decline)....translates to a 10% market decline (assuming a 60/40 large cap/smid cap breakdown - in fact the breakdown is closer to 88/12).
In the absence of any serious weakness in earnings (and the economy), it is highly unlikely that we will see much more than a 10% correction, unless PEs were to compress due to some major risk factor.
Consequently, when you look at the Naz and S&P 500 I'm not expecting them to fall too much. Doing a back of the envelope of the major indexes:
* 50%+ of each index is comprised of stodgy mega-caps trading at an average of about 15x forward earnings (even when you include Apple and Google and Amazon).
* It seems obvious to me that the large caps are undervalued relative to the smid caps. Smid caps are trading at roughly 18x forward earnings (and that might be understating it).
* When the "risk on" trade expires and the "risk off" trade returns, it is easy to see a little pullback and rotation along the following lines. Large cap multiple compression from 15x to 14x (6%-7% decline), smid cap multiple compression from 18x to 15x (16%-17% decline)....translates to a 10% market decline (assuming a 60/40 large cap/smid cap breakdown - in fact the breakdown is closer to 88/12).
In the absence of any serious weakness in earnings (and the economy), it is highly unlikely that we will see much more than a 10% correction, unless PEs were to compress due to some major risk factor.
The Slough of Despond
It feels like we are in the slough of despond.
Fighting a market is not a wise thing (least of all on the positive side of the economic/market cycle). Taking your medicine and getting with the game is always easier said than done.
The markets incessant march onward and upward since its August lows is wearing us down. Just "buy the dip" is the mantra of the moment.
I'm thinking we're not far from a nice pullback, and "sell the rip" is probably a better banner.
Doubling down is a very dangerous sport, but can sometimes cover over a multitude of sins.
The courage to be, and the courage of ones convictions are in short supply. But at some point you've got to take a stand.
Fighting a market is not a wise thing (least of all on the positive side of the economic/market cycle). Taking your medicine and getting with the game is always easier said than done.
The markets incessant march onward and upward since its August lows is wearing us down. Just "buy the dip" is the mantra of the moment.
I'm thinking we're not far from a nice pullback, and "sell the rip" is probably a better banner.
Doubling down is a very dangerous sport, but can sometimes cover over a multitude of sins.
The courage to be, and the courage of ones convictions are in short supply. But at some point you've got to take a stand.
Thursday, January 13, 2011
The Problem With Relative Value*
Virtually every asset class looks attractive relative to bonds right now (except for cash**).
And that is the problem when you have an externality like a central bank setting interest rates. That distortion of the supply/demand nexus, sets up an imbalance. In the current case, it is the misallocation of resources within an economy toward risky assets*** (although it is highly ironic that petrified retail investors actually sought out bonds like a giffen good).
Relative value investors (and that is what most are) look at those signals and from them determine that equities, commodities, precious metals, real estate, you name it, are attractive relative to bonds. And they are. The problem is bond yields are at artificially low levels, and when they normalize (a.k.a., go up) those assets that looked attractive relative to bonds previously no longer look as attractive.
Proper analysis of risk assets should incorporate normalized growth, margins, and discount rates into their framework, otherwise they risk falling for the "relative value illusion" and a host of other fallacies (ie. cyclical illusion, history will repeat illusion, et al).
*Actually there are numerous problems associated with relative value analysis, but that is for another day.
**But even cash looks attractive if you believe bond rates are going to go up.
***Actually, the misallocation may be less to risky assets, than to risky behavior.
And that is the problem when you have an externality like a central bank setting interest rates. That distortion of the supply/demand nexus, sets up an imbalance. In the current case, it is the misallocation of resources within an economy toward risky assets*** (although it is highly ironic that petrified retail investors actually sought out bonds like a giffen good).
Relative value investors (and that is what most are) look at those signals and from them determine that equities, commodities, precious metals, real estate, you name it, are attractive relative to bonds. And they are. The problem is bond yields are at artificially low levels, and when they normalize (a.k.a., go up) those assets that looked attractive relative to bonds previously no longer look as attractive.
Proper analysis of risk assets should incorporate normalized growth, margins, and discount rates into their framework, otherwise they risk falling for the "relative value illusion" and a host of other fallacies (ie. cyclical illusion, history will repeat illusion, et al).
*Actually there are numerous problems associated with relative value analysis, but that is for another day.
**But even cash looks attractive if you believe bond rates are going to go up.
***Actually, the misallocation may be less to risky assets, than to risky behavior.
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