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.
Tuesday, July 19, 2011
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.
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