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.
Showing posts with label Quarterly Commentary. Show all posts
Showing posts with label Quarterly Commentary. Show all posts
Friday, October 28, 2011
Tuesday, January 26, 2010
4Q09 SMID Cap Commentary
Market Review – Climbing the Wall of Worry
It was the best of times, and the worst of times for small-mid (SMID) cap investors in 2009. Fortunately, for a year that started so badly, the market ended on a high note having experienced its second best rally since 1933 (adjusted for time). Over the period, the SMID cap sector, as captured by the S&P 1000 index, rose more than 33%, including an 80%+ return off its March lows. The last quarter of the year saw the market coasting toward a positive 5% finish, helped by a 7% upward move in December. With interest rates at historically low levels, signs of recovery in the air, and fear receding, mid caps, represented by the S&P 400, were one of the best areas to invest in 2009, providing investors a 37% return on the year. Small caps meanwhile, represented by the S&P 600, produced a solid 25% yoy return. Growth beat value in both the mid cap and small cap realms, while Energy (65%), Tech (55%), Consumer Discretionary (53%) and Materials (51%) led the SMID cap index, with Telecom (-1.44%), Financials (4%) and Utilities (12%) sector laggards.
Cyclical Recovery Runs Into Secular Headwinds
For now, the storm has passed and the clouds are clearing. It is time to assess the damage, and to prepare for the storms to come. 2010 is likely to provide a few air pockets as the market wrestles with whether the economy can transition from artificial stimulus (fiscal and monetary) to self-sustaining growth. We are awash in worry. If we have an over-abundance of anything at the moment, it is worry (and maybe liquidity). But worry is the fuel upon which markets rise. Market rallies are born out of skepticism and frightened investors. We saw the equity market rally more than 60% off its lows last year and yet money flowed into bonds and stayed in cash. The market is expecting 25-35% EPS growth in 2010, with much of it backend loaded to 2H10. If earnings do come through, then this will provide substantive support for the market. Another likely addition to the marketplace this year is more stimulus aimed at jobs creation (and mid-term elections). The government is committed to solving our problems. They have already said this and demonstrated it in very tangible ways. You've heard it said, "don't fight the Fed," well we've also learned "don’t bet against the govt" (at least not yet). It also doesn’t hurt that credit markets, reflected in shrinking bond spreads, are healing. Now, we await the banks to open the lending spigots. Looking forward, zero interest rate policy (ZIRP) will continue to tempt investors back into riskier assets. The negative feedback loop of the recession has been arrested and we are on the hesitant road to recovery. Valuations are reasonable and there are few signs of consumer inflation. Rising markets have already engendered a pick-up in leading economic indicators, with business and consumer confidence set to follow. The market is hopeful and will be watching for ongoing signs of recovery.
But don't get too comfortable. The economy is fragile, and both short term and long term risks abound. A legion of risks are in plain view. At some point, cyclical tailwinds will run into secular headwinds. Structurally we are in many ways worse off after the recession than before. We lack the political will to make the hard and necessary decisions to get things right. We have, once again, failed to allow the market to clear, and so are left with the burden of accumulated deferments. The lesson from this whole mess is that we haven’t learnt the lesson. There is a price to be paid for profligacy and denying the laws of economics. As a country we (many other developed countries are in the same boat) have lived beyond our means and made promises we are unlikely to keep. Those secular headwinds will be reflected in rising inflation and interest rates, lower growth, increased savings, higher taxes, more regulation, and constraints on government spending going forward. Welcome to the new normal! With regard to imbalances in the global economic system, China is the elephant in the room, as both a lightening rod and a potential catalyst. Moral hazard and inflation are likely to be the greatest legacies of the crisis. The end to the international monetary system of recent history is in sight. The next decade may not be a great time of economic flourishing, but it won’t be the end of the world either. With equity markets re-set in 2008-09, long term returns are probably in the 6%-8% range. It is possible the future will be somewhat like the 70s. Life goes on, change takes place all around, the old passes away, and the foundations for a more prosperous future are established.
Portfolio Review
The SMID BRI strategy composite handily outperformed its benchmark and peers in 2009, but underperformed the benchmark slightly in the fourth quarter. The outperformance for the year was due in part to an underweight position in Financials and an overweight position in Tech, counterbalanced by an underweight position in Consumer Discretionary. We continue to maintain an overweight exposure to Tech, and Healthcare, with underweight exposure to Financials, Consumer Discretionary, Consumer Staples and Utilities. Strong performers for the year were SEI Investments, Citrix Systems, Theratechnologies, Nutrisystem, Logitech and Yamana Gold. Underperforming names were Accuray, Zoltek, MEMC Electric Materials, Alvarion and Investment Technology Group. The strategy’s cash position averaged 13% throughout 2009 weighing negatively on performance in a year when the market rose strongly. We did not employ the inverse ETF option in Tactical accounts during 2009, however we recently enacted the tactical option in mid-January, reducing equity exposure from 90% to 80%.
Outlook
There is much to worry about. But pessimism is the fuel of the proverbial "wall of worry." The rising market and 0% interest rates are serving as a self-reinforcing feedback loop, stoking the market onward and upward. Although we are in recovery, the outlook is still cloudy. Positive economic trends and easy liquidity seem to be taking the edge off risk aversion. However, given the meteoric rise of the market and significant risk factors in the econosphere, we are cautious toward the market and the potential for a pullback. The consensus seems to be coming in behind the recovery and the markets rise, emboldened by low interest rates and the knowledge that there is plenty of money that can flow out of bonds and cash. If the market continues to rise, we will likely reduce our exposure and take a more defensive posture. If the market falls back, we are likely to add new names to the portfolio. It seems that the risk/return trade-off is skewed toward the downside at this point. As the day approaches where the public/private hand-off grows closer, expect volatility to increase. At a bottoms-up level, great deals are harder to come by. For the time being, we will continue to hold an above average amount of cash to help weather any pullback and as a source of capital should we find acceptable investment opportunities. Markets don’t go up in a straight line forever, nor do they generally collapse during recoveries. 2010 is shaping up to be a year of ups and downs, with the potential to go either way.
It was the best of times, and the worst of times for small-mid (SMID) cap investors in 2009. Fortunately, for a year that started so badly, the market ended on a high note having experienced its second best rally since 1933 (adjusted for time). Over the period, the SMID cap sector, as captured by the S&P 1000 index, rose more than 33%, including an 80%+ return off its March lows. The last quarter of the year saw the market coasting toward a positive 5% finish, helped by a 7% upward move in December. With interest rates at historically low levels, signs of recovery in the air, and fear receding, mid caps, represented by the S&P 400, were one of the best areas to invest in 2009, providing investors a 37% return on the year. Small caps meanwhile, represented by the S&P 600, produced a solid 25% yoy return. Growth beat value in both the mid cap and small cap realms, while Energy (65%), Tech (55%), Consumer Discretionary (53%) and Materials (51%) led the SMID cap index, with Telecom (-1.44%), Financials (4%) and Utilities (12%) sector laggards.
Cyclical Recovery Runs Into Secular Headwinds
For now, the storm has passed and the clouds are clearing. It is time to assess the damage, and to prepare for the storms to come. 2010 is likely to provide a few air pockets as the market wrestles with whether the economy can transition from artificial stimulus (fiscal and monetary) to self-sustaining growth. We are awash in worry. If we have an over-abundance of anything at the moment, it is worry (and maybe liquidity). But worry is the fuel upon which markets rise. Market rallies are born out of skepticism and frightened investors. We saw the equity market rally more than 60% off its lows last year and yet money flowed into bonds and stayed in cash. The market is expecting 25-35% EPS growth in 2010, with much of it backend loaded to 2H10. If earnings do come through, then this will provide substantive support for the market. Another likely addition to the marketplace this year is more stimulus aimed at jobs creation (and mid-term elections). The government is committed to solving our problems. They have already said this and demonstrated it in very tangible ways. You've heard it said, "don't fight the Fed," well we've also learned "don’t bet against the govt" (at least not yet). It also doesn’t hurt that credit markets, reflected in shrinking bond spreads, are healing. Now, we await the banks to open the lending spigots. Looking forward, zero interest rate policy (ZIRP) will continue to tempt investors back into riskier assets. The negative feedback loop of the recession has been arrested and we are on the hesitant road to recovery. Valuations are reasonable and there are few signs of consumer inflation. Rising markets have already engendered a pick-up in leading economic indicators, with business and consumer confidence set to follow. The market is hopeful and will be watching for ongoing signs of recovery.
But don't get too comfortable. The economy is fragile, and both short term and long term risks abound. A legion of risks are in plain view. At some point, cyclical tailwinds will run into secular headwinds. Structurally we are in many ways worse off after the recession than before. We lack the political will to make the hard and necessary decisions to get things right. We have, once again, failed to allow the market to clear, and so are left with the burden of accumulated deferments. The lesson from this whole mess is that we haven’t learnt the lesson. There is a price to be paid for profligacy and denying the laws of economics. As a country we (many other developed countries are in the same boat) have lived beyond our means and made promises we are unlikely to keep. Those secular headwinds will be reflected in rising inflation and interest rates, lower growth, increased savings, higher taxes, more regulation, and constraints on government spending going forward. Welcome to the new normal! With regard to imbalances in the global economic system, China is the elephant in the room, as both a lightening rod and a potential catalyst. Moral hazard and inflation are likely to be the greatest legacies of the crisis. The end to the international monetary system of recent history is in sight. The next decade may not be a great time of economic flourishing, but it won’t be the end of the world either. With equity markets re-set in 2008-09, long term returns are probably in the 6%-8% range. It is possible the future will be somewhat like the 70s. Life goes on, change takes place all around, the old passes away, and the foundations for a more prosperous future are established.
Portfolio Review
The SMID BRI strategy composite handily outperformed its benchmark and peers in 2009, but underperformed the benchmark slightly in the fourth quarter. The outperformance for the year was due in part to an underweight position in Financials and an overweight position in Tech, counterbalanced by an underweight position in Consumer Discretionary. We continue to maintain an overweight exposure to Tech, and Healthcare, with underweight exposure to Financials, Consumer Discretionary, Consumer Staples and Utilities. Strong performers for the year were SEI Investments, Citrix Systems, Theratechnologies, Nutrisystem, Logitech and Yamana Gold. Underperforming names were Accuray, Zoltek, MEMC Electric Materials, Alvarion and Investment Technology Group. The strategy’s cash position averaged 13% throughout 2009 weighing negatively on performance in a year when the market rose strongly. We did not employ the inverse ETF option in Tactical accounts during 2009, however we recently enacted the tactical option in mid-January, reducing equity exposure from 90% to 80%.
Outlook
There is much to worry about. But pessimism is the fuel of the proverbial "wall of worry." The rising market and 0% interest rates are serving as a self-reinforcing feedback loop, stoking the market onward and upward. Although we are in recovery, the outlook is still cloudy. Positive economic trends and easy liquidity seem to be taking the edge off risk aversion. However, given the meteoric rise of the market and significant risk factors in the econosphere, we are cautious toward the market and the potential for a pullback. The consensus seems to be coming in behind the recovery and the markets rise, emboldened by low interest rates and the knowledge that there is plenty of money that can flow out of bonds and cash. If the market continues to rise, we will likely reduce our exposure and take a more defensive posture. If the market falls back, we are likely to add new names to the portfolio. It seems that the risk/return trade-off is skewed toward the downside at this point. As the day approaches where the public/private hand-off grows closer, expect volatility to increase. At a bottoms-up level, great deals are harder to come by. For the time being, we will continue to hold an above average amount of cash to help weather any pullback and as a source of capital should we find acceptable investment opportunities. Markets don’t go up in a straight line forever, nor do they generally collapse during recoveries. 2010 is shaping up to be a year of ups and downs, with the potential to go either way.
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