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.
Tuesday, January 26, 2010
'Tis a truly sad day
The Supreme Court's decision to allow corporations to spend what they want on political free speech is the final nail in the coffin of US democracy.
Not a matter of if, but when.
I imagine it will take many more years of decay and erosion before it fragments into fiefdoms. The eventual overrunning of the ramparts will likely coincide with a major financial crisis.
Not a matter of if, but when.
I imagine it will take many more years of decay and erosion before it fragments into fiefdoms. The eventual overrunning of the ramparts will likely coincide with a major financial crisis.
Wednesday, January 13, 2010
Tax re-rating
At what point do you factor in future tax rate hikes into PE multiples and DCF valuations?
We know there are tax rate hikes coming down the pike. We don't know when, what form they will take, what level they will be, or to whom they will apply.
It is probably a little too early to speculate on how it will shape out, but it is not unreasonable to get a feel for which firms and sectors are most exposed. At a guess, I would say energy, healthcare, financial services and potentially technology would be the most susceptible to targeted tax hikes (if that were to be the modus operandi). Mainly because they operate with high margins and are in politically expedient areas. A tax rate increase equates to an instantaneous downward shift of the cash flow stream. Assuming a tax rate rise from 36% to 39%, this equates to an approximate 4%-5% decline in earnings. How this affects the risk premia (ie. the multiples) is a little more difficult to gauge, but presumably it lowers the multiple because the after tax cash flow available for reinvestment is reduced.
The closest parallel from the recent past was probably the brouhaha over bringing options expense into income statements. At the end of the day it was a tempest in a tea cup, probably because option expense was already known from financial footnotes.
It remains to be seen whether uncertainty over tax rate rises will ruffle the markets. I haven't seen or heard much about it, yet!
We know there are tax rate hikes coming down the pike. We don't know when, what form they will take, what level they will be, or to whom they will apply.
It is probably a little too early to speculate on how it will shape out, but it is not unreasonable to get a feel for which firms and sectors are most exposed. At a guess, I would say energy, healthcare, financial services and potentially technology would be the most susceptible to targeted tax hikes (if that were to be the modus operandi). Mainly because they operate with high margins and are in politically expedient areas. A tax rate increase equates to an instantaneous downward shift of the cash flow stream. Assuming a tax rate rise from 36% to 39%, this equates to an approximate 4%-5% decline in earnings. How this affects the risk premia (ie. the multiples) is a little more difficult to gauge, but presumably it lowers the multiple because the after tax cash flow available for reinvestment is reduced.
The closest parallel from the recent past was probably the brouhaha over bringing options expense into income statements. At the end of the day it was a tempest in a tea cup, probably because option expense was already known from financial footnotes.
It remains to be seen whether uncertainty over tax rate rises will ruffle the markets. I haven't seen or heard much about it, yet!
Wednesday, December 30, 2009
The Coming Collapse
Given the path we are on (high levels of debt, unsustainable deficits and the promise of massive unfunded future liabilities), it is not a matter of if, but when, the current structures and institutions that comprise the existing international monetary system (actually that is bit of a misnomer because there is no actual system, but a loose assortment of institutions, rules and accepted norms) collapse under the weight of their own imbalances and corruptions.
2008 was a shot across the bow, but it doesn't look as though we are paying heed to the warning. As such, in the absence of courageous change and honest leadership, we are still on a path to reckoning. You can pay the piper now, or pay the piper later (with interest). That is the choice when you stretch beyond the laws of economics.
But let me be clear. It is not likely to be a collapse in a catastrophic sense. Rather it is likely to be over a long period, punctuated by short periods of crisis, and with the consequent dismantling of whatever structure, institution or norm is ailing us at that particular point in time.
We will awake at some point in the future, and in looking back, will see that all the institutions, structures, rules, and norms that guided us, have been replaced by a new set of rules, structures, and institutions.
2008 was a shot across the bow, but it doesn't look as though we are paying heed to the warning. As such, in the absence of courageous change and honest leadership, we are still on a path to reckoning. You can pay the piper now, or pay the piper later (with interest). That is the choice when you stretch beyond the laws of economics.
But let me be clear. It is not likely to be a collapse in a catastrophic sense. Rather it is likely to be over a long period, punctuated by short periods of crisis, and with the consequent dismantling of whatever structure, institution or norm is ailing us at that particular point in time.
We will awake at some point in the future, and in looking back, will see that all the institutions, structures, rules, and norms that guided us, have been replaced by a new set of rules, structures, and institutions.
A phrase that really irks me
It irks me when people refer to hedge funds as a catch-all.
There is the hedge fund as a distinct legal entity in some offshore haven - a really bad investment vehicle for investors in my opinion (high fees, lock-ins, side pockets, minimal transparency, and limited regulation...need I say more).
There are also hedge fund-type investment strategies - these usually differ from the traditional mutual fund-type strategies by incorporating such other investing elements as leverage, shorting, futures, options, other derivatives, alternative assets, greater theme orientation (event driven, global macro, etc.), etc..
There is also the euphemistic use of the phrase hedge fund to describe the actors behind the markets machinations. In the absence of anymore Long Term Capital Managements, it is most likely that the "hedge funds" implied by this use are probably large bank prop desks.
As with most industries, power is concentrated, with 80% of the assets residing in 10% of the hedge funds (industry has roughly $2 trillion in assets, spread among 5000 odd hedge funds).
There is the hedge fund as a distinct legal entity in some offshore haven - a really bad investment vehicle for investors in my opinion (high fees, lock-ins, side pockets, minimal transparency, and limited regulation...need I say more).
There are also hedge fund-type investment strategies - these usually differ from the traditional mutual fund-type strategies by incorporating such other investing elements as leverage, shorting, futures, options, other derivatives, alternative assets, greater theme orientation (event driven, global macro, etc.), etc..
There is also the euphemistic use of the phrase hedge fund to describe the actors behind the markets machinations. In the absence of anymore Long Term Capital Managements, it is most likely that the "hedge funds" implied by this use are probably large bank prop desks.
As with most industries, power is concentrated, with 80% of the assets residing in 10% of the hedge funds (industry has roughly $2 trillion in assets, spread among 5000 odd hedge funds).
Roger Hodgson & Supertramp
Came across a blog the other day talking about songs that make life worth living and the guy there referenced a couple of Dan Fogelberg songs and a bunch of Supertramp songs.
Now I love Supertramp and grew up listening to my brother listening to Supertramp (as he made tapes from Casey Kasem and the American Top 40 off the radio), but I have a hard time hearing lyrics and it is usually the sounds and choruses that I identify with. When I went back and revisited some of those songs, I was taken aback by their spiritual depth and philosophical speculations (from some so young), and it also provided greater perspective on their other songs. And so I looked up Supertramp on Wikipedia and that led me to Roger Hodgson and a desire to find out more about the guy behind many of the songs and the music.
A good time of personal introspection.
P.S. The songs mentioned were lessor known signatures: Fools Overture, Even in the Quietest Moments and Lord, Is it Mine (look 'em up on YouTube). I pretty much like most of Supertramps stuff and think Crime of the Century is one of the greatest albums ever (but I need to get Breakfast in America).
Now I love Supertramp and grew up listening to my brother listening to Supertramp (as he made tapes from Casey Kasem and the American Top 40 off the radio), but I have a hard time hearing lyrics and it is usually the sounds and choruses that I identify with. When I went back and revisited some of those songs, I was taken aback by their spiritual depth and philosophical speculations (from some so young), and it also provided greater perspective on their other songs. And so I looked up Supertramp on Wikipedia and that led me to Roger Hodgson and a desire to find out more about the guy behind many of the songs and the music.
A good time of personal introspection.
P.S. The songs mentioned were lessor known signatures: Fools Overture, Even in the Quietest Moments and Lord, Is it Mine (look 'em up on YouTube). I pretty much like most of Supertramps stuff and think Crime of the Century is one of the greatest albums ever (but I need to get Breakfast in America).
Friday, December 18, 2009
The Key to 2010
Q. Will we go up by more than 10%, or down by more than 10% from current levels in 2010? Ans. Yes.
The key to having a really good 2010 will be picking which comes first. I'm pretty sure both will happen, but if you get the call right it can make for a much more enjoyable year. Despite my skeptical bias on the longer term outlook, it seems to me that the odds are stacked toward an upward move of 10% first.
Reasons supporting that contention: growing confidence in the economic recovery; increasing signs of an economic recovery; current market trends and momentum are supportive; investors coming out of their bunkers; cash at 0%; big money is positive; still large amount of skepticism and risk aversion (sentiment is supportive); continuation of the carry trade; the optimism of entering a new year and a new decade; ongoing relief that catastrophe has been averted; the scramble to get back in; the confirmation bias; recent market consolidation sets us up for the next move higher.
Factors mitigating that contention: market needs a break after a 65% bounce; the psyche is fragile; signs of reversal in the trend; investors pulling in their wings and putting money in the bank after a good 2009; focus moving to fiscal/monetary exits and outstanding systemic risk factors; growing risk aversion; a crowded reflation/carry trade; increasing doubt in the sustainability of the recovery.
The key to having a really good 2010 will be picking which comes first. I'm pretty sure both will happen, but if you get the call right it can make for a much more enjoyable year. Despite my skeptical bias on the longer term outlook, it seems to me that the odds are stacked toward an upward move of 10% first.
Reasons supporting that contention: growing confidence in the economic recovery; increasing signs of an economic recovery; current market trends and momentum are supportive; investors coming out of their bunkers; cash at 0%; big money is positive; still large amount of skepticism and risk aversion (sentiment is supportive); continuation of the carry trade; the optimism of entering a new year and a new decade; ongoing relief that catastrophe has been averted; the scramble to get back in; the confirmation bias; recent market consolidation sets us up for the next move higher.
Factors mitigating that contention: market needs a break after a 65% bounce; the psyche is fragile; signs of reversal in the trend; investors pulling in their wings and putting money in the bank after a good 2009; focus moving to fiscal/monetary exits and outstanding systemic risk factors; growing risk aversion; a crowded reflation/carry trade; increasing doubt in the sustainability of the recovery.
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