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TEAMThink 5-25-2012
Executive Summary
- Facebook and Europe have dominated the US financial press in recent days/weeks, but we believe it is wise to pay attention to Asia and Latin America
- Currency and bond markets globally suggest a far worse backdrop than US stocks. Will US stocks sustain in their own world or will they play catch up to the downside? Eventually we expect US stocks to succumb.
- 2012 may end up being more challenging to navigate than 2008 due to government interventions and real distress in emerging markets
- We will be keying off when hiding spots get hit
Look East Young Man
The problems in Europe and the fiasco surrounding the Facebook IPO have dominated CNBC and other US financial media coverage of markets in the past couple of weeks, but we are seeing increasing evidence that there are real problems unfolding in most major emerging market economies. There appears to be a US dollar shortage unfolding in China, many Asian currencies are getting slaughtered versus the US dollar and Japanese yen, economic data has gone from bad to worse, and bond yields have plummeted. A combination of the Chinese trade surplus evaporating and export companies holding onto their US dollars rather than converting them to yuan has begun to cause havoc.
Bond yields reached record lows this week in the following countries: Germany, Finland, France, UK, Austria, Switzerland, Netherlands, South Africa, Australia, Sweden, New Zealand and Japan. Industrial commodity prices have fallen sharply, with oil and copper prices finally giving up the ghost in recent weeks. Industrial commodities that are less impacted by financial buyers, such as rubber, lead and nickel, have been weak for about a year.
These market developments suggest to us that the global recession we've expected is in full swing, with previously rapid growth economies like China, India and Brazil beginning to feel real pain. Those economies experienced a more traditional business cycle, as their central banks tightened policies in order to try and head off inflation. This tightening precipitated an inversion in their yield curves (long term rates move below short term rates) and their economies have slowed substantially. Banking system issues in China are very likely due to the urban real estate bubble deflating, but it appears that Indian and Brazilian banks may have their own problems. Australia's economy is getting hit with a deflating housing bubble of its own and is getting hit by lower commodity prices as well.
Given this confluence of market developments, we believe a hard landing is likely unfolding in China and that outright economic contraction in the major emerging markets is possible if not probable. While many on Wall Street debate whether China will grow at 7% or 8% we believe the more timely debate should be whether the Chinese economy will grow at all. Of course, Chinese government economic data is likely even worse than US data, so it will likely be impossible to know for sure how the Chinese economy is performing. However, this is why we try to take our signals from market prices, which is where we see evidence of real trouble.
So while the problems in Europe are justifiably concerning most, we believe it wise to be prepared for other crises to move to the forefront in the coming weeks.
Crisis = Opportunity?
A global recession is not the end of the world of course. The long stretches of growth the world has enjoyed over the past 25 years, which we believe has been due to unhealthy credit creation and growing imbalances in the global economy, have created a real sense of complacency. Over the very long stretch of history, it has been normal for recessions to arrive every 3-5 years. The relatively long expansions over the past 25 years is the anomaly.
Markets have a sadistically beautiful way of working, as recession brings about lower prices, purges the system of unhealthy excesses, and lays the foundation for recovery. For investors who are positioned to survive during a recessionary deflation in asset prices, a recessionary bear market is something to welcome. This is precisely the posture we try to make sure we assume each cycle, and our caution often results in us getting prepared a bit early and this cycle has been no exception. However, our shorts/hedges in broader stock indexes have begun to turn profitable and the blood bath in gold and silver miners appears to have abated for now.
The combined result of these developments is that our portfolio positioning, which we began to implement in mid February, is finally beginning to pay off. We've certainly surrendered a pound of flesh in the process, which we need to grow back, but we are confident that we are well positioned to operate from a posture of strength as most others operate from a posture of fear and weakness. It has been a long six months for us and our clients, but we are confident that the next six months will offer tremendous opportunities for us to emerge from this period with significant portfolio growth opportunities.
It Won't Be Easy
Despite my optimism that we are well positioned to capitalize on what may be vast opportunities as various crises unfold in the coming months, it will surely not be easy or simple. 2008 was obviously a very volatile and difficult environment to navigate, but in some ways it was easy for those that understood the deflationary dynamics and the fact that policymakers were largely oblivious and reactionary. We expected policy action but we also expected it to arrive largely after a severe amount of damage had been done.
One of our assumptions this cycle has been that the next crisis would be confronted in a more proactive way by policymakers, and to date I think that's largely been the case. The ECB's launch of two rounds of LTRO's in December 2011 and February 2012 occurred prior to any major bank failures etc. Funding markets have remained relatively stable due to massive central bank intervention, which is VERY different than 2008. However, it is very difficult to ascertain exactly how bad markets will get before a major inflection point is reached in which policy action overwhelms fear and panic.
The relative stability in US markets has masked what has been real carnage in international stock, currency and commodity markets. Many emerging market stocks markets are down 20-30% in US dollar terms over the past 2 months alone, with many down 30-40% below their 2011 peaks. In addition, many are very near the lows they reached at the depths of the global market decline from August-October 2011. To put this into perspective, the Dow Jones Industrial Average would have to fall about 2,000 points, or about 15%, in order to reach a comparable level.
Given the deterioration of the global economy, the problems in Europe and the potential for currently unforeseen problems in major countries like India, China and Brazil, is it unreasonable to think that global markets could move to levels below the lows reached last year? I do not think so. In fact, many bond markets have already moved to new lows in yield (as referenced above) and many emerging market currencies have gone to new lows. For example, the Brazilian real recently reached a level versus the US dollar which was about 8% lower than the low reached last fall. Following a brief rally in the real last fall, it moved over 25% from that peak to it recent low - a MASSIVE currency market move in that amount of time. Similar moves have been unfolding in many currencies.
Whackamole
One characteristic of bear markets, and even severe stock market corrections, is that most or all hiding places are eventually whacked. We've seen a significant amount of relative appetite in US stocks for what are normally considered "defensive" stocks. Consumer staples, telecom, healthcare and utilities are commonly believed to be more defensive sectors. They tend to offer higher dividend yields and more stable operating conditions for their businesses. In an environment in which the 10 year US treasury yields 1.75%, I can't blame someone who chooses to buy a food company that yields 3-4%.
Some of these defensive stocks have taken on momentum characteristics (trading like high growth tech stocks when they are in favor) that are typically a red flag. In addition to the whackamole tendency of markets, we are keying off of when/if these hiding places succumb to broader market weakness. This could accompany a more panicked selling environment which typically is associated with a more durable and tradable market low. We have not yet observed that kind of condition.
This kind of market dynamic is too narrow and nuanced for us to try and capitalize on in our separate account strategy, but it is something we can and are trying to take advantage of in our fund.. Given the relative appetite for safety within the stock market, the relative cost of buying "insurance" on these defensive areas appears extremely cheap to us. We've had success in the past in buying this kind of "insurance" in historically low volatility market segments, as the risk/reward dynamics can be compelling. Effectively, it can be like buying flood insurance on a house that is not usually in a flood plain....and then a flood emerging. The value of the insurance can explode due to others all of a sudden rushing for protection against conditions they just recently believed to be remotely possible.
Tough Short Term Call
Forecasting short term market direction is always a tough endeavor, but we believe the present is especially difficult. Our process strongly suggests that a cyclical bear market has begun in US stocks, but that prognosis is valid over a period of months - not days or weeks. Even during cyclical bear markets, it is normal for markets to experienced significant rallies - often referred to as "bear market rallies." Markets reached a level of selling exhaustion last Friday which does commonly precede one of these "bear market rallies, " and markets have certainly rallied a bit this week.
However, the rally has been pretty weak on many measures we monitor which makes the near term a tough call. It seems very plausible to me that we could see another leg higher in the rally which began this past Monday, which could take the S&P 500 back up to the 1340-1360 area or even a bit higher. It also seems very plausible that the rally this week is already over and that markets will crack relatively soon, with 1230 and then 1160 being the next two lower "targets" we have.
Our separate account strategy is positioned for the intermediate term, so we are fairly set in our allocation until we believe a more durable low is reached. In our fund, we have been actively adjusting exposure to try and manage the risks of an extension of the rally up to the 1340-1360 zone. We are likely to suffer a good bit in the fund under that scenario, but our goal is to keep the damage reasonable, as we believe such a rally is highly uncertain, and not all that important relative to the opportunities we see on the short side over the coming weeks - i.e. some potential short term pain in exchange for some intermediate term gain.
Humor for the Holiday Weekend
Chances of the US being the only major economy to avoid a recession? Well, that is as about as likely as catching back to back home run balls in a big league park....oh.....
- Facebook and Europe have dominated the US financial press in recent days/weeks, but we believe it is wise to pay attention to Asia and Latin America
- Currency and bond markets globally suggest a far worse backdrop than US stocks. Will US stocks sustain in their own world or will they play catch up to the downside? Eventually we expect US stocks to succumb.
- 2012 may end up being more challenging to navigate than 2008 due to government interventions and real distress in emerging markets
- We will be keying off when hiding spots get hit
Look East Young Man
The problems in Europe and the fiasco surrounding the Facebook IPO have dominated CNBC and other US financial media coverage of markets in the past couple of weeks, but we are seeing increasing evidence that there are real problems unfolding in most major emerging market economies. There appears to be a US dollar shortage unfolding in China, many Asian currencies are getting slaughtered versus the US dollar and Japanese yen, economic data has gone from bad to worse, and bond yields have plummeted. A combination of the Chinese trade surplus evaporating and export companies holding onto their US dollars rather than converting them to yuan has begun to cause havoc.
Bond yields reached record lows this week in the following countries: Germany, Finland, France, UK, Austria, Switzerland, Netherlands, South Africa, Australia, Sweden, New Zealand and Japan. Industrial commodity prices have fallen sharply, with oil and copper prices finally giving up the ghost in recent weeks. Industrial commodities that are less impacted by financial buyers, such as rubber, lead and nickel, have been weak for about a year.
These market developments suggest to us that the global recession we've expected is in full swing, with previously rapid growth economies like China, India and Brazil beginning to feel real pain. Those economies experienced a more traditional business cycle, as their central banks tightened policies in order to try and head off inflation. This tightening precipitated an inversion in their yield curves (long term rates move below short term rates) and their economies have slowed substantially. Banking system issues in China are very likely due to the urban real estate bubble deflating, but it appears that Indian and Brazilian banks may have their own problems. Australia's economy is getting hit with a deflating housing bubble of its own and is getting hit by lower commodity prices as well.
Given this confluence of market developments, we believe a hard landing is likely unfolding in China and that outright economic contraction in the major emerging markets is possible if not probable. While many on Wall Street debate whether China will grow at 7% or 8% we believe the more timely debate should be whether the Chinese economy will grow at all. Of course, Chinese government economic data is likely even worse than US data, so it will likely be impossible to know for sure how the Chinese economy is performing. However, this is why we try to take our signals from market prices, which is where we see evidence of real trouble.
So while the problems in Europe are justifiably concerning most, we believe it wise to be prepared for other crises to move to the forefront in the coming weeks.
Crisis = Opportunity?
A global recession is not the end of the world of course. The long stretches of growth the world has enjoyed over the past 25 years, which we believe has been due to unhealthy credit creation and growing imbalances in the global economy, have created a real sense of complacency. Over the very long stretch of history, it has been normal for recessions to arrive every 3-5 years. The relatively long expansions over the past 25 years is the anomaly.
Markets have a sadistically beautiful way of working, as recession brings about lower prices, purges the system of unhealthy excesses, and lays the foundation for recovery. For investors who are positioned to survive during a recessionary deflation in asset prices, a recessionary bear market is something to welcome. This is precisely the posture we try to make sure we assume each cycle, and our caution often results in us getting prepared a bit early and this cycle has been no exception. However, our shorts/hedges in broader stock indexes have begun to turn profitable and the blood bath in gold and silver miners appears to have abated for now.
The combined result of these developments is that our portfolio positioning, which we began to implement in mid February, is finally beginning to pay off. We've certainly surrendered a pound of flesh in the process, which we need to grow back, but we are confident that we are well positioned to operate from a posture of strength as most others operate from a posture of fear and weakness. It has been a long six months for us and our clients, but we are confident that the next six months will offer tremendous opportunities for us to emerge from this period with significant portfolio growth opportunities.
It Won't Be Easy
Despite my optimism that we are well positioned to capitalize on what may be vast opportunities as various crises unfold in the coming months, it will surely not be easy or simple. 2008 was obviously a very volatile and difficult environment to navigate, but in some ways it was easy for those that understood the deflationary dynamics and the fact that policymakers were largely oblivious and reactionary. We expected policy action but we also expected it to arrive largely after a severe amount of damage had been done.
One of our assumptions this cycle has been that the next crisis would be confronted in a more proactive way by policymakers, and to date I think that's largely been the case. The ECB's launch of two rounds of LTRO's in December 2011 and February 2012 occurred prior to any major bank failures etc. Funding markets have remained relatively stable due to massive central bank intervention, which is VERY different than 2008. However, it is very difficult to ascertain exactly how bad markets will get before a major inflection point is reached in which policy action overwhelms fear and panic.
The relative stability in US markets has masked what has been real carnage in international stock, currency and commodity markets. Many emerging market stocks markets are down 20-30% in US dollar terms over the past 2 months alone, with many down 30-40% below their 2011 peaks. In addition, many are very near the lows they reached at the depths of the global market decline from August-October 2011. To put this into perspective, the Dow Jones Industrial Average would have to fall about 2,000 points, or about 15%, in order to reach a comparable level.
Given the deterioration of the global economy, the problems in Europe and the potential for currently unforeseen problems in major countries like India, China and Brazil, is it unreasonable to think that global markets could move to levels below the lows reached last year? I do not think so. In fact, many bond markets have already moved to new lows in yield (as referenced above) and many emerging market currencies have gone to new lows. For example, the Brazilian real recently reached a level versus the US dollar which was about 8% lower than the low reached last fall. Following a brief rally in the real last fall, it moved over 25% from that peak to it recent low - a MASSIVE currency market move in that amount of time. Similar moves have been unfolding in many currencies.
Whackamole
One characteristic of bear markets, and even severe stock market corrections, is that most or all hiding places are eventually whacked. We've seen a significant amount of relative appetite in US stocks for what are normally considered "defensive" stocks. Consumer staples, telecom, healthcare and utilities are commonly believed to be more defensive sectors. They tend to offer higher dividend yields and more stable operating conditions for their businesses. In an environment in which the 10 year US treasury yields 1.75%, I can't blame someone who chooses to buy a food company that yields 3-4%.
Some of these defensive stocks have taken on momentum characteristics (trading like high growth tech stocks when they are in favor) that are typically a red flag. In addition to the whackamole tendency of markets, we are keying off of when/if these hiding places succumb to broader market weakness. This could accompany a more panicked selling environment which typically is associated with a more durable and tradable market low. We have not yet observed that kind of condition.
This kind of market dynamic is too narrow and nuanced for us to try and capitalize on in our separate account strategy, but it is something we can and are trying to take advantage of in our fund.. Given the relative appetite for safety within the stock market, the relative cost of buying "insurance" on these defensive areas appears extremely cheap to us. We've had success in the past in buying this kind of "insurance" in historically low volatility market segments, as the risk/reward dynamics can be compelling. Effectively, it can be like buying flood insurance on a house that is not usually in a flood plain....and then a flood emerging. The value of the insurance can explode due to others all of a sudden rushing for protection against conditions they just recently believed to be remotely possible.
Tough Short Term Call
Forecasting short term market direction is always a tough endeavor, but we believe the present is especially difficult. Our process strongly suggests that a cyclical bear market has begun in US stocks, but that prognosis is valid over a period of months - not days or weeks. Even during cyclical bear markets, it is normal for markets to experienced significant rallies - often referred to as "bear market rallies." Markets reached a level of selling exhaustion last Friday which does commonly precede one of these "bear market rallies, " and markets have certainly rallied a bit this week.
However, the rally has been pretty weak on many measures we monitor which makes the near term a tough call. It seems very plausible to me that we could see another leg higher in the rally which began this past Monday, which could take the S&P 500 back up to the 1340-1360 area or even a bit higher. It also seems very plausible that the rally this week is already over and that markets will crack relatively soon, with 1230 and then 1160 being the next two lower "targets" we have.
Our separate account strategy is positioned for the intermediate term, so we are fairly set in our allocation until we believe a more durable low is reached. In our fund, we have been actively adjusting exposure to try and manage the risks of an extension of the rally up to the 1340-1360 zone. We are likely to suffer a good bit in the fund under that scenario, but our goal is to keep the damage reasonable, as we believe such a rally is highly uncertain, and not all that important relative to the opportunities we see on the short side over the coming weeks - i.e. some potential short term pain in exchange for some intermediate term gain.
Humor for the Holiday Weekend
Chances of the US being the only major economy to avoid a recession? Well, that is as about as likely as catching back to back home run balls in a big league park....oh.....
TEAMThink 4-27-2012
Executive Summary
- The leading economic indicators we weight heavily in our process have taken another turn down, which is directly in contrast from market consensus.
- Europe appears to be cascading towards the next chapter in its crisis.
- The Fed confirmed this week that they stand at the ready to print more if things get weaker, and since we believe that is already baked in the cake....
- Can the "Strong Economy Bulls" pass the baton to the "QE 3 Bulls" so seamlessly? We don't think so but crazier things have happened.
Economic Reality
It appears that consensus is somewhere between the denial and migration phases of accepting that the global economy is in real trouble, and that the hope of the US diverging is unlikely. Recent economic releases have come in quite weak, and corporate earnings reports from companies most levered to ex-US growth have been very mixed. The leading indicators we monitor which use year over year data (to account for the massive seasonal adjustment issues surrounding the collapse in 2008/2009) are making new lows with some vigor. This suggests that a recession is not only unavoidable but may not be short and shallow. Data out of much of the rest of the world has been getting worse for months, and even the all mighty Germany has begun to show cracks.
Spanish debt has fallen sharply in price recently and driven yields back close to where they were last fall, despite over a trillion in euros being pumped into the system by the ECB. My colleague, David Borowsky, has been all over the European data for us and a couple of weeks ago noted that he sensed a major shift in sentiment being conveyed by non-German leaders about focusing on growth versus austerity. We received official confirmation of that this week, as deficit targets were slackened. This comes as Spain announced it continues to be depression and the UK has fallen back into recession.
The first round of French elections suggests the socialist party candidate may win early next month in the final round, which would also indicate a move away from austerity. With sovereign debt strains already massive and a possible need to bailout Spain and its banking system, I'd be surprised if the ECB is not back with another round of intervention at some point soon, with possible fiscal stimulus coming from France and possibly others. However, like the situation in the US, I'd expect there needs to be more pain before actions are taken.
My Head Hurts
I say that both literally and figuratively after a long week after a long couple of months. It has obviously been a very difficult 2 months for our investors and the stress levels here at TEAM can be cut with a knife. While we've been battered and bruised, markets may have one more brutal twist in store for us just as our fundamental outlook is gaining wider acceptance.
One of the main planks for the bulls during the first 3 months of the year was based upon the perception of strong US economic growth and that the US was due to diverge even if much of the rest of the world experienced problems. Our brutal draw down in gold and related mining shares accelerated when concerns grew acute over the past 4 weeks that QE 3 was nowhere in sight and the Fed may even tighten sometime much sooner than previously expected.
While gold and the related miners appear to have responded favorably this week to the Fed's announcement that they stand ready to print more if things weaken, the broader stock market has also rallied sharply. Given the extreme level of bullishness reached this spring, the extremely high level of profit margins and valuation for most stocks, we had discounted the likelihood of bulls shifting their rational for speculation so swiftly - at least in any sustaining fashion. Essentially, if the broader stock market were to launch from here, it would do so on the eve of a recession, while suffering less than a 5% decline, while "investors" do a complete 180 on their rationale for owning stocks.
I still think a sustained move higher from this point, based on the expectation that things will get bad enough to warrant QE 3, is very unlikely. However, we must be prepared for that scenario if it begins to play out. With this in mind, here are the two main scenarios we believe are reasonable assuming our fundamental outlook is valid:
1. Markets launch from here in a sustained fashion due to a Pavlovian response and expectation for QE 3. Under this scenario, I think we would be positioned ok, but certainly not optimally. I would think our significant exposure to metals miners would perform extremely well in this scenario, and possibly in an explosive fashion due to extreme undervaluation relative to gold and terribly bearish sentiment. Effectively, stocks would begin to go up on bad news, as the bad news would confirm that QE 3 is just around the corner.
2. The Pavlovian response peters out relatively fast and markets roll over as the reality of bad news begins to usher in doubts about whether the Fed is behind the curve - i.e. the addict begins to get the DT's without the QE drug. This scenario would result in markets falling by a significant amount until the Fed finally does act once the coincident data gets bad enough. The initial drop of significance would then be followed by the inevitable QE 3, which would then create another potential choice:
A. A launch phase commences from when QE 3 is announced and markets don't look back.
B. A major rally initially which exhausts and then markets really exact a pound of flesh by testing the lows or even going to new lows and creating a panicked environment. If markets roll back over after QE is announced, and that is the main reason people are buying (as the economy would be very poor in this scenario), selling could beget more selling.
The main difference I see at this stage is that QE 1 and QE 2 were both announced just as leading economic indicators were already pointing towards a recovery/up tick in economic growth. They are suggesting the exact opposite at this point in the cycle, which I believe complicates matters significantly for the QE = buy stocks crowd. I have little doubt there is excitement to buy based on QE, as has been reflected this week, but I have big questions about the buying power sustaining.
Investment Implications
Our bias at this stage is significantly tilted towards the 2nd scenario, with the need to make decisions about navigating between A and B a luxury we can consider when/if we get to that point. Our process has what we call "intermediate sell signals" in many stock markets around the world, as well as a number of major US stock market sectors/industries and bell weather individual stocks. The broader US stock market is testing a shorter term sell signal we've had, which has not yet scaled into an intermediate term sell signal. We also have confirming intermediate sell signals in economically sensitive commodities like copper. German bunds and US treasuries are at or near recent low yields, which also supports the recession thesis.
This backdrop leads me to expect that the US stock market is testing its recent top and poised to roll over into a more pronounced decline. However, tests can result in marginal new highs in broad market indexes like the Dow even as most market segments do not confirm. Unless we see significant evidence that a sustained move to the upside in broad markets is likely, we expect to retain our significant broad stock market short/hedging exposure.
Humor for the Weekend
I think this is appropriate for two reasons. First, the golden balls are timely given the chance that gold has put in a bottom. Second, the players could be replaced by global governments as they each try to steal growth from each other by debasing their currencies.
- The leading economic indicators we weight heavily in our process have taken another turn down, which is directly in contrast from market consensus.
- Europe appears to be cascading towards the next chapter in its crisis.
- The Fed confirmed this week that they stand at the ready to print more if things get weaker, and since we believe that is already baked in the cake....
- Can the "Strong Economy Bulls" pass the baton to the "QE 3 Bulls" so seamlessly? We don't think so but crazier things have happened.
Economic Reality
It appears that consensus is somewhere between the denial and migration phases of accepting that the global economy is in real trouble, and that the hope of the US diverging is unlikely. Recent economic releases have come in quite weak, and corporate earnings reports from companies most levered to ex-US growth have been very mixed. The leading indicators we monitor which use year over year data (to account for the massive seasonal adjustment issues surrounding the collapse in 2008/2009) are making new lows with some vigor. This suggests that a recession is not only unavoidable but may not be short and shallow. Data out of much of the rest of the world has been getting worse for months, and even the all mighty Germany has begun to show cracks.
Spanish debt has fallen sharply in price recently and driven yields back close to where they were last fall, despite over a trillion in euros being pumped into the system by the ECB. My colleague, David Borowsky, has been all over the European data for us and a couple of weeks ago noted that he sensed a major shift in sentiment being conveyed by non-German leaders about focusing on growth versus austerity. We received official confirmation of that this week, as deficit targets were slackened. This comes as Spain announced it continues to be depression and the UK has fallen back into recession.
The first round of French elections suggests the socialist party candidate may win early next month in the final round, which would also indicate a move away from austerity. With sovereign debt strains already massive and a possible need to bailout Spain and its banking system, I'd be surprised if the ECB is not back with another round of intervention at some point soon, with possible fiscal stimulus coming from France and possibly others. However, like the situation in the US, I'd expect there needs to be more pain before actions are taken.
My Head Hurts
I say that both literally and figuratively after a long week after a long couple of months. It has obviously been a very difficult 2 months for our investors and the stress levels here at TEAM can be cut with a knife. While we've been battered and bruised, markets may have one more brutal twist in store for us just as our fundamental outlook is gaining wider acceptance.
One of the main planks for the bulls during the first 3 months of the year was based upon the perception of strong US economic growth and that the US was due to diverge even if much of the rest of the world experienced problems. Our brutal draw down in gold and related mining shares accelerated when concerns grew acute over the past 4 weeks that QE 3 was nowhere in sight and the Fed may even tighten sometime much sooner than previously expected.
While gold and the related miners appear to have responded favorably this week to the Fed's announcement that they stand ready to print more if things weaken, the broader stock market has also rallied sharply. Given the extreme level of bullishness reached this spring, the extremely high level of profit margins and valuation for most stocks, we had discounted the likelihood of bulls shifting their rational for speculation so swiftly - at least in any sustaining fashion. Essentially, if the broader stock market were to launch from here, it would do so on the eve of a recession, while suffering less than a 5% decline, while "investors" do a complete 180 on their rationale for owning stocks.
I still think a sustained move higher from this point, based on the expectation that things will get bad enough to warrant QE 3, is very unlikely. However, we must be prepared for that scenario if it begins to play out. With this in mind, here are the two main scenarios we believe are reasonable assuming our fundamental outlook is valid:
1. Markets launch from here in a sustained fashion due to a Pavlovian response and expectation for QE 3. Under this scenario, I think we would be positioned ok, but certainly not optimally. I would think our significant exposure to metals miners would perform extremely well in this scenario, and possibly in an explosive fashion due to extreme undervaluation relative to gold and terribly bearish sentiment. Effectively, stocks would begin to go up on bad news, as the bad news would confirm that QE 3 is just around the corner.
2. The Pavlovian response peters out relatively fast and markets roll over as the reality of bad news begins to usher in doubts about whether the Fed is behind the curve - i.e. the addict begins to get the DT's without the QE drug. This scenario would result in markets falling by a significant amount until the Fed finally does act once the coincident data gets bad enough. The initial drop of significance would then be followed by the inevitable QE 3, which would then create another potential choice:
A. A launch phase commences from when QE 3 is announced and markets don't look back.
B. A major rally initially which exhausts and then markets really exact a pound of flesh by testing the lows or even going to new lows and creating a panicked environment. If markets roll back over after QE is announced, and that is the main reason people are buying (as the economy would be very poor in this scenario), selling could beget more selling.
The main difference I see at this stage is that QE 1 and QE 2 were both announced just as leading economic indicators were already pointing towards a recovery/up tick in economic growth. They are suggesting the exact opposite at this point in the cycle, which I believe complicates matters significantly for the QE = buy stocks crowd. I have little doubt there is excitement to buy based on QE, as has been reflected this week, but I have big questions about the buying power sustaining.
Investment Implications
Our bias at this stage is significantly tilted towards the 2nd scenario, with the need to make decisions about navigating between A and B a luxury we can consider when/if we get to that point. Our process has what we call "intermediate sell signals" in many stock markets around the world, as well as a number of major US stock market sectors/industries and bell weather individual stocks. The broader US stock market is testing a shorter term sell signal we've had, which has not yet scaled into an intermediate term sell signal. We also have confirming intermediate sell signals in economically sensitive commodities like copper. German bunds and US treasuries are at or near recent low yields, which also supports the recession thesis.
This backdrop leads me to expect that the US stock market is testing its recent top and poised to roll over into a more pronounced decline. However, tests can result in marginal new highs in broad market indexes like the Dow even as most market segments do not confirm. Unless we see significant evidence that a sustained move to the upside in broad markets is likely, we expect to retain our significant broad stock market short/hedging exposure.
Humor for the Weekend
I think this is appropriate for two reasons. First, the golden balls are timely given the chance that gold has put in a bottom. Second, the players could be replaced by global governments as they each try to steal growth from each other by debasing their currencies.
TEAMThink 4-6-2012
Executive Summary
- The past 6+ weeks have been a brutal period for us and our strategy. We've had comparable periods in the past but that doesn't make us feel any better while in the belly of the beast.
- Currency, commodity and bond markets have largely been trading in line with our outlook for weeks, while the stock market has continued to whistle past the graveyard. As I stated in the 3-22-2012 post, we were seeing acute signs that exhaustion in stocks was imminent. After another couple of weeks of manic spikes and declines, Friday's employment reports appears to have been a potential "butterfly" flapping its wings.
- Gold and silver mining shares have suffered a full blown sellers' panic, which is a mini-2008. Despite the major indexes for the industry moving to new lows and falling sharply, the internals of the industry have been stronger. Essentially, many stocks have not moved to new lows, which can be a sign that selling is exhausting.
- Along with the dispersion in mining stocks (some making new lows and others not), gold and silver have not moved to new lows. Technically speaking, both have held up at price levels that suggest their corrections may be near an end as well.
- While very painful, our conviction of our portfolio positioning remains very high. While recent portfolio declines would suggest otherwise, we've actually reduced broad market exposure significantly in recent weeks. Like August of 2011, we expect that a period of weaker stock markets may be accompanied by a period of significant strength in gold and related miners. Even if the miners are the proverbial baby being thrown out with the bath water if the broader stock market fall sharply, portfolios should be very resilient as the hedges we've deployed actually start performing as expected.
- The Fed is backed into a corner and knows only one thing to do. As a global recession takes hold, we expect the Fed and other major central banks to ramp up the printing presses. The US Fed is paranoid that we may face a 1937 environment, as emerging markets tightened monetary policies during what they believe to be a fragile "recovery". We expect them to be fairly swift in confronting market and economic weakness if it emerges in the coming weeks.
We Must Be Masochists
My partner Sam and I have joked for over a decade now that we cannot wait until a 1982-2000 style secular bull market environment returns, as deploying a macro strategy in the present secular bear market period is a miserable existence at times. It requires that we try to navigate and time market cycles and inflection points. This means we must be buying when others are panic selling and sell when others are panic buying. The past month has been just such an environment and we've followed what we are convinced will ultimately prove profitable, but damn if it isn't a living hell while the panic continues. We've seen outright panic selling in gold and silver mining stocks, which have played a prominent role in our strategy since April 2003. At the same time, the major stock market averages have been supported by an increasingly narrow set of big cap stocks in manic buyers' panic - with Apple being the king of that hill. I won't get into why I believe Apple is very dangerous to own at these prices out of fear of being targeted by Appleoneons.
Buying panic selling, or at least not selling into it, combined with selling panic buying has resulted in very poor performance since mid February. We've suffered through similar periods in the past, whether it was buying small cap value funds in 2000 when many clients only wanted to invest in technology, buying in late 2002 and early 2003, selling in the summer and fall of 2007, or buying in the fall of 2008 and spring of 2009. It is always hard and scary to do what is necessary to be a successful long term investor. If it weren't, then everyone would be rich and we wouldn't have our business. I like to think that part of what our clients pay us for should be classified as hazard pay, as these periods are filled with misery, frustration and disgust. However, despite our carnal impulses to join the panics, we do our best to wipe our vomit off our computer screens enough to do what we are convinced to be prudent.
Markets Breaking Down
I started to write a different post than I ended up posting on 3-22-2012 on Friday, March 16th. Markets began to behave with a very different tone that Friday, to the point where David Borowsky and I spent much of that weekend discussing and debating what had happened and what it may mean. Like many, I've found that writing can help me focus and think more clearly, which that "phantom post" did. Since that day, I'd argue that currency, commodity and bond markets across the world have largely been trading in line with our macro outlook - i.e. a burgeoning global recession that will include the US and Germany. Portions of the US stock market have remained in fantasy land for much of the past three weeks, though Friday's weak employment report may change that.
We've observed that economic data from around the world has been getting worse for weeks on end....including in the US and Germany. As people are apt to do towards the end of speculative frenzies, it appears many investors have been rationalizing what we've seen as clear signs of weakness. I'll admit to having periods of cloudiness in January and February, as some parts of the economy have benefited short term from investory building in the auto industry and an unusually warm winter. The depth and duration of a global recession are still uncertain, but we are more confident than ever that one has either already begun or will be during the 2nd quarter. Segments of the US stock market have already been flashing warning signs, as sectors leveraged to global growth like energy and materials have become relatively weak. We expect the rest of the market to succumb to the reality, and Friday's futures session following the employment report may be the start.
I Hate You - But I Love You
Gold and silver mining stocks have been a common topic of discussion with our clients/investors and for good reason. Someone would have to be lacking a pulse not to be impacted by the horrific decline that has unfolded over the past 6+ weeks. Obviously, had we expected this to occur we would have taken actions to try and avoid it. As I communicated in my 3-22-2012 post, we are prepared to reduce exposure if we believe a 2008 style meltdown is unfolding. I described above the internal dispersion we are viewing in the mining stocks, as well as the higher lows that gold and silver have made recently. That market action is distinctly different than what unfolded in 2008.....at least so far. Those differences could certainly be vanquished with additional deterioration in the prices of more mining stocks and the commodities, but so far it has caused us to take a more patient approach....much like we did last June and July when a similar shockwave hit the mining stocks.
We've received a lot of inquiries expressing dismay and concern about our seemingly endless one way love affair with the gold mining stocks, and over the past 2 years it has surely been an unrequited affection on our part. Ironically, over this period the actual business performance of the companies has improved dramatically, as earnings, cash flows and dividends have all grown significantly. Yet, the stocks have languished and ultimately tanked over the past week. I wish I could provide some grand explanation for why this happened, but there isn't one. Sometimes markets do crazy things, and that is what I believe is unfolding at present, as I cannot not imagine a more bullish set of conditions for the mining stocks than those that currently exist and appear poised to unfold in the coming weeks/months.
Of course, if the world is on the cusp of a depressionary deflation and the price of gold crashes and stays at much lower levels for a long time, then the miners will likely be horrible investments. I place the chances of that scenario somewhere between remote and nearly impossible. What we are left to try and determine is whether or not we are seeing a 2008 style deleveraging which will sustain for long enough prior to government intervention that could plunge prices much lower before ultimately responding to the printing presses.
Ironically, the most recent drop in gold and the miners was catalyzed by a widespread view that the Fed is likely to refrain from further printing.....or even raise rates....because of how super awesome the US economy is and will continue to be. Please forgive my sarcasm, as I admit to having reached my wits end over the past month as I've seen seemingly endless rationalizations. So while many freaked out about a hawkish Fed, we've been concerned about the big risk to our positions being a theoretical situation where the Fed all of a sudden sees weakness and for some reasons doesn't print more money. The massive gulf in how we see events unfolding versus the consensus has been reflected in our very poor performance over the past 6-8 weeks.
When Will the Dope Wear Off?
As I stated earlier in this post, for the past few weeks we've had acute signals that even the stock market may be vulnerable to awakening to reality. My sense of market dynamics has been that the intensity of buyers has been driven by momentum and performance chasing, with a lack of fundamental conviction underpinning the intensity. Even the most optimistic forecasters out of those I wouldn't characterize as hacks, have been projecting a modest continuation of an economic recovery within the context of very slow global growth. That is hardly the backdrop for wild eyed animal spirits. I suspect that the conviction levels of many investors may be very low, and that if data/info comes in weak (whether it is additional economic data or a yucky corporate earnings reporting season), then the last bastion of optimism could be hung out to dry - i.e. momentum shifts to the downside.
If I am correct in my assessment of squishy conviction supporting the momentum that has unfolded in recent months, we could be in the early stages of a very interesting period. John Hussman of the Hussman Funds has done a good bit of commentary about how a broad array of market conditions that have been present for weeks places the current market in elite territory of many of the worst periods in history to own stocks. As he has described the environment, stocks are overvalued, overbought (meaning very extended to the upside) and investors are over bullish sentiment wise. When I look at that kind of array and historical implications of the conditions, combined with the exhaustion signals our own process suggests, I am very concerned there could be a major market decline.
Of course, my concerns have been evolving since mid-February and so far been like the Boy Who Cries Wolf. However, we've raised significant amounts of cash, implemented broader stock market hedges and even sent out communication to our separate account clients recommending they consider moving 401K type accounts to cash. The last time we sent such a recommendation was at the end of 2007, so we don't take such action unless we are really worried about traditional stock market investments.
Cornered Dog
I believe the Fed is likely to emerge like a cornered dog in the coming months. While we are very concerned about the broader stock market here, our portfolio positioning is actually such that we'd expect to benefit from a broader market decline.We continue to expect gold and the miners to be wild cards for now. I suspect another couple of bad economic data points and a 10% kind of stock market decline will have many of those, who have been using optimistic economic alchemy to justify speculation, to begin crying for the Fed to print more money to bail out their poorly bought stock exposure.
I fully expect the Fed to respond in kind when we get to that point, but it is likely weeks or even a month or two away. However, I do expect them to act and in a significant fashion, as the global backdrop remains extremely concerning due to a severe recession unfolding in Europe and a potential hard landing in China. The shortened futures trading session on Friday following the very weak employment report provided what I believe could be a preview of how markets may respond to wider recognition of recession. Stocks sold off sharply, US treasuries rallied, but something very different unfolded in the currency market. Over the past few years, a "risk off" day has typically included a rally in the US dollar. However, Friday's session involved weakness in the US dollar, as well as closely associated currencies of Mexico and Canada. Formerly "risk on" currencies like the Australian dollar rallied. It appears to me that some believe that the correlation of weak US dollar translating into strong US stocks is sacrosanct, and I believe that to be a flawed expectation.
This brings us back to the bain of my existence - gold mining stocks. Under the scenario I just presented, I would expect gold to do well, and as an extension also the gold mining stocks. However, the panic and hatred of the mining stocks may be so severe as to require them to go down for a bit more even if gold does catch a bid. Both gold and the miners could get caught up in a broad liquidation as well. Our portfolios would be in pretty good shape in that scenario, as we'd expect our broad market hedges to provide significant cushion against any additional decline in the miners.
Ultimately, my conviction level for our intermediate term outlook could not be higher. My concern remains surviving until global central banks are once again left with the choice of systemic jeopardy or money printing. I think markets are very close to sniffing out the recession unfolding, and while i expect the Fed and others to be quick on the trigger finger, I don't know when that will be. But when that occurs and the next market cycle launches, I expect the recovery and returns in our metals related positions to be epic.
Since the beginning of the gold bull market about a decade ago, the miners have reached what I'd consider an extreme discount valuation to the price of gold on three other occasions. All three resulted in the industry group appreciated by over 100% within 18 months once the decline exhausted. That may seem hard to imagine at present, but the stocks are cheaper versus gold than at any other point other than the low in October 2008. From that point, the XAU gold miners index went from its low of about 64 to about 200 a little over 12 months later.
The stock prices of the miners are not just some squiggles on a chart, they do represent fractional ownership in actual businesses. The businesses of the large miners are currently generating free cash flow yields of between 15%-20% in many cases. They reason some still believe the miners should trade with a relationship to gold is because the price of gold actually does impact things like earnings, cash flows and dividends. Historically, a ratio of between 3 and 5 between the price of an ounce of gold/XAU was "normal". In October 2008 this ratio was over 11, while as of Thursday's close it was 9.86.
It is this basic arithmetic combined with our high conviction of our forecast which causes us to tolerate the living hell which has become owning the miners. If gold were to go to $2,000 at some point in the next 12 months, which I believe is not only possible but likely, then an XAU ratio of 6 would translate into a price of 333, or what would be a gain of about 100% from the current level of 165. If gold ultimately goes to much higher prices as I expect, and the mining stocks become beloved rather than despised, as I also expect, then the potential is alarming. Assuming a gold price of $5,000 and an XAU ratio of 3 would result in a value of 1,666, or 10 times the current level.
While such numbers are total conjecture and may not occur, I do believe they are possible, if not probable. During its last great bull market, gold went from $35 to $800. A comparable increase from low around $250 from earlier last decade would result in a price of $5,700. Of course, the 1970's did not involve every major central bank in the world printing money at unprecedented levels, so that framework may prove too conservative. Regardless, given the risks we see to our clients' wealth and standards of living and the value and opportunity in the gold mining stocks, I believe they currently present the kind of opportunity that arrives very infrequently - perhaps the last being the great technology growth stocks of the late 1980's and early 1990's just prior to the computer revolution exploding onto the scene.
Humor for the Weekend
In honor of the official start of spring.....at least to me....baseball is back!
- The past 6+ weeks have been a brutal period for us and our strategy. We've had comparable periods in the past but that doesn't make us feel any better while in the belly of the beast.
- Currency, commodity and bond markets have largely been trading in line with our outlook for weeks, while the stock market has continued to whistle past the graveyard. As I stated in the 3-22-2012 post, we were seeing acute signs that exhaustion in stocks was imminent. After another couple of weeks of manic spikes and declines, Friday's employment reports appears to have been a potential "butterfly" flapping its wings.
- Gold and silver mining shares have suffered a full blown sellers' panic, which is a mini-2008. Despite the major indexes for the industry moving to new lows and falling sharply, the internals of the industry have been stronger. Essentially, many stocks have not moved to new lows, which can be a sign that selling is exhausting.
- Along with the dispersion in mining stocks (some making new lows and others not), gold and silver have not moved to new lows. Technically speaking, both have held up at price levels that suggest their corrections may be near an end as well.
- While very painful, our conviction of our portfolio positioning remains very high. While recent portfolio declines would suggest otherwise, we've actually reduced broad market exposure significantly in recent weeks. Like August of 2011, we expect that a period of weaker stock markets may be accompanied by a period of significant strength in gold and related miners. Even if the miners are the proverbial baby being thrown out with the bath water if the broader stock market fall sharply, portfolios should be very resilient as the hedges we've deployed actually start performing as expected.
- The Fed is backed into a corner and knows only one thing to do. As a global recession takes hold, we expect the Fed and other major central banks to ramp up the printing presses. The US Fed is paranoid that we may face a 1937 environment, as emerging markets tightened monetary policies during what they believe to be a fragile "recovery". We expect them to be fairly swift in confronting market and economic weakness if it emerges in the coming weeks.
We Must Be Masochists
My partner Sam and I have joked for over a decade now that we cannot wait until a 1982-2000 style secular bull market environment returns, as deploying a macro strategy in the present secular bear market period is a miserable existence at times. It requires that we try to navigate and time market cycles and inflection points. This means we must be buying when others are panic selling and sell when others are panic buying. The past month has been just such an environment and we've followed what we are convinced will ultimately prove profitable, but damn if it isn't a living hell while the panic continues. We've seen outright panic selling in gold and silver mining stocks, which have played a prominent role in our strategy since April 2003. At the same time, the major stock market averages have been supported by an increasingly narrow set of big cap stocks in manic buyers' panic - with Apple being the king of that hill. I won't get into why I believe Apple is very dangerous to own at these prices out of fear of being targeted by Appleoneons.
Buying panic selling, or at least not selling into it, combined with selling panic buying has resulted in very poor performance since mid February. We've suffered through similar periods in the past, whether it was buying small cap value funds in 2000 when many clients only wanted to invest in technology, buying in late 2002 and early 2003, selling in the summer and fall of 2007, or buying in the fall of 2008 and spring of 2009. It is always hard and scary to do what is necessary to be a successful long term investor. If it weren't, then everyone would be rich and we wouldn't have our business. I like to think that part of what our clients pay us for should be classified as hazard pay, as these periods are filled with misery, frustration and disgust. However, despite our carnal impulses to join the panics, we do our best to wipe our vomit off our computer screens enough to do what we are convinced to be prudent.
Markets Breaking Down
I started to write a different post than I ended up posting on 3-22-2012 on Friday, March 16th. Markets began to behave with a very different tone that Friday, to the point where David Borowsky and I spent much of that weekend discussing and debating what had happened and what it may mean. Like many, I've found that writing can help me focus and think more clearly, which that "phantom post" did. Since that day, I'd argue that currency, commodity and bond markets across the world have largely been trading in line with our macro outlook - i.e. a burgeoning global recession that will include the US and Germany. Portions of the US stock market have remained in fantasy land for much of the past three weeks, though Friday's weak employment report may change that.
We've observed that economic data from around the world has been getting worse for weeks on end....including in the US and Germany. As people are apt to do towards the end of speculative frenzies, it appears many investors have been rationalizing what we've seen as clear signs of weakness. I'll admit to having periods of cloudiness in January and February, as some parts of the economy have benefited short term from investory building in the auto industry and an unusually warm winter. The depth and duration of a global recession are still uncertain, but we are more confident than ever that one has either already begun or will be during the 2nd quarter. Segments of the US stock market have already been flashing warning signs, as sectors leveraged to global growth like energy and materials have become relatively weak. We expect the rest of the market to succumb to the reality, and Friday's futures session following the employment report may be the start.
I Hate You - But I Love You
Gold and silver mining stocks have been a common topic of discussion with our clients/investors and for good reason. Someone would have to be lacking a pulse not to be impacted by the horrific decline that has unfolded over the past 6+ weeks. Obviously, had we expected this to occur we would have taken actions to try and avoid it. As I communicated in my 3-22-2012 post, we are prepared to reduce exposure if we believe a 2008 style meltdown is unfolding. I described above the internal dispersion we are viewing in the mining stocks, as well as the higher lows that gold and silver have made recently. That market action is distinctly different than what unfolded in 2008.....at least so far. Those differences could certainly be vanquished with additional deterioration in the prices of more mining stocks and the commodities, but so far it has caused us to take a more patient approach....much like we did last June and July when a similar shockwave hit the mining stocks.
We've received a lot of inquiries expressing dismay and concern about our seemingly endless one way love affair with the gold mining stocks, and over the past 2 years it has surely been an unrequited affection on our part. Ironically, over this period the actual business performance of the companies has improved dramatically, as earnings, cash flows and dividends have all grown significantly. Yet, the stocks have languished and ultimately tanked over the past week. I wish I could provide some grand explanation for why this happened, but there isn't one. Sometimes markets do crazy things, and that is what I believe is unfolding at present, as I cannot not imagine a more bullish set of conditions for the mining stocks than those that currently exist and appear poised to unfold in the coming weeks/months.
Of course, if the world is on the cusp of a depressionary deflation and the price of gold crashes and stays at much lower levels for a long time, then the miners will likely be horrible investments. I place the chances of that scenario somewhere between remote and nearly impossible. What we are left to try and determine is whether or not we are seeing a 2008 style deleveraging which will sustain for long enough prior to government intervention that could plunge prices much lower before ultimately responding to the printing presses.
Ironically, the most recent drop in gold and the miners was catalyzed by a widespread view that the Fed is likely to refrain from further printing.....or even raise rates....because of how super awesome the US economy is and will continue to be. Please forgive my sarcasm, as I admit to having reached my wits end over the past month as I've seen seemingly endless rationalizations. So while many freaked out about a hawkish Fed, we've been concerned about the big risk to our positions being a theoretical situation where the Fed all of a sudden sees weakness and for some reasons doesn't print more money. The massive gulf in how we see events unfolding versus the consensus has been reflected in our very poor performance over the past 6-8 weeks.
When Will the Dope Wear Off?
As I stated earlier in this post, for the past few weeks we've had acute signals that even the stock market may be vulnerable to awakening to reality. My sense of market dynamics has been that the intensity of buyers has been driven by momentum and performance chasing, with a lack of fundamental conviction underpinning the intensity. Even the most optimistic forecasters out of those I wouldn't characterize as hacks, have been projecting a modest continuation of an economic recovery within the context of very slow global growth. That is hardly the backdrop for wild eyed animal spirits. I suspect that the conviction levels of many investors may be very low, and that if data/info comes in weak (whether it is additional economic data or a yucky corporate earnings reporting season), then the last bastion of optimism could be hung out to dry - i.e. momentum shifts to the downside.
If I am correct in my assessment of squishy conviction supporting the momentum that has unfolded in recent months, we could be in the early stages of a very interesting period. John Hussman of the Hussman Funds has done a good bit of commentary about how a broad array of market conditions that have been present for weeks places the current market in elite territory of many of the worst periods in history to own stocks. As he has described the environment, stocks are overvalued, overbought (meaning very extended to the upside) and investors are over bullish sentiment wise. When I look at that kind of array and historical implications of the conditions, combined with the exhaustion signals our own process suggests, I am very concerned there could be a major market decline.
Of course, my concerns have been evolving since mid-February and so far been like the Boy Who Cries Wolf. However, we've raised significant amounts of cash, implemented broader stock market hedges and even sent out communication to our separate account clients recommending they consider moving 401K type accounts to cash. The last time we sent such a recommendation was at the end of 2007, so we don't take such action unless we are really worried about traditional stock market investments.
Cornered Dog
I believe the Fed is likely to emerge like a cornered dog in the coming months. While we are very concerned about the broader stock market here, our portfolio positioning is actually such that we'd expect to benefit from a broader market decline.We continue to expect gold and the miners to be wild cards for now. I suspect another couple of bad economic data points and a 10% kind of stock market decline will have many of those, who have been using optimistic economic alchemy to justify speculation, to begin crying for the Fed to print more money to bail out their poorly bought stock exposure.
I fully expect the Fed to respond in kind when we get to that point, but it is likely weeks or even a month or two away. However, I do expect them to act and in a significant fashion, as the global backdrop remains extremely concerning due to a severe recession unfolding in Europe and a potential hard landing in China. The shortened futures trading session on Friday following the very weak employment report provided what I believe could be a preview of how markets may respond to wider recognition of recession. Stocks sold off sharply, US treasuries rallied, but something very different unfolded in the currency market. Over the past few years, a "risk off" day has typically included a rally in the US dollar. However, Friday's session involved weakness in the US dollar, as well as closely associated currencies of Mexico and Canada. Formerly "risk on" currencies like the Australian dollar rallied. It appears to me that some believe that the correlation of weak US dollar translating into strong US stocks is sacrosanct, and I believe that to be a flawed expectation.
This brings us back to the bain of my existence - gold mining stocks. Under the scenario I just presented, I would expect gold to do well, and as an extension also the gold mining stocks. However, the panic and hatred of the mining stocks may be so severe as to require them to go down for a bit more even if gold does catch a bid. Both gold and the miners could get caught up in a broad liquidation as well. Our portfolios would be in pretty good shape in that scenario, as we'd expect our broad market hedges to provide significant cushion against any additional decline in the miners.
Ultimately, my conviction level for our intermediate term outlook could not be higher. My concern remains surviving until global central banks are once again left with the choice of systemic jeopardy or money printing. I think markets are very close to sniffing out the recession unfolding, and while i expect the Fed and others to be quick on the trigger finger, I don't know when that will be. But when that occurs and the next market cycle launches, I expect the recovery and returns in our metals related positions to be epic.
Since the beginning of the gold bull market about a decade ago, the miners have reached what I'd consider an extreme discount valuation to the price of gold on three other occasions. All three resulted in the industry group appreciated by over 100% within 18 months once the decline exhausted. That may seem hard to imagine at present, but the stocks are cheaper versus gold than at any other point other than the low in October 2008. From that point, the XAU gold miners index went from its low of about 64 to about 200 a little over 12 months later.
The stock prices of the miners are not just some squiggles on a chart, they do represent fractional ownership in actual businesses. The businesses of the large miners are currently generating free cash flow yields of between 15%-20% in many cases. They reason some still believe the miners should trade with a relationship to gold is because the price of gold actually does impact things like earnings, cash flows and dividends. Historically, a ratio of between 3 and 5 between the price of an ounce of gold/XAU was "normal". In October 2008 this ratio was over 11, while as of Thursday's close it was 9.86.
It is this basic arithmetic combined with our high conviction of our forecast which causes us to tolerate the living hell which has become owning the miners. If gold were to go to $2,000 at some point in the next 12 months, which I believe is not only possible but likely, then an XAU ratio of 6 would translate into a price of 333, or what would be a gain of about 100% from the current level of 165. If gold ultimately goes to much higher prices as I expect, and the mining stocks become beloved rather than despised, as I also expect, then the potential is alarming. Assuming a gold price of $5,000 and an XAU ratio of 3 would result in a value of 1,666, or 10 times the current level.
While such numbers are total conjecture and may not occur, I do believe they are possible, if not probable. During its last great bull market, gold went from $35 to $800. A comparable increase from low around $250 from earlier last decade would result in a price of $5,700. Of course, the 1970's did not involve every major central bank in the world printing money at unprecedented levels, so that framework may prove too conservative. Regardless, given the risks we see to our clients' wealth and standards of living and the value and opportunity in the gold mining stocks, I believe they currently present the kind of opportunity that arrives very infrequently - perhaps the last being the great technology growth stocks of the late 1980's and early 1990's just prior to the computer revolution exploding onto the scene.
Humor for the Weekend
In honor of the official start of spring.....at least to me....baseball is back!
TEAM Don't Think 3-22-2012
Executive Summary
One suggestion we've heard from our retail clients is to include an executive summary - particularly for longer and more technically focused posts.
- We see a large and growing disparity between market consensus and reality relative to the current global economy, and more importantly the economic outlook for the US and world in the coming months.
- I lay out some details as to why we believe the current market consensus is not only wrong but potentially dangerously so. "Seasonal adjustments" is at the core of the issue.
- However, when the madness of crowds takes over and speculation becomes rampant, it can take on a life of its own and endure for longer than we'd like and certainly expect. Those who don't think and just act impulsively are rewarded in such an environment.....for a while.
- Our process is like a matrix, as we take a weight of the evidence approach. The last time the weight was this tilted towards bearishness was the fall of 2007.
- As we are apt to be, our portfolio moves have been a bit early. Portfolios have suffered due to weakness in gold and related miners, while our hedges remained resilient.
- While we remain extremely bullish on the gold miners long term, we are on alert for the possibility of a 2008-style meltdown despite what we see as increasingly positive long term fundamentals. However, if we see signs of a more extended meltdown, we may reduce exposure with the hopes of buying back at lower prices - as we did in 2008.
- Despite our bearish outlook for the stock market, we believe there are opportunities to survive and possibly even thrive under the circumstances. Our baseline goal is to survive with current portfolio balances largely in tact to capitalize on opportunities, while trying to generate returns both long and short when we believe the risk/reward is favorable.
All Aboard - Strap in for a Long One!
Many people think of fear as it pertains to investing within the context of selling or panic. This is certainly true and we've seen a fair amount of panicked selling over the past decade - culminating in the fall of 2008. However, there is another lesser discussed side of the fear coin - panic buying. Such market periods lend themselves to not worrying about facts or logic. Panicked buying is about the animal spirits and emotion. Today I lay out what we see as some of the vital facts unfolding, which we see as being ignored by most. History shows that the facts are typically ignored for only so long before markets adjust violently to reality.
However, as I chronicled in this blog in early July last year and again in late December, when markets move against what we see as the facts on the ground, we do a couple of things. First, we revisit our research and analysis for possible holes. Second, we look at our analytical framework which is designed to gauge the madness of crowds - i.e. the voting booth aspect of the market.
Our firm believes that markets are inherently random and chaotic in the short to intermediate term and view financial markets as another complex system within the natural world. Millions of traders/investors "vote" each day by buying and selling. The reason they do so is typically somewhat rational individually, but the madness of crowds can take hold and drive markets into la la land.
I would label the recent move in the US stock market as showing a lot of signs of a speculative mania. These market periods typically result in what I call the "all news is good news syndrome." People catch the speculative bug, as they feel compelled to get on the train before it leaves the station. Any and all news is rationalized as good news and used as a justification to support getting and staying on the train. I'm seeing rampant signs of this unfolding at present. The last time I saw this kind of nuttiness was in April last year to some degree, but more and more it is starting to be more like the summer/fall of 2007, in my opinion - at least behaviorally.
I don't see a major credit fueled aspect to the current market environment (which typically accompany relatively rare bubbles) outside of central bank money printing, so I don't think the dangers of the current backdrop are the same as those in 2007. However, I do believe that there is a large and growing disparity between widely held consensus views that the "madness of crowds" has embraced versus what we see as the facts on the ground.
It's the Economy Stupid
If one were to read media reports or talk to the vast majority of professional investors, one is likely to come away thinking that the US economy has been and continues to be getting better. Cheers that the recovery is sustaining and renewing are fairly widespread. We see the weight of the evidence, or the facts on the ground, directly contradicting the consensus view. Here are some facts:
1. Much of the reported improvement in the past few months' government economic reports has been due to seasonal adjustments the government implements in order to try and smooth out various factors. For example, the statisticians will try to "normalize" for holiday hiring/firing in December and January each year, as well as for weather related layoffs that are "regular' - such as landscapers losing work during the winter in the northeast.
I'm not a big conspiracy guy, and I believe most of the things the professionals at the federal the Bureau of Labor and Statistics (BLS) do are well intentioned. However, their adjustments can complicate matters at times. For example, this year was an unusually warm winter in much of the country and many seasonal jobs which may have typically been lost likely were not - yet the BLS added on its "normal" number of fictional jobs as an adjustment.
In addition, the significant collapse in the US economy in 4th Quarter 2008 and 1st Quarter 2009 has wreaked havoc on the seasonal adjustments ever since, as outlier data typically do with statistical models. One way to try and normalize for these seasonal adjustment issues is to look at year over year numbers rather than month over month or quarter over quarter. The vast majority of the media has been, and always reports the latter.
I play about 20 baseball games a year in the league I play, and I take pride in being a good two strike hitter. Last season I struck out zero times in probably about 70 at bats. I've got two strikes on me when it comes to this seasonal adjustment issue and I refuse to allow our clients to suffer a strike out. Many investors fell for the exact same seasonal adjustment issues in 2010 and 2011, as Q4 and Q1 data came in "stronger than expected," only to see things weaken considerably in the 2nd and 3rd quarters. Both years included MAJOR stock market corrections. We "see" the slider in the dirt coming this time and aren't going to swing.
Using year over year economic data, the US economy has been getting modestly worse over the past five months in all the major categories on which recessions are determined. In fact, the trends in the data have only ever unfolded as they currently are either directly before or already in a recession - at least over the past 50 years for which there is robust data.....with NO exceptions. Of course, things may be different this time, though that typically is a dangerous phrase to use as an investor. Just today (Thursday), Fedex reported a year over decline in packages shipped of 4%, which is definitively NOT seasonally adjusted.
2. I recently spent some time with a senior lobbyist (married to my wife's medical school roommate) who works in Washington D.C. We were discussing markets and the economy, and he expressed to me that his experience has been that the vast majority of people in Washington pay attention to two things when it comes to the economy: the headline unemployment rate and the Dow Jones Industrial Average. Many have used these two figures to justify their optimistic outlook on the economy, in a bout of circular logic to justify stock market speculation. Of course, the details are always more complicated. Employment trends have improved very modestly in recent months, though some of that has to do with labor force participation falling and the seasonal adjustment issues I mentioned above. However, it is critical to recognize that employment is a coincident indicator at best, and typically modestly lags the economy. For example, payroll figures remained growing several months into 2008, which was months after the recession had already begun!
Just as the stock market has predicted 10 out of the last 3 recessions, it is also typically an equally bad timing tool for recovery forecasting. For example, the stock market remained resilient into May of 2008 despite recession already taken hold and a largest post WWII collapse laying directly ahead. The 2001 recession was accompanied by a modest stock market reaction (outside of the tech bubble popping), and the market actually tanked in 2002 when the economy was in a relatively slow recovery.
3. Most importantly, for the short to intermediate term, none of these facts matter. It is only the madness of crowds that matters. Markets are in many ways a rorschach test during sentiment extremes, as people see what they want to see. Personal disposal income has fallen 5 months in a row? Economic data from around the world is deteriorating and 1st and 2nd derivatives deteriorating at a significant rate? Negatives are either ignored or rationalized. Any kind of news that can be spun as good (like the employment data) is latched onto and held out like a badge of honor!
4. Cash is not sitting on the sidelines and moving into stocks, and bonds are not being sold to buy stocks. I hear this argument all over the place, yet it is as silly an argument as 1+1=4. It is empirically false yet is more popularly embraced than the Tooth Fairy. In the secondary markets, where the vast majority of trades are transacted, for every buyer there is a seller. If I sell a bond, there HAS to be a buyer. If I take that cash and buy a stock, SOMEONE is selling me the stock. I'll use a simple example - as simple as 1+1=2.
John has $10k sitting in a money market fund and decides to buy a $10k bond from Sally, then the cash simply moves from John to Sally and the bond from Sally to John. Now let's assume John decides to get more aggressive and sells his bond to Frank for $11k, then Frank pays John $11k in cash, who then uses the cash to buy stock XYZ from Susie....who then deposits the $11k in cash into her money market.
As you hopefully can tell from the example, the exact same stocks and bonds are still "in the market." On net, no money "went into stocks" or "went out of bonds." For every buyer there is a seller and for every seller there is a buyer.....period. What drives prices up or down is the relative motivation between the buyer and the seller. In my example, John didn't sell his bond until it had appreciated to be worth $11k. It didn't go up to that level because money rotated into bonds. It went up because that was the level at which John was willing to sell and Frank was willing to buy - also known as price discovery.
So all the people who are screaming about all the cash on the sidelines fueling the stock market higher, or the fact that bonds are falling in price because people are selling bonds and buying stocks, are flat out wrong. The reason stocks are going up in value is because prices are being bid up by buyers having a greater desire and intensity to buy than sellers have to sell.
5. The deterioration in economic data is not just in the US. In fact, we are seeing a synchronized deterioration around the world. Australia appears headed for its first recession in a couple of decades, China appears to be slowing rapidly, most of Europe is likely already in recession or worse, while Germany appears on the precipice. Could the US completely diverge from the rest of the world? It is certainly possible, if not likely. However, when we see ample evidence to the contrary we believe it is wise to respect it given the global backdrop.
6. Stock market valuations are back to dangerous levels. Watching more than 5 minutes of CNBC makes my head want to explode at times. I vividly remember much of the same nonsense uttered in 2007 that are being used to rationalize speculation. Using reliable long term valuations metrics, the US stock market is priced higher than it has been except at the bubble peak in 2000 and the peak in 2007. This doesn't mean that the madness of crowds can't drive an already expensive market to be even more expensive, but to argue it is cheap is silly. The common arguments used are that stocks are cheap relative to bonds (like saying a Bently is cheap relative to a Maybach) or that the market is trading at a P/E of 15 versus the long term average of 16. The problem with this argument is that the "E" in the P/E is comparing apples to oranges. The long term average of 16 is using trailing 12 month net earnings, while the 15 being touted is using forward estimated operating earnings. In addition, those forward estimated operating earnings are assuming near record profit margins.
An almost exact set of circumstances occurred in mid 2007 by many to argue the stock market was cheap - just before a drop of over 50%. I won't bore you with the bevy of valuation metrics we use, but I will say that they overwhelmingly confirm that stocks are at the very upper end of their historical range, with only bubble periods of 1929, 2000 and 2007 eclipsing these levels by any meaningful amount.
7. Corporate profit warnings for this quarter are running higher than they have since the financial crisis of 2008/2009.
What to Do
The recent speculative environment has had several "blow back" effects on our investment positioning. First, the economic optimism, has a lot of people talking about not only no more money printing from the US Fed, but even now discussion of Fantasy Land......I mean an "exit strategy." The last time such talk occurred was in the spring of 2010....just before the economy softened significantly and markets tanked...which ushered in QE II.
Long term interest rates have spiked a bit and gold and related mining stocks have been sold in a panicked fashion - the intensity of sellers has clearly been far higher than the intensity of buyers. In fact, a long published survey of gold market timing newsletter writers reported that the average recommended position in gold by the newsletters was -16% this week - meaning they actually recommend people short/bet against gold. This is the lowest reading in the survey since the fall of 2008, from which point gold stocks proceeded to rally by over 100% in less than a year.
Because we've retained a substantial investment in precious metals miners, this panicked sell off has done significant short term damage to our performance and clients' accounts. I certainly sympathize with those clients who are sick of hearing from me/TEAM relative to the under performance of the miners. No one is more frustrated or exhausted than I with the seemingly endless torment the investments have caused. We would not be willing to tolerate the torment if we didn't believe that the positions offered tremendous long term opportunity.
However, we are also not oblivious to the fact that emotional markets that fuel panicked buying and selling can sustain for much longer than we would ever expect. The panicked buying in various stock market segments (technology stocks being the most prominent) is helping to cause our hedges to lose some value, while a significant chunk of our long exposure is suffering from panicked selling - a veritable worst of both worlds for now. We've experienced similar periods on many other occasions in the past. The two that are most prominent in my mind are last June, when a very similar dynamic unfolded, and December 2007 when US financial stocks rallied sharply and crushed our short exposure to that sector temporarily.
Our risk management process is disciplined and if we do not begin to see signs of a change in the next week or two, we may be forced to reduce some of our precious metals mining exposure and possibly reduce some of our hedges. It is certainly possible that we are misreading the facts or that things are different this time, but my conviction level in our analysis of the underlying fundamentals (i.e. the economic outlook and market valuation) is extremely high. What I am less certain about is how long and far the current panicked buying and selling can and will endure. I've grown to respect the madness of crowds enough to know we need to have contingency plans just in case.
We are very unlikely to actively partake in additional speculation from these levels in the broader stock market. Even if a global recession is not imminent, the market conditions at present have historically been a terrible time to add new stock market exposure. Even if additional speculative gains are coming, comparable periods in the past resulted in the gains being temporary and surrendered...and typically a lot more....and often in a violent fashion.
We've taken additional measure to reduce portfolio risk, but done so largely by raising cash levels. The part of our analytical process which is specifically geared to try and assess the madness of crowds is flashing bright yellow warning signs, so I think the speculative momentum is likely very close to exhausting. The next 2 to 3 weeks are likely to be very important in how we navigate the next 3 to 6 months.
Our base case at present is that economic data turns south very soon in a fashion that causes more people to question/doubt the optimistic outlook. The initial "weak" numbers are likely to be chalked up as one off's, but markets should begin to respond. As a recessionary outlook becomes more widespread, we expect markets to respond violently and the Fed and many other global central banks to start another round of money printing. The biggest concern we have now is how nutty the speculation can get before the recognition phase occurs.
Ultimately, we believe client portfolios are well positioned to weather a very challenging economic and market environment in the months ahead. We believe our process has been tested under extreme conditions in the past and are confident we are well prepared to thrive once again under challenging conditions.
Reminder to be Careful Following the Consensus at Inflection Points
One suggestion we've heard from our retail clients is to include an executive summary - particularly for longer and more technically focused posts.
- We see a large and growing disparity between market consensus and reality relative to the current global economy, and more importantly the economic outlook for the US and world in the coming months.
- I lay out some details as to why we believe the current market consensus is not only wrong but potentially dangerously so. "Seasonal adjustments" is at the core of the issue.
- However, when the madness of crowds takes over and speculation becomes rampant, it can take on a life of its own and endure for longer than we'd like and certainly expect. Those who don't think and just act impulsively are rewarded in such an environment.....for a while.
- Our process is like a matrix, as we take a weight of the evidence approach. The last time the weight was this tilted towards bearishness was the fall of 2007.
- As we are apt to be, our portfolio moves have been a bit early. Portfolios have suffered due to weakness in gold and related miners, while our hedges remained resilient.
- While we remain extremely bullish on the gold miners long term, we are on alert for the possibility of a 2008-style meltdown despite what we see as increasingly positive long term fundamentals. However, if we see signs of a more extended meltdown, we may reduce exposure with the hopes of buying back at lower prices - as we did in 2008.
- Despite our bearish outlook for the stock market, we believe there are opportunities to survive and possibly even thrive under the circumstances. Our baseline goal is to survive with current portfolio balances largely in tact to capitalize on opportunities, while trying to generate returns both long and short when we believe the risk/reward is favorable.
All Aboard - Strap in for a Long One!
Many people think of fear as it pertains to investing within the context of selling or panic. This is certainly true and we've seen a fair amount of panicked selling over the past decade - culminating in the fall of 2008. However, there is another lesser discussed side of the fear coin - panic buying. Such market periods lend themselves to not worrying about facts or logic. Panicked buying is about the animal spirits and emotion. Today I lay out what we see as some of the vital facts unfolding, which we see as being ignored by most. History shows that the facts are typically ignored for only so long before markets adjust violently to reality.
However, as I chronicled in this blog in early July last year and again in late December, when markets move against what we see as the facts on the ground, we do a couple of things. First, we revisit our research and analysis for possible holes. Second, we look at our analytical framework which is designed to gauge the madness of crowds - i.e. the voting booth aspect of the market.
Our firm believes that markets are inherently random and chaotic in the short to intermediate term and view financial markets as another complex system within the natural world. Millions of traders/investors "vote" each day by buying and selling. The reason they do so is typically somewhat rational individually, but the madness of crowds can take hold and drive markets into la la land.
I would label the recent move in the US stock market as showing a lot of signs of a speculative mania. These market periods typically result in what I call the "all news is good news syndrome." People catch the speculative bug, as they feel compelled to get on the train before it leaves the station. Any and all news is rationalized as good news and used as a justification to support getting and staying on the train. I'm seeing rampant signs of this unfolding at present. The last time I saw this kind of nuttiness was in April last year to some degree, but more and more it is starting to be more like the summer/fall of 2007, in my opinion - at least behaviorally.
I don't see a major credit fueled aspect to the current market environment (which typically accompany relatively rare bubbles) outside of central bank money printing, so I don't think the dangers of the current backdrop are the same as those in 2007. However, I do believe that there is a large and growing disparity between widely held consensus views that the "madness of crowds" has embraced versus what we see as the facts on the ground.
It's the Economy Stupid
If one were to read media reports or talk to the vast majority of professional investors, one is likely to come away thinking that the US economy has been and continues to be getting better. Cheers that the recovery is sustaining and renewing are fairly widespread. We see the weight of the evidence, or the facts on the ground, directly contradicting the consensus view. Here are some facts:
1. Much of the reported improvement in the past few months' government economic reports has been due to seasonal adjustments the government implements in order to try and smooth out various factors. For example, the statisticians will try to "normalize" for holiday hiring/firing in December and January each year, as well as for weather related layoffs that are "regular' - such as landscapers losing work during the winter in the northeast.
I'm not a big conspiracy guy, and I believe most of the things the professionals at the federal the Bureau of Labor and Statistics (BLS) do are well intentioned. However, their adjustments can complicate matters at times. For example, this year was an unusually warm winter in much of the country and many seasonal jobs which may have typically been lost likely were not - yet the BLS added on its "normal" number of fictional jobs as an adjustment.
In addition, the significant collapse in the US economy in 4th Quarter 2008 and 1st Quarter 2009 has wreaked havoc on the seasonal adjustments ever since, as outlier data typically do with statistical models. One way to try and normalize for these seasonal adjustment issues is to look at year over year numbers rather than month over month or quarter over quarter. The vast majority of the media has been, and always reports the latter.
I play about 20 baseball games a year in the league I play, and I take pride in being a good two strike hitter. Last season I struck out zero times in probably about 70 at bats. I've got two strikes on me when it comes to this seasonal adjustment issue and I refuse to allow our clients to suffer a strike out. Many investors fell for the exact same seasonal adjustment issues in 2010 and 2011, as Q4 and Q1 data came in "stronger than expected," only to see things weaken considerably in the 2nd and 3rd quarters. Both years included MAJOR stock market corrections. We "see" the slider in the dirt coming this time and aren't going to swing.
Using year over year economic data, the US economy has been getting modestly worse over the past five months in all the major categories on which recessions are determined. In fact, the trends in the data have only ever unfolded as they currently are either directly before or already in a recession - at least over the past 50 years for which there is robust data.....with NO exceptions. Of course, things may be different this time, though that typically is a dangerous phrase to use as an investor. Just today (Thursday), Fedex reported a year over decline in packages shipped of 4%, which is definitively NOT seasonally adjusted.
2. I recently spent some time with a senior lobbyist (married to my wife's medical school roommate) who works in Washington D.C. We were discussing markets and the economy, and he expressed to me that his experience has been that the vast majority of people in Washington pay attention to two things when it comes to the economy: the headline unemployment rate and the Dow Jones Industrial Average. Many have used these two figures to justify their optimistic outlook on the economy, in a bout of circular logic to justify stock market speculation. Of course, the details are always more complicated. Employment trends have improved very modestly in recent months, though some of that has to do with labor force participation falling and the seasonal adjustment issues I mentioned above. However, it is critical to recognize that employment is a coincident indicator at best, and typically modestly lags the economy. For example, payroll figures remained growing several months into 2008, which was months after the recession had already begun!
Just as the stock market has predicted 10 out of the last 3 recessions, it is also typically an equally bad timing tool for recovery forecasting. For example, the stock market remained resilient into May of 2008 despite recession already taken hold and a largest post WWII collapse laying directly ahead. The 2001 recession was accompanied by a modest stock market reaction (outside of the tech bubble popping), and the market actually tanked in 2002 when the economy was in a relatively slow recovery.
3. Most importantly, for the short to intermediate term, none of these facts matter. It is only the madness of crowds that matters. Markets are in many ways a rorschach test during sentiment extremes, as people see what they want to see. Personal disposal income has fallen 5 months in a row? Economic data from around the world is deteriorating and 1st and 2nd derivatives deteriorating at a significant rate? Negatives are either ignored or rationalized. Any kind of news that can be spun as good (like the employment data) is latched onto and held out like a badge of honor!
4. Cash is not sitting on the sidelines and moving into stocks, and bonds are not being sold to buy stocks. I hear this argument all over the place, yet it is as silly an argument as 1+1=4. It is empirically false yet is more popularly embraced than the Tooth Fairy. In the secondary markets, where the vast majority of trades are transacted, for every buyer there is a seller. If I sell a bond, there HAS to be a buyer. If I take that cash and buy a stock, SOMEONE is selling me the stock. I'll use a simple example - as simple as 1+1=2.
John has $10k sitting in a money market fund and decides to buy a $10k bond from Sally, then the cash simply moves from John to Sally and the bond from Sally to John. Now let's assume John decides to get more aggressive and sells his bond to Frank for $11k, then Frank pays John $11k in cash, who then uses the cash to buy stock XYZ from Susie....who then deposits the $11k in cash into her money market.
As you hopefully can tell from the example, the exact same stocks and bonds are still "in the market." On net, no money "went into stocks" or "went out of bonds." For every buyer there is a seller and for every seller there is a buyer.....period. What drives prices up or down is the relative motivation between the buyer and the seller. In my example, John didn't sell his bond until it had appreciated to be worth $11k. It didn't go up to that level because money rotated into bonds. It went up because that was the level at which John was willing to sell and Frank was willing to buy - also known as price discovery.
So all the people who are screaming about all the cash on the sidelines fueling the stock market higher, or the fact that bonds are falling in price because people are selling bonds and buying stocks, are flat out wrong. The reason stocks are going up in value is because prices are being bid up by buyers having a greater desire and intensity to buy than sellers have to sell.
5. The deterioration in economic data is not just in the US. In fact, we are seeing a synchronized deterioration around the world. Australia appears headed for its first recession in a couple of decades, China appears to be slowing rapidly, most of Europe is likely already in recession or worse, while Germany appears on the precipice. Could the US completely diverge from the rest of the world? It is certainly possible, if not likely. However, when we see ample evidence to the contrary we believe it is wise to respect it given the global backdrop.
6. Stock market valuations are back to dangerous levels. Watching more than 5 minutes of CNBC makes my head want to explode at times. I vividly remember much of the same nonsense uttered in 2007 that are being used to rationalize speculation. Using reliable long term valuations metrics, the US stock market is priced higher than it has been except at the bubble peak in 2000 and the peak in 2007. This doesn't mean that the madness of crowds can't drive an already expensive market to be even more expensive, but to argue it is cheap is silly. The common arguments used are that stocks are cheap relative to bonds (like saying a Bently is cheap relative to a Maybach) or that the market is trading at a P/E of 15 versus the long term average of 16. The problem with this argument is that the "E" in the P/E is comparing apples to oranges. The long term average of 16 is using trailing 12 month net earnings, while the 15 being touted is using forward estimated operating earnings. In addition, those forward estimated operating earnings are assuming near record profit margins.
An almost exact set of circumstances occurred in mid 2007 by many to argue the stock market was cheap - just before a drop of over 50%. I won't bore you with the bevy of valuation metrics we use, but I will say that they overwhelmingly confirm that stocks are at the very upper end of their historical range, with only bubble periods of 1929, 2000 and 2007 eclipsing these levels by any meaningful amount.
7. Corporate profit warnings for this quarter are running higher than they have since the financial crisis of 2008/2009.
What to Do
The recent speculative environment has had several "blow back" effects on our investment positioning. First, the economic optimism, has a lot of people talking about not only no more money printing from the US Fed, but even now discussion of Fantasy Land......I mean an "exit strategy." The last time such talk occurred was in the spring of 2010....just before the economy softened significantly and markets tanked...which ushered in QE II.
Long term interest rates have spiked a bit and gold and related mining stocks have been sold in a panicked fashion - the intensity of sellers has clearly been far higher than the intensity of buyers. In fact, a long published survey of gold market timing newsletter writers reported that the average recommended position in gold by the newsletters was -16% this week - meaning they actually recommend people short/bet against gold. This is the lowest reading in the survey since the fall of 2008, from which point gold stocks proceeded to rally by over 100% in less than a year.
Because we've retained a substantial investment in precious metals miners, this panicked sell off has done significant short term damage to our performance and clients' accounts. I certainly sympathize with those clients who are sick of hearing from me/TEAM relative to the under performance of the miners. No one is more frustrated or exhausted than I with the seemingly endless torment the investments have caused. We would not be willing to tolerate the torment if we didn't believe that the positions offered tremendous long term opportunity.
However, we are also not oblivious to the fact that emotional markets that fuel panicked buying and selling can sustain for much longer than we would ever expect. The panicked buying in various stock market segments (technology stocks being the most prominent) is helping to cause our hedges to lose some value, while a significant chunk of our long exposure is suffering from panicked selling - a veritable worst of both worlds for now. We've experienced similar periods on many other occasions in the past. The two that are most prominent in my mind are last June, when a very similar dynamic unfolded, and December 2007 when US financial stocks rallied sharply and crushed our short exposure to that sector temporarily.
Our risk management process is disciplined and if we do not begin to see signs of a change in the next week or two, we may be forced to reduce some of our precious metals mining exposure and possibly reduce some of our hedges. It is certainly possible that we are misreading the facts or that things are different this time, but my conviction level in our analysis of the underlying fundamentals (i.e. the economic outlook and market valuation) is extremely high. What I am less certain about is how long and far the current panicked buying and selling can and will endure. I've grown to respect the madness of crowds enough to know we need to have contingency plans just in case.
We are very unlikely to actively partake in additional speculation from these levels in the broader stock market. Even if a global recession is not imminent, the market conditions at present have historically been a terrible time to add new stock market exposure. Even if additional speculative gains are coming, comparable periods in the past resulted in the gains being temporary and surrendered...and typically a lot more....and often in a violent fashion.
We've taken additional measure to reduce portfolio risk, but done so largely by raising cash levels. The part of our analytical process which is specifically geared to try and assess the madness of crowds is flashing bright yellow warning signs, so I think the speculative momentum is likely very close to exhausting. The next 2 to 3 weeks are likely to be very important in how we navigate the next 3 to 6 months.
Our base case at present is that economic data turns south very soon in a fashion that causes more people to question/doubt the optimistic outlook. The initial "weak" numbers are likely to be chalked up as one off's, but markets should begin to respond. As a recessionary outlook becomes more widespread, we expect markets to respond violently and the Fed and many other global central banks to start another round of money printing. The biggest concern we have now is how nutty the speculation can get before the recognition phase occurs.
Ultimately, we believe client portfolios are well positioned to weather a very challenging economic and market environment in the months ahead. We believe our process has been tested under extreme conditions in the past and are confident we are well prepared to thrive once again under challenging conditions.
Reminder to be Careful Following the Consensus at Inflection Points
TEAMThink 3-5-2012
Circle of Trust
One of the challenges investors face in the information age is trying to discern what is important and what is not. We get bombarded by "coverage" from various research firms on a daily basis - literally receiving hundreds of emails a day. When I speak with the trade desks we deal with, we are apparently somewhat unusual, as when I express that they are wasting their time by sending us all that stuff they seem perplexed. Apparently, most firms not only pay attention to much of the research, but are willing to pay for it!
I've found that most of what we receive is noise. Over the years, we've accumulated a list of people and firms that provide information, research and opinions which we believe are worthy of consideration. We rely upon no single source for anything, as our process is more like a matrix. However, our "Circle of Trust" is actually pretty small.
Widespread Ignorance
Sometimes I am stunned when a blatantly false premise is so widely used by so many that it is adopted as the gospel. One of the latest I've noticed is the argument that one of the things driving the stock market higher is "people" allocating out of bonds and into stocks. This kind of comment displays a stunning ignorance to how markets function.
There are two very basic ways to characterize markets - primary and secondary. Primary markets are when new stocks and bonds are issued and new money literally comes to market. When a company IPO's, it issues new stock that did not exist before. In addition, if a company buys back its own stock and retires it to its treasury, that takes supply of stock out of the market.
The secondary market exists to trade stocks/bonds that are already in the market. This is where investor/trader A sells something and investor/trader B buys it. The mechanics of the secondary market are really quite simple - for every buyer there is a seller.
For example, if investor XYZ decides he/she wants to sell $100,000 of their bonds and reallocate to stocks, investor XYZ sells the bond to investor ABC. Let's assume investor ABC uses money they have in a money market fund to purchase the bond. ABC's money is transfered to XYZ, and now owns the bond. XYZ takes the $100,000 and buys the stocks they want to own from DEF. DEF takes the $100,000 for their stock and deposits it in their money market account.
As you can see (hopefully!), the net impact to markets is zero. The same amount is in money market funds, the same number of bonds exist and the same number of shares of stock. What drives the marginal price of each instrument is the relative intensity and risk appetite of the buyers versus the sellers at any given time.
Therefore, the recent rally in stocks has not been driven by people rotating out of bonds and into stocks. This idea is so widespread that even some of the people in our "Circle of Trust" reference it at times! Stocks have been going up for a lot of different reasons, but at the root is that the intensity of buyers has been overwhelming the intensity of sellers. Just like any good charity auction organizer knows, the intensity of buyers is more likely to increase when the buyers are emotionally stimulated and possibly even intoxicated!
Stock buyers have become intoxicated with all sorts of ideas, whether it is confidence in an economic recovery, a good old fashioned buyers panic due to the "train leaving the station without me", professional pressure due to trailing a benchmark, or short sellers panicking and buying back the stock they are short. These are just examples of what is actually driviing prices higher and they all deal with emotion and fear/greed. People have a tendency to rationalize things to justify their actions. "Stocks are cheap" (they aren't), or "the economy is getting better" (it isn't) are repeated as mantras and it can be difficult to filter out such noise.
Market Update
I must be a masochist. One of the fundamental aspects of our investment process is trying to identify market inflection points and then capitlize on them. Given that fact, one would think I would enjoy that endeavor...but it can be a miserable process . I do not enjoy market periods when people and markets are acting silly. I was tortured last May through July when most people were completely ignoring the widespread evidence of a significant downturn in the global economy. I almost went postal from August 2007 through May 2008 as markets were complacent about the implosion of the global financial system which was unfolding. I was miserable on my vacation to Peru with my family during the last week of February and first week of March in 2009, as we had eliminated our hedges but clients were panicked like everyone else that armaggedon was unfolding.
As Yogi Berra once said, "It is deja vu all over again." Markets, for the time being at least, are trading in direct contrast with what our outlook for the next several months entails. First, we believe that the economy is on the brink of at least a shallow recession. Second, the Fed and other central banks will continue to print money in increasing amounts, as structural debt problems continue to play out. In the near term, what we are long is getting hit harder than what we are using to hedge our portfolios. This is a frustrating thing to experience. For example, on Monday the major gold miners index was down about 2%, while small cap stocks were up a bit.
We've experienced similar periods in the past. For example, our short exposure in financial stocks in the fall of 2007 rallied very sharply compared to our more defensive long positions in areas like healthcare. Our positioning proved to be prudent over time, but in the short term it was brutal. Just last year, we hedged via emerging market stocks from May into August, but emerging market stocks remained resilient and refused to go down - even as fundamentals were deteriorating rapidly. At the same time, precious metals suffered a short term correction, which hit our long positions. The net result was a situation in which we were temporarily losing money on both our longs and our hedges/shorts - hardly fun!
The past two weeks have been similar for us, as the vehicles we've selected to hedge with have been fairly resilient, while a good portion of what we are long has been hit fairly hard. For example, one area we are increasingly bullish on longer term within the energy sector is coal stocks. Our positions are intended to be held for many months if not years, and we are willing to tolerate short term volatility because we believe the longer term risk/reward is compelling. However, many of the coal stocks are down 10-20% over the past two weeks, in an overall stock market environment that is fairly flat. Many precious metals miners are down 8%-10% over the same period.
Ultimately, we expect our positioning to be rewarded, but the interim is always challenging and sometimes unpleasant to get through.
Circle of Trust for the Week
One of the challenges investors face in the information age is trying to discern what is important and what is not. We get bombarded by "coverage" from various research firms on a daily basis - literally receiving hundreds of emails a day. When I speak with the trade desks we deal with, we are apparently somewhat unusual, as when I express that they are wasting their time by sending us all that stuff they seem perplexed. Apparently, most firms not only pay attention to much of the research, but are willing to pay for it!
I've found that most of what we receive is noise. Over the years, we've accumulated a list of people and firms that provide information, research and opinions which we believe are worthy of consideration. We rely upon no single source for anything, as our process is more like a matrix. However, our "Circle of Trust" is actually pretty small.
Widespread Ignorance
Sometimes I am stunned when a blatantly false premise is so widely used by so many that it is adopted as the gospel. One of the latest I've noticed is the argument that one of the things driving the stock market higher is "people" allocating out of bonds and into stocks. This kind of comment displays a stunning ignorance to how markets function.
There are two very basic ways to characterize markets - primary and secondary. Primary markets are when new stocks and bonds are issued and new money literally comes to market. When a company IPO's, it issues new stock that did not exist before. In addition, if a company buys back its own stock and retires it to its treasury, that takes supply of stock out of the market.
The secondary market exists to trade stocks/bonds that are already in the market. This is where investor/trader A sells something and investor/trader B buys it. The mechanics of the secondary market are really quite simple - for every buyer there is a seller.
For example, if investor XYZ decides he/she wants to sell $100,000 of their bonds and reallocate to stocks, investor XYZ sells the bond to investor ABC. Let's assume investor ABC uses money they have in a money market fund to purchase the bond. ABC's money is transfered to XYZ, and now owns the bond. XYZ takes the $100,000 and buys the stocks they want to own from DEF. DEF takes the $100,000 for their stock and deposits it in their money market account.
As you can see (hopefully!), the net impact to markets is zero. The same amount is in money market funds, the same number of bonds exist and the same number of shares of stock. What drives the marginal price of each instrument is the relative intensity and risk appetite of the buyers versus the sellers at any given time.
Therefore, the recent rally in stocks has not been driven by people rotating out of bonds and into stocks. This idea is so widespread that even some of the people in our "Circle of Trust" reference it at times! Stocks have been going up for a lot of different reasons, but at the root is that the intensity of buyers has been overwhelming the intensity of sellers. Just like any good charity auction organizer knows, the intensity of buyers is more likely to increase when the buyers are emotionally stimulated and possibly even intoxicated!
Stock buyers have become intoxicated with all sorts of ideas, whether it is confidence in an economic recovery, a good old fashioned buyers panic due to the "train leaving the station without me", professional pressure due to trailing a benchmark, or short sellers panicking and buying back the stock they are short. These are just examples of what is actually driviing prices higher and they all deal with emotion and fear/greed. People have a tendency to rationalize things to justify their actions. "Stocks are cheap" (they aren't), or "the economy is getting better" (it isn't) are repeated as mantras and it can be difficult to filter out such noise.
Market Update
I must be a masochist. One of the fundamental aspects of our investment process is trying to identify market inflection points and then capitlize on them. Given that fact, one would think I would enjoy that endeavor...but it can be a miserable process . I do not enjoy market periods when people and markets are acting silly. I was tortured last May through July when most people were completely ignoring the widespread evidence of a significant downturn in the global economy. I almost went postal from August 2007 through May 2008 as markets were complacent about the implosion of the global financial system which was unfolding. I was miserable on my vacation to Peru with my family during the last week of February and first week of March in 2009, as we had eliminated our hedges but clients were panicked like everyone else that armaggedon was unfolding.
As Yogi Berra once said, "It is deja vu all over again." Markets, for the time being at least, are trading in direct contrast with what our outlook for the next several months entails. First, we believe that the economy is on the brink of at least a shallow recession. Second, the Fed and other central banks will continue to print money in increasing amounts, as structural debt problems continue to play out. In the near term, what we are long is getting hit harder than what we are using to hedge our portfolios. This is a frustrating thing to experience. For example, on Monday the major gold miners index was down about 2%, while small cap stocks were up a bit.
We've experienced similar periods in the past. For example, our short exposure in financial stocks in the fall of 2007 rallied very sharply compared to our more defensive long positions in areas like healthcare. Our positioning proved to be prudent over time, but in the short term it was brutal. Just last year, we hedged via emerging market stocks from May into August, but emerging market stocks remained resilient and refused to go down - even as fundamentals were deteriorating rapidly. At the same time, precious metals suffered a short term correction, which hit our long positions. The net result was a situation in which we were temporarily losing money on both our longs and our hedges/shorts - hardly fun!
The past two weeks have been similar for us, as the vehicles we've selected to hedge with have been fairly resilient, while a good portion of what we are long has been hit fairly hard. For example, one area we are increasingly bullish on longer term within the energy sector is coal stocks. Our positions are intended to be held for many months if not years, and we are willing to tolerate short term volatility because we believe the longer term risk/reward is compelling. However, many of the coal stocks are down 10-20% over the past two weeks, in an overall stock market environment that is fairly flat. Many precious metals miners are down 8%-10% over the same period.
Ultimately, we expect our positioning to be rewarded, but the interim is always challenging and sometimes unpleasant to get through.
Circle of Trust for the Week
TEAMThink 2-27-2012
Warren Buffet is No Mike Schmidt
When I was 8 years old and started my nearly 30 year "career" in baseball, I wanted to be Mike Schmidt. I even used to hold my back elbow high and shake my behind like he did when preparing for each pitch. Schmidt was one of the greatest third baseman of all time and in watching film from that era it is amazing to see how normal he looked. Sure, his forearms were chiseled but he wasn't a bloated caricature like we all witnessed during the steroid and HGH era.
I remember respecting other ballplayers and being in awe of their skills, but none ascending to the pedestal like Schmidt. Like many, I admired Pete Rose's hustle and intensity. I marveled at Steve Carlton's slider. The explosion of Doc Gooden onto the scene as a teenager mowing down major league batters was incredible. Fernando Valenzuela's screwball still makes my elbow hurt. Will Clark's smooth swing and Wade Boggs' "eye" and ability to pepper to the opposite field off the green monster were sights to behold. Ken Griffey, Jr. running in the outfield as a teenager was like watching a gazelle.
In the investment world, I've always been drawn to macro people. Just as with Schmidt, I've always felt like I could relate to the way they play the game. Macro thinking has always appealed to me - I suspect it is just how I am wired. The macro investors I've admired as my career progressed are George Soros, Stan Druckenmiller, Jim Rogers, Paul Tudor Jones, and Bruce Kovner. I suspect I don't have a "Schmidt level" admiration for a single macro investor because I've never had the pleasure of personally watching them in action, as I did Schmidt.....I've only read accounts of their conquests. It's kind of like how I feel about Babe Ruth and Ted Williams, as I know they were great but never saw them play live.
I have great admiration and respect for other great investors/speculators who approach the world from different perspectives. Obviously, Warren Buffet is in a select group of all time great value investors, as he took his mentor's (Ben Graham) approach to investing and added his own considerable elements - namely leverage via insurance company float and the willingness to pay up a bit for high and durable quality.
"Larry Summers Syndrome"
For those who don't know, Larry Summers is a former US Treasury Secretary and former president of Harvard University. He is reported to have an IQ at genius levels, and from various accounts I've read he is not above reminding those around him of that fact. I've found that there can be a positive correlation between someone's IQ and one's confidence in their ability to be smart in most subjects....i.e. the veritable know it alls. Summers and his ilk profess to be capitalists, but when push comes to shove they don't really trust markets. They tend to think they can offer smarter "solutions" to "fix" things. They like to socially engineer and tinker in the economy and use their influence and the tools of government to do so.
In the case of Warren Buffet, I believe he's shown significant capabilities in various areas. First, there is no question he is a brilliant value investor. Second, he is a brilliant PR machine, as he's developed a public brand over the years as a bumpkin from Omaha who magically does simple things with incredible results, while the truth couldn't be more different. Third, I believe he's a brilliantly proficient rent seeker and crony capitalist. He's used and worked government to his and his shareholders' benefit over the years.
In my opinion, there are two areas in which Buffet has shown the symptoms of suffering from the "Larry Summers Syndrome". Buffet likes to share his views on various political issues, as well as various macro themes. I won't get bogged down in the quagmire that is political debate, but I will address the latter. Buffet's track record on forecasting and navigating big macro themes is mixed at best. In fact, I would describe his ability in that area as mediocre. I don't see why his obvious brilliance in value investing automatically translates into similar brilliance in how a government should operate or macro investing. Should people of their eras have paid attention to Thomas Jefferson's opinions on surgical procedures or Albert Einstein's opinions on psychiatry?
From time to time Buffet's made various macro calls and tried to invest/trade like some of the macro luminaries I've mentioned. He bought a ton of silver at one point and sold it after a relatively short period at a modest gain - only to have silver proceed to go up several hundred percent following his sale. He's dabbled in foreign currency trading with mixed results. He wrote massive amounts of equity index "insurance" via put options just before the largest deflationary implosion in modern times. It is this error that highlights the third "talent" I listed above - rent seeking and being a crony capitalist. Over the past few years he has loaded up on industries related to housing and been early/wrong in forecasting a residential housing recovery.
Had the US government not stepped in to bail the banks out and the Fed printed massive amounts of money, it is plausible that Buffet's model of leveraged finance would have collapsed. Now, had he been a silent market participant through that period and maintained his positioning based on a macro expectation that the government would act as it did, that would be one thing. However, he actively lobbied the government to act as they did....and just so happened to bail out his poorly positioned balance sheet.
I certainly believe Mr. Buffet has a first amendment right to express his views on whatever he chooses. Also, noone is perfect and everyone makes mistakes at times. My point is that the media and some market watchers are apt to annoint his views on various issues as carrying a level of significance and I believe doing so can be unwise.
Warren Buffet is No Jim Rogers
If aspired to be a great lefthanded screwball pitcher, then Fernando Valenzuela would have obviously been the ballplayer to emulate. Why should I listen to Valenzuela's advice on how to play gold glove third base and hit 35 hr's a year? When it comes to macro investing topics, I don't know why anyone would expect special insight from Warren Buffet. I believe his commentary in this year's Berkshire shareholder letter, beginning on page 18, is an excellent example. In my opinion, he uses flawed logic and shows a fundamental obliviousness to gold's historical role as money..
The fact is, and one can argue whether it makes sense or not...but that doesn't change reality, that gold has served as money in human society for over 5,000 years. To compare money to assets is silly. Buffet states that the world's outstanding value of gold is about $9.6 trillion and goes on to argue that he'd rather own an equal $ amount in productive assets - whether it be farmland or Exxon Mobile.
I think a more logical question is whether he'd rather own $9.6 trillion worth of one of the world's oldest forms of money, or the same amount in paper money yielding basically the same amount (i.e. nothing). Of course, gold's supply is limited to the amount in the earth's crust and the ability of people to get it out of that crust. Global gold supplies are growing VERY slowly - around 1% per year. Contrast that with the EXPLOSION in paper money over the past 10+ years. The explosion is not limited to the US, as the Europeans, Chinese and Japanese are all willing attendees at the printing press party. As the following chart shows, the increase in the price of gold has been highly correlated with the explosion in money printing:
One can debate whether gold should be viewed as money, but that is something best left to the halls of universities, in my opinion. As I stated, we have over 5,000 years of history that shows humans have consistently viewed it as such. In addition, after a hiatus during the 1990's as there was a crescendo in the faith in the powers of central planners....I mean central bankers, gold is once again re-taking its global standing as money. A recent example is the attempt on the part of the Europeans to potentially force the Greeks to hand over their gold as part of the most recent bailout package. Rather than conquistadors or panzer divisions, the modern day pillagers appear to come dressed in expensive Italian suits and and espousing bureaucratic gibberish.
I get that Buffet was trying to provide a thought exercise, so I'll provide my own version. Given our macro outlook that the backdrop of massive money printing will endure for an extended period, would I rather own the entirety of Berkshire Hathaway, which is valued at just under $200 billion, or the four largest publicly traded gold mining companies in the world (just over $200 billion in aggregate value)? At least this thought experiment compares one kind of apple to another. I think I know which bet Mr. Buffet would make. While I don't know what their answers would be, Messrs Rogers, Soros, and Tudor Jones are all on record as being bullish on gold. Call me crazy, but I believe investors would be well served to listen to those who have a track record of excelling at forecasting and capitalizing on macro trends when looking for guidance on such topics.
Some Harry Kalas and Mike Schmidt to Celebrate the Beginning of Spring Training
When I was 8 years old and started my nearly 30 year "career" in baseball, I wanted to be Mike Schmidt. I even used to hold my back elbow high and shake my behind like he did when preparing for each pitch. Schmidt was one of the greatest third baseman of all time and in watching film from that era it is amazing to see how normal he looked. Sure, his forearms were chiseled but he wasn't a bloated caricature like we all witnessed during the steroid and HGH era.
I remember respecting other ballplayers and being in awe of their skills, but none ascending to the pedestal like Schmidt. Like many, I admired Pete Rose's hustle and intensity. I marveled at Steve Carlton's slider. The explosion of Doc Gooden onto the scene as a teenager mowing down major league batters was incredible. Fernando Valenzuela's screwball still makes my elbow hurt. Will Clark's smooth swing and Wade Boggs' "eye" and ability to pepper to the opposite field off the green monster were sights to behold. Ken Griffey, Jr. running in the outfield as a teenager was like watching a gazelle.
In the investment world, I've always been drawn to macro people. Just as with Schmidt, I've always felt like I could relate to the way they play the game. Macro thinking has always appealed to me - I suspect it is just how I am wired. The macro investors I've admired as my career progressed are George Soros, Stan Druckenmiller, Jim Rogers, Paul Tudor Jones, and Bruce Kovner. I suspect I don't have a "Schmidt level" admiration for a single macro investor because I've never had the pleasure of personally watching them in action, as I did Schmidt.....I've only read accounts of their conquests. It's kind of like how I feel about Babe Ruth and Ted Williams, as I know they were great but never saw them play live.
I have great admiration and respect for other great investors/speculators who approach the world from different perspectives. Obviously, Warren Buffet is in a select group of all time great value investors, as he took his mentor's (Ben Graham) approach to investing and added his own considerable elements - namely leverage via insurance company float and the willingness to pay up a bit for high and durable quality.
"Larry Summers Syndrome"
For those who don't know, Larry Summers is a former US Treasury Secretary and former president of Harvard University. He is reported to have an IQ at genius levels, and from various accounts I've read he is not above reminding those around him of that fact. I've found that there can be a positive correlation between someone's IQ and one's confidence in their ability to be smart in most subjects....i.e. the veritable know it alls. Summers and his ilk profess to be capitalists, but when push comes to shove they don't really trust markets. They tend to think they can offer smarter "solutions" to "fix" things. They like to socially engineer and tinker in the economy and use their influence and the tools of government to do so.
In the case of Warren Buffet, I believe he's shown significant capabilities in various areas. First, there is no question he is a brilliant value investor. Second, he is a brilliant PR machine, as he's developed a public brand over the years as a bumpkin from Omaha who magically does simple things with incredible results, while the truth couldn't be more different. Third, I believe he's a brilliantly proficient rent seeker and crony capitalist. He's used and worked government to his and his shareholders' benefit over the years.
In my opinion, there are two areas in which Buffet has shown the symptoms of suffering from the "Larry Summers Syndrome". Buffet likes to share his views on various political issues, as well as various macro themes. I won't get bogged down in the quagmire that is political debate, but I will address the latter. Buffet's track record on forecasting and navigating big macro themes is mixed at best. In fact, I would describe his ability in that area as mediocre. I don't see why his obvious brilliance in value investing automatically translates into similar brilliance in how a government should operate or macro investing. Should people of their eras have paid attention to Thomas Jefferson's opinions on surgical procedures or Albert Einstein's opinions on psychiatry?
From time to time Buffet's made various macro calls and tried to invest/trade like some of the macro luminaries I've mentioned. He bought a ton of silver at one point and sold it after a relatively short period at a modest gain - only to have silver proceed to go up several hundred percent following his sale. He's dabbled in foreign currency trading with mixed results. He wrote massive amounts of equity index "insurance" via put options just before the largest deflationary implosion in modern times. It is this error that highlights the third "talent" I listed above - rent seeking and being a crony capitalist. Over the past few years he has loaded up on industries related to housing and been early/wrong in forecasting a residential housing recovery.
Had the US government not stepped in to bail the banks out and the Fed printed massive amounts of money, it is plausible that Buffet's model of leveraged finance would have collapsed. Now, had he been a silent market participant through that period and maintained his positioning based on a macro expectation that the government would act as it did, that would be one thing. However, he actively lobbied the government to act as they did....and just so happened to bail out his poorly positioned balance sheet.
I certainly believe Mr. Buffet has a first amendment right to express his views on whatever he chooses. Also, noone is perfect and everyone makes mistakes at times. My point is that the media and some market watchers are apt to annoint his views on various issues as carrying a level of significance and I believe doing so can be unwise.
Warren Buffet is No Jim Rogers
If aspired to be a great lefthanded screwball pitcher, then Fernando Valenzuela would have obviously been the ballplayer to emulate. Why should I listen to Valenzuela's advice on how to play gold glove third base and hit 35 hr's a year? When it comes to macro investing topics, I don't know why anyone would expect special insight from Warren Buffet. I believe his commentary in this year's Berkshire shareholder letter, beginning on page 18, is an excellent example. In my opinion, he uses flawed logic and shows a fundamental obliviousness to gold's historical role as money..
The fact is, and one can argue whether it makes sense or not...but that doesn't change reality, that gold has served as money in human society for over 5,000 years. To compare money to assets is silly. Buffet states that the world's outstanding value of gold is about $9.6 trillion and goes on to argue that he'd rather own an equal $ amount in productive assets - whether it be farmland or Exxon Mobile.
I think a more logical question is whether he'd rather own $9.6 trillion worth of one of the world's oldest forms of money, or the same amount in paper money yielding basically the same amount (i.e. nothing). Of course, gold's supply is limited to the amount in the earth's crust and the ability of people to get it out of that crust. Global gold supplies are growing VERY slowly - around 1% per year. Contrast that with the EXPLOSION in paper money over the past 10+ years. The explosion is not limited to the US, as the Europeans, Chinese and Japanese are all willing attendees at the printing press party. As the following chart shows, the increase in the price of gold has been highly correlated with the explosion in money printing:
One can debate whether gold should be viewed as money, but that is something best left to the halls of universities, in my opinion. As I stated, we have over 5,000 years of history that shows humans have consistently viewed it as such. In addition, after a hiatus during the 1990's as there was a crescendo in the faith in the powers of central planners....I mean central bankers, gold is once again re-taking its global standing as money. A recent example is the attempt on the part of the Europeans to potentially force the Greeks to hand over their gold as part of the most recent bailout package. Rather than conquistadors or panzer divisions, the modern day pillagers appear to come dressed in expensive Italian suits and and espousing bureaucratic gibberish.
I get that Buffet was trying to provide a thought exercise, so I'll provide my own version. Given our macro outlook that the backdrop of massive money printing will endure for an extended period, would I rather own the entirety of Berkshire Hathaway, which is valued at just under $200 billion, or the four largest publicly traded gold mining companies in the world (just over $200 billion in aggregate value)? At least this thought experiment compares one kind of apple to another. I think I know which bet Mr. Buffet would make. While I don't know what their answers would be, Messrs Rogers, Soros, and Tudor Jones are all on record as being bullish on gold. Call me crazy, but I believe investors would be well served to listen to those who have a track record of excelling at forecasting and capitalizing on macro trends when looking for guidance on such topics.
Some Harry Kalas and Mike Schmidt to Celebrate the Beginning of Spring Training
TEAMThink 2-24-2012
Put that in Your Pipe and Smoke It
The following is an interview from early Friday morning with Lakshman Achuthan of Economic Cycle Research Institute (ECRI). We are a client of the firm and their forecasts are an important part of our overall process.
I believe the interview is informative for two reasons. First, it provides a very clear and powerful explanation as to why they've retained their recession forecast. Second, the response of the CNBC "anchors" shows how far from consensus the ECRI forecast is. Given this very wide gulf between what we believe to be reality (ECRI's outlook) and consensus, it meets our criteria for what we label a "critical state". This means that we believe that market dynamics have become highly pressurized and that increased levels of volatility are increasingly probable.
I admit to suffering from "consensusitis" in recent weeks, as the level of hype surrounding some economic data releases has been substantial. As you'll see if you watch the video below, cognitive dissonance and confirmation bias are plagues that infect us all. To try and combat those inherent tendencies, we rely upon the analytical process we've spent years building. When we do allow a third party research provider into our relatively small circle of influence, it is because we believe they too have a process which combats cognitive dissonance. ECRI meets our criteria and I admire their conviction in sticking to their process, as we pride ourselves on trying to do the same.
As Mr. Achuthan states, the relative depth and duration of a recession are uncertain, as are the flow through affects to financial markets due to the unprecedented amount of money printing by central banks around the world. Given this backdrop, I'd expect that markets may respond as coincident economic data deteriorates in the coming weeks, but that the Fed may also react at either its March or April meeting. If events unfold as we expect, investors may be shaken violently out of their cognitive dissonance in the coming days/weeks.
Portfolio Update
We've retained our "gloves up" posture, as markets continue to defy gravity. Market tops are typically a process rather than a single point, and we've certainly been witnessing this in recent weeks. For example, prominent stock market industries like utilities and transportation appear to have already topped and begun to roll over. Even the red hot Nasdaq index has experienced thinning leadership as the most recent advance has been driven by an increasingly smaller number of large cap stocks. This week, even on days where the stock market was strong, US Treasury bonds were resilient
Our analytical process has not yet provided us with good data on the likely details of a market correction, should one even unfold. At this stage, we have a basic expectation that I will now share, but it is subject to significant revisions depending on how things develop. I think the broad US stock indexes are poised for a 5-10% correction over the next month or two. However, there are likely to be market industries and segments that get hit much harder. The Federal Reserve is likely to announce additional policy stimulus at one of the next three meetings - to be held in mid March, the end of April and then again in June. I believe we are likely entering a period of significant relative outperformance in market segments which are leveraged to higher commodity prices. As Mr. Achuthan states in the interview above, the money being printed has to flow somewhere and I expect a significant amount to flock to hard assets.
It is too early to try and ascertain whether these market segments can diverge during a broader market correction. At this point, we are retaining our exposure to precious metals, energy and agriculture and hedging those positions with positions leveraged to any declines in various market segments, with small cap stock indexes being most prominent. In our fund, we've used the significant recent rally in the euro versus various currencies to realize our gains. Overall, we've reduced our foreign exchange exposure in the fund dramatically over the past two weeks. We've positioned the fund to be long a lot of "gamma" with volatilities having come down. I would expect our fund to be extremely well hedged if a stock market correction were to unfold, with the potential for the fund to appreciate in such an environment. In our separate accounts, we've maintained our hedged positioning.
Something to Think About Over the Weekend
An excellent example of cognitive dissonance I've observed in recent days is the rationalization of the spike in oil and gasoline prices as being evidence of a global economic recovery.....you know....instead of Syria...Iran...Iraq...Nigeria. My how our minds play tricks on us all.
The following is an interview from early Friday morning with Lakshman Achuthan of Economic Cycle Research Institute (ECRI). We are a client of the firm and their forecasts are an important part of our overall process.
I believe the interview is informative for two reasons. First, it provides a very clear and powerful explanation as to why they've retained their recession forecast. Second, the response of the CNBC "anchors" shows how far from consensus the ECRI forecast is. Given this very wide gulf between what we believe to be reality (ECRI's outlook) and consensus, it meets our criteria for what we label a "critical state". This means that we believe that market dynamics have become highly pressurized and that increased levels of volatility are increasingly probable.
I admit to suffering from "consensusitis" in recent weeks, as the level of hype surrounding some economic data releases has been substantial. As you'll see if you watch the video below, cognitive dissonance and confirmation bias are plagues that infect us all. To try and combat those inherent tendencies, we rely upon the analytical process we've spent years building. When we do allow a third party research provider into our relatively small circle of influence, it is because we believe they too have a process which combats cognitive dissonance. ECRI meets our criteria and I admire their conviction in sticking to their process, as we pride ourselves on trying to do the same.
As Mr. Achuthan states, the relative depth and duration of a recession are uncertain, as are the flow through affects to financial markets due to the unprecedented amount of money printing by central banks around the world. Given this backdrop, I'd expect that markets may respond as coincident economic data deteriorates in the coming weeks, but that the Fed may also react at either its March or April meeting. If events unfold as we expect, investors may be shaken violently out of their cognitive dissonance in the coming days/weeks.
Portfolio Update
We've retained our "gloves up" posture, as markets continue to defy gravity. Market tops are typically a process rather than a single point, and we've certainly been witnessing this in recent weeks. For example, prominent stock market industries like utilities and transportation appear to have already topped and begun to roll over. Even the red hot Nasdaq index has experienced thinning leadership as the most recent advance has been driven by an increasingly smaller number of large cap stocks. This week, even on days where the stock market was strong, US Treasury bonds were resilient
Our analytical process has not yet provided us with good data on the likely details of a market correction, should one even unfold. At this stage, we have a basic expectation that I will now share, but it is subject to significant revisions depending on how things develop. I think the broad US stock indexes are poised for a 5-10% correction over the next month or two. However, there are likely to be market industries and segments that get hit much harder. The Federal Reserve is likely to announce additional policy stimulus at one of the next three meetings - to be held in mid March, the end of April and then again in June. I believe we are likely entering a period of significant relative outperformance in market segments which are leveraged to higher commodity prices. As Mr. Achuthan states in the interview above, the money being printed has to flow somewhere and I expect a significant amount to flock to hard assets.
It is too early to try and ascertain whether these market segments can diverge during a broader market correction. At this point, we are retaining our exposure to precious metals, energy and agriculture and hedging those positions with positions leveraged to any declines in various market segments, with small cap stock indexes being most prominent. In our fund, we've used the significant recent rally in the euro versus various currencies to realize our gains. Overall, we've reduced our foreign exchange exposure in the fund dramatically over the past two weeks. We've positioned the fund to be long a lot of "gamma" with volatilities having come down. I would expect our fund to be extremely well hedged if a stock market correction were to unfold, with the potential for the fund to appreciate in such an environment. In our separate accounts, we've maintained our hedged positioning.
Something to Think About Over the Weekend
An excellent example of cognitive dissonance I've observed in recent days is the rationalization of the spike in oil and gasoline prices as being evidence of a global economic recovery.....you know....instead of Syria...Iran...Iraq...Nigeria. My how our minds play tricks on us all.
TEAMThink 2-15-2012
Gloves Up
As the father of two young kids, it is wonderful to see them experience some of the cultural things from my childhood (my daughter plays a mean game of Dig Dug) and to respond with similar joy. After a recent trip to Philadelphia to take in the historical sites, we made a stop off at the Rocky statue at the Philadelphia Museum of Art. The kids got a kick out of running up the steps of the museum and the description of the movie we provided them. They wanted to watch the movie as soon as we could once we arrived home. Watching my kids attempt one armed push ups on our family room floor was priceless.
There are certain market concepts that transcend time as well. One timeless mantra for investors/traders is that markets can stay irrational for longer than one can stay solvent. Another is that an overbought market can remain overbought - and in doing so typically suggests a healthy market dynamic. The market rally since the October bottom has been impressive to observe, and it has remained overbought in recent weeks. Over the past month, we've begun to see the kind of parabolic moves in some stocks that typically signal a momentum move is close to exhausting. At the same time, we've also witnessed some classic divergences in recent weeks, as the Utility index has rolled over and now very recently the Transports have underperformed.
I remember writing a commentary back in 2007 documenting how very few of the Dow stocks were making a new high as the Dow itself was making a new high that October. Well, the recent market can be summed up with one word: "Apple". That juggernaut has gone parabolic and is likely to resolve itself as parabolas typically do (mountains have two sides!), but it has masked a good deal of deterioration - nothing that is terribly alarming yet, but enough for us to grow concerned about the chances of an acute correction of some significance.
While I've commented about some of these conditions in recent weeks, I also stated that we have been targeting the 1345-1365 area in the S&P 500 as a likely destination for the move higher, and where we may begin to get more defensive. Given the backdrop we've seen, along with reaching that price area, we've taken some substantial measures in recent days to reduce portfolio risk. This is not a "bear market" forecast , but rather getting more conservative in order to hopefully weather a potential 5%-10% correction in the broad stock market indexes. I'd actually view a nasty and violent correction back to the 1,220 area in the S&P 500 as being a bullish intermediate term development.
Portfolio Moves
In separate accounts, we've added a significant hedge using a leveraged inverse small cap ETF, which longer term clients will remember fondly from when we utilized it extensively (and very profitably) in 2008. In our fund, where we are much more active and can be more aggressive, we've add a wide number of hedging positions, many of which are via put options. The strong market rally in recent months brought the "cost of insurance" down dramatically - to the point where we've taken major hedging positions as well as some speculative trading positions. The majority of our exposure is in major stock market indexes, with a tilt towards small cap stocks. However, we have also used the recent parabola in tech stocks to add some put exposure in that area as well.
These hedging positions are offset by our continued exposure to energy, agriculture and precious metals equities. I believe there is a fair shot that the precious metals miners have already suffered their sharp correction and could do quite well during a broad stock market correction - at least on a relative if not absolute basis.
So overall, we are not leaving the ring - just putting our gloves up to let Clubber Lang punch him self out for a while.
Hump Day Humor
At least I get a kick out of it.....
As the father of two young kids, it is wonderful to see them experience some of the cultural things from my childhood (my daughter plays a mean game of Dig Dug) and to respond with similar joy. After a recent trip to Philadelphia to take in the historical sites, we made a stop off at the Rocky statue at the Philadelphia Museum of Art. The kids got a kick out of running up the steps of the museum and the description of the movie we provided them. They wanted to watch the movie as soon as we could once we arrived home. Watching my kids attempt one armed push ups on our family room floor was priceless.
There are certain market concepts that transcend time as well. One timeless mantra for investors/traders is that markets can stay irrational for longer than one can stay solvent. Another is that an overbought market can remain overbought - and in doing so typically suggests a healthy market dynamic. The market rally since the October bottom has been impressive to observe, and it has remained overbought in recent weeks. Over the past month, we've begun to see the kind of parabolic moves in some stocks that typically signal a momentum move is close to exhausting. At the same time, we've also witnessed some classic divergences in recent weeks, as the Utility index has rolled over and now very recently the Transports have underperformed.
I remember writing a commentary back in 2007 documenting how very few of the Dow stocks were making a new high as the Dow itself was making a new high that October. Well, the recent market can be summed up with one word: "Apple". That juggernaut has gone parabolic and is likely to resolve itself as parabolas typically do (mountains have two sides!), but it has masked a good deal of deterioration - nothing that is terribly alarming yet, but enough for us to grow concerned about the chances of an acute correction of some significance.
While I've commented about some of these conditions in recent weeks, I also stated that we have been targeting the 1345-1365 area in the S&P 500 as a likely destination for the move higher, and where we may begin to get more defensive. Given the backdrop we've seen, along with reaching that price area, we've taken some substantial measures in recent days to reduce portfolio risk. This is not a "bear market" forecast , but rather getting more conservative in order to hopefully weather a potential 5%-10% correction in the broad stock market indexes. I'd actually view a nasty and violent correction back to the 1,220 area in the S&P 500 as being a bullish intermediate term development.
Portfolio Moves
In separate accounts, we've added a significant hedge using a leveraged inverse small cap ETF, which longer term clients will remember fondly from when we utilized it extensively (and very profitably) in 2008. In our fund, where we are much more active and can be more aggressive, we've add a wide number of hedging positions, many of which are via put options. The strong market rally in recent months brought the "cost of insurance" down dramatically - to the point where we've taken major hedging positions as well as some speculative trading positions. The majority of our exposure is in major stock market indexes, with a tilt towards small cap stocks. However, we have also used the recent parabola in tech stocks to add some put exposure in that area as well.
These hedging positions are offset by our continued exposure to energy, agriculture and precious metals equities. I believe there is a fair shot that the precious metals miners have already suffered their sharp correction and could do quite well during a broad stock market correction - at least on a relative if not absolute basis.
So overall, we are not leaving the ring - just putting our gloves up to let Clubber Lang punch him self out for a while.
Hump Day Humor
At least I get a kick out of it.....
TEAMThink 2-3-2012
Keeping Our Eye on the Ball
I shared two charts in my 11-4-2011 post relating to total credit market debt and the monetary base in the US. You can scroll down for a brief refresher, but I believe last week's Fed meeting and press conference support our view that their policies are focused on this long term issue - not business cycle dynamics.
Chairman Bernanke made news by coming across as fairly dovish relative to the recent optimism about the US economy based on improving short term economic data. Bernanke was careful to point out that they are concerned about bringing unemployment down, but also concerned about inflation getting too low, as they define it. Last Friday's GDP report was extremely interesting in two ways. First, the headline real growth level came in at 2.8% - only modestly below the 3.0 expectation. However, the inflation deflator was just 0.4%, which was over 1% below the expected level. This resulted in nominal GDP growth well below the expected level, even as the real figure was pretty close.
There has been a significant amount of discussion in economic circles as to whether the Fed will or should put forth an explicit nominal GDP target. For example, the Fed could state that they are targeting nominal GDP growth of 5% and then use that level as justification to enact stimulus if that level is not reached. This would open up political cover to maintain loose policies even if inflation were to move above their stated objective of 2%. If nominal GDP was 4%, with inflation running at 3% and real GDP at 1%, then targeting a nominal GDP level of 5% could be used as justification to increase stimulus even though 3% inflation would be above the stated 2% target.
I'm sure all of this may make some readers' heads spin, but it is literally the kind of nonsense that is debated and driving the policy discussions on Wall Street and in Washington DC. Our markets and economy long ago ceased to be "free". The entire debate does highlight what we've argued for a long time now - the Fed is targeting nominal GDP and doesn't really care all that much about higher inflation on a cyclical time frame - as long as they believe they can get it back down over time. The Fed is still obsessed with deflation and the dreaded "Japanese outcome." I view the 4th quarter GDP report as a significant move towards igniting QE III by the Fed, as the move in their measure of inflation close to the zero line may be enough. They also have the cover of the drop in commodity prices over the past nine months. Even with coincident economic data looking ok, I think there is a better than 50% chance that QE III is launched this spring anyway.
As I argued back in the fall, one of the things we've been focusing on is the potential for a "white swan", which is to say for things to work out in an unexpectedly bullish way for risk assets - at least on a cyclical basis. If the economy has already put in a cyclical bottom in what turns out to have been a very moderate or shallow recession, and the Fed launches a new round of money printing this spring, certain segments of the financial markets could ignite. Specifically, I'd expect hard assets/commodities to perform well, as a weak US dollar is at the forefront of Fed policy, in my opinion. Currencies in countries with stronger fiscal fundamentals would also most likely be well positioned.
Obviously there is still a good deal of uncertainty as to the economic outlook and how financial markets respond regardless of the actual outcome. However, I believe there is little uncertainty as to how the Fed will respond in the coming months. They want inflation and nominal GDP higher, and will act until they get it. The massive debt burden our country faces demands it unless a deflationary contraction is embraced, for which there is zero political appetite - especially in an election year.
Markets Update
The US stock market has become very overbought in the short and intermediate term, which is often a precursor to some kind of correction. However, the timing of a correction is highly uncertain, as markets can stay overbought for weeks or even months. For example, following the announcement of QE II in the fall of 2010, markets finished the year extremely overbought, yet churned around for two months before finally correcting a bit following the Japanese earthquake, tsunami and nuclear crisis. The S&P 500 has reached the bottom part of our initial target zone (1345-1365) off the August and October double bottom. While anything is possible, I'd be surprised if this zone does not present significant resistance and possibly usher in a sharp correction in order to rebuild a wall of worry.
There appear to be a lot of under invested bulls, which typically results in the kind of grinding higher market we've experienced in recent weeks, as every dip is bought. Ultimately, this kind of situation is resolved when the initial dip is bought but then fails and a very violent vacuum lower develops. I think the 1345-1365 area has a good chance of capping the current rally, with 3%-5% decline being a minimal expected correction, 5%-7% being typical historically, and a 7%-10% plausible.
We've enjoyed a very good start to 2012 performance wise. As I indicated at the end of 2011, I believed that the last two weeks of 2011 seemed silly and artificial in some ways given the intensity of selling in market segments like junior gold mining stocks. In many respects, our performance so far this year is just making back the "artificial" decline at the end of 2011. We've been positioned for the environment I describe above for months, which in retrospect was a little early.
In our separate account strategy, we intend to stay the course for the most part, as we expect a correction to be just that - a correction within a new cyclical bull market. In our fund, we've taken down our risk levels from what had been well above average at the beginning of the year to a bit below average. If/when we see tangible signs of a burgeoning correction, we may deploy some tactical/opportunistic equity short exposure in our fund, as it is managed with a more active/aggressive strategy than the separate account strategy.
Humor for the Week
I shared two charts in my 11-4-2011 post relating to total credit market debt and the monetary base in the US. You can scroll down for a brief refresher, but I believe last week's Fed meeting and press conference support our view that their policies are focused on this long term issue - not business cycle dynamics.
Chairman Bernanke made news by coming across as fairly dovish relative to the recent optimism about the US economy based on improving short term economic data. Bernanke was careful to point out that they are concerned about bringing unemployment down, but also concerned about inflation getting too low, as they define it. Last Friday's GDP report was extremely interesting in two ways. First, the headline real growth level came in at 2.8% - only modestly below the 3.0 expectation. However, the inflation deflator was just 0.4%, which was over 1% below the expected level. This resulted in nominal GDP growth well below the expected level, even as the real figure was pretty close.
There has been a significant amount of discussion in economic circles as to whether the Fed will or should put forth an explicit nominal GDP target. For example, the Fed could state that they are targeting nominal GDP growth of 5% and then use that level as justification to enact stimulus if that level is not reached. This would open up political cover to maintain loose policies even if inflation were to move above their stated objective of 2%. If nominal GDP was 4%, with inflation running at 3% and real GDP at 1%, then targeting a nominal GDP level of 5% could be used as justification to increase stimulus even though 3% inflation would be above the stated 2% target.
I'm sure all of this may make some readers' heads spin, but it is literally the kind of nonsense that is debated and driving the policy discussions on Wall Street and in Washington DC. Our markets and economy long ago ceased to be "free". The entire debate does highlight what we've argued for a long time now - the Fed is targeting nominal GDP and doesn't really care all that much about higher inflation on a cyclical time frame - as long as they believe they can get it back down over time. The Fed is still obsessed with deflation and the dreaded "Japanese outcome." I view the 4th quarter GDP report as a significant move towards igniting QE III by the Fed, as the move in their measure of inflation close to the zero line may be enough. They also have the cover of the drop in commodity prices over the past nine months. Even with coincident economic data looking ok, I think there is a better than 50% chance that QE III is launched this spring anyway.
As I argued back in the fall, one of the things we've been focusing on is the potential for a "white swan", which is to say for things to work out in an unexpectedly bullish way for risk assets - at least on a cyclical basis. If the economy has already put in a cyclical bottom in what turns out to have been a very moderate or shallow recession, and the Fed launches a new round of money printing this spring, certain segments of the financial markets could ignite. Specifically, I'd expect hard assets/commodities to perform well, as a weak US dollar is at the forefront of Fed policy, in my opinion. Currencies in countries with stronger fiscal fundamentals would also most likely be well positioned.
Obviously there is still a good deal of uncertainty as to the economic outlook and how financial markets respond regardless of the actual outcome. However, I believe there is little uncertainty as to how the Fed will respond in the coming months. They want inflation and nominal GDP higher, and will act until they get it. The massive debt burden our country faces demands it unless a deflationary contraction is embraced, for which there is zero political appetite - especially in an election year.
Markets Update
The US stock market has become very overbought in the short and intermediate term, which is often a precursor to some kind of correction. However, the timing of a correction is highly uncertain, as markets can stay overbought for weeks or even months. For example, following the announcement of QE II in the fall of 2010, markets finished the year extremely overbought, yet churned around for two months before finally correcting a bit following the Japanese earthquake, tsunami and nuclear crisis. The S&P 500 has reached the bottom part of our initial target zone (1345-1365) off the August and October double bottom. While anything is possible, I'd be surprised if this zone does not present significant resistance and possibly usher in a sharp correction in order to rebuild a wall of worry.
There appear to be a lot of under invested bulls, which typically results in the kind of grinding higher market we've experienced in recent weeks, as every dip is bought. Ultimately, this kind of situation is resolved when the initial dip is bought but then fails and a very violent vacuum lower develops. I think the 1345-1365 area has a good chance of capping the current rally, with 3%-5% decline being a minimal expected correction, 5%-7% being typical historically, and a 7%-10% plausible.
We've enjoyed a very good start to 2012 performance wise. As I indicated at the end of 2011, I believed that the last two weeks of 2011 seemed silly and artificial in some ways given the intensity of selling in market segments like junior gold mining stocks. In many respects, our performance so far this year is just making back the "artificial" decline at the end of 2011. We've been positioned for the environment I describe above for months, which in retrospect was a little early.
In our separate account strategy, we intend to stay the course for the most part, as we expect a correction to be just that - a correction within a new cyclical bull market. In our fund, we've taken down our risk levels from what had been well above average at the beginning of the year to a bit below average. If/when we see tangible signs of a burgeoning correction, we may deploy some tactical/opportunistic equity short exposure in our fund, as it is managed with a more active/aggressive strategy than the separate account strategy.
Humor for the Week
TEAMThink 1-23-2012
2+2=1?
I laid out in my 1/13 blog post how we were amending out outlook a bit relative to recession recognition and the potential for risk markets to suffer sometime over the next couple of months once a recession was recognized. We've been relying upon leading economic indicators to help us create a narrative to what markets are "speaking" to us - i.e. that a significant cyclical bottom was put in from August through October of 2011. As I always try to remind myself and others, one of the cornerstones of our investment process, which is geared to embracing that markets are random and chaotic, is that intellectual flexibility is paramount. I pride myself on trying to make sure we prioritize making money way ahead of being right.
At the risk of being drafted as a Republican presidential candidate, I will now lay out how we are flip flopping around on our outlook like a fish out of water. In case you cannot tell by now, our conviction level in a specific narrative as to why markets are unfolding as they are is modest. The scenario I laid out in the 1/13 post immediately below this one still seems to be plausible, but we think an alternative scenario also makes sense.
What if we already had a recession and the economy has already troughed and is in the early stages of a cyclical recovery? Such a question may seem absurd at a time when the vast majority of economists and strategists are crowded in one of two camps, with most arguing the US will avoid recession altogether and the other arguing that a 2008 type abyss lays directly ahead. We've never shied away from throwing out scenarios that seem absurd relative to consensus!
Gross Domestic Income (GDI) has trended down for 6 straight quarters and is the typically ignored sister report to Gross Domestic Product (GDP). The US Fed has done a study which shows that GDP has typically been revised over time to move in line with GDI. GDI was basically zero during the 3rd quarter of 2011 and we'll get 4th quarter government data by the end of January. Something GDI and GDP share is that they are reported in real terms using government generated inflation statistics. As I've commented on for years now, government calculated inflation statistics have become a joke, as there has been an explicit campaign to understate inflation in order to try and cut entitlement benefits like Social Security. There have been two major changes over the past 30 years, and there is a new bipartisan movement currently underway to change the calculation once again as part of "budget reform."
The specific inflation number used in the GDP report is called a deflator, which is different than the consumer price index (CPI) in some ways - and mostly in showing lower inflation. But to keep things relatively simple, I'll use the CPI for the purposes of this post. The US government has reported a CPI for 2011 of 3.2%. When the government reports GDP of say 2%, that is in real terms. One would need to add the 2% plus the inflation rate, 3.2% in this instance, to get nominal GDP growth. Obviously, the inflation figure plays a huge roll in this calculation.
If the government were still reporting CPI as it did prior to the Boskin Commission changing things in the 1990's, it would have been over 6% for 2011. If nominal GDP were to be 6% for all of 2011, this would mean that real economic growth ex inflation would basically be zero! In reality, that is about what I think happened in 2011. For example, in Q2, GDP and GDI were reported to have been 1.3% and 0.2%, and Q3 were reported at 1.8% and 0.2%. These were official numbers using current inflation calculations. If one were to assume real world inflation was actually 2%-3% higher than reported, that would have resulted in GDP of negative 1-2% during the 2nd and 3rd quarters and possibly around zero for the 4th quarter when it is announced. GDI would have been in the negative 2%-4% range, which certainly fits with the terrible consumer sentiment over that period.
This is all just an intellectual exercise, but I believe it does open a question as to whether an economic contraction in real terms (using realistic inflation rates and not trumped up government statistics) did occur sometime starting over the summer, with a trough occurring sometime between September and now. It is possible the current cycle may not result in the formal declaration of a recession by the government, as they are using phony baloney data.
Market Dynamics
The scenario I lay out is another that makes sense to me given how financial markets and coincident economic data have unfolded in recent months. Risk markets made what I described to be classic cyclical bottoms in August and October of 2011 and have been progressing since with classic cyclical dynamics. Early cycle sectors like housing, transports, financials and industrials have assumed market leadership in recent weeks. Government bonds in the US and Germany have begun to trade very weak recently, as interest rates have begun to head higher. Riskier currencies have begun to outperform, with emerging market currencies assuming leadership once again. European bank stocks have launched to the upside, much as US banks did during the spring of 2009. Commodity markets appear to have stabilized and begun to trend higher. The Chinese stock market appears to have finally exhausted to the downside - at least for now.
As we consider this backdrop, we believe it is prudent to continue giving risk markets the benefit of the doubt for now. Having said that, we are growing increasingly concerned that a correction/retracement of significance is likely to unfold at some point before Q1 ends. A 5-10% correction would be normal within the context of a cyclical recovery. Sentiment has become quite bullish in recent weeks and markets rarely reward excessive optimism without first sending a shockwave with which to endure. However, unless we see a significant shift in how markets are moving, we expect to maintain a bullish cyclical bias.
Finally, if the Fed and other central banks add additional stimulus into the scenario I've laid out in this post, it could be like adding lighter fluid onto an already burning cyclical fire. I think such a development could make precious metals and commodities explosive positions for the remainder of 2012.
Humor for the Weekend
I laid out in my 1/13 blog post how we were amending out outlook a bit relative to recession recognition and the potential for risk markets to suffer sometime over the next couple of months once a recession was recognized. We've been relying upon leading economic indicators to help us create a narrative to what markets are "speaking" to us - i.e. that a significant cyclical bottom was put in from August through October of 2011. As I always try to remind myself and others, one of the cornerstones of our investment process, which is geared to embracing that markets are random and chaotic, is that intellectual flexibility is paramount. I pride myself on trying to make sure we prioritize making money way ahead of being right.
At the risk of being drafted as a Republican presidential candidate, I will now lay out how we are flip flopping around on our outlook like a fish out of water. In case you cannot tell by now, our conviction level in a specific narrative as to why markets are unfolding as they are is modest. The scenario I laid out in the 1/13 post immediately below this one still seems to be plausible, but we think an alternative scenario also makes sense.
What if we already had a recession and the economy has already troughed and is in the early stages of a cyclical recovery? Such a question may seem absurd at a time when the vast majority of economists and strategists are crowded in one of two camps, with most arguing the US will avoid recession altogether and the other arguing that a 2008 type abyss lays directly ahead. We've never shied away from throwing out scenarios that seem absurd relative to consensus!
Gross Domestic Income (GDI) has trended down for 6 straight quarters and is the typically ignored sister report to Gross Domestic Product (GDP). The US Fed has done a study which shows that GDP has typically been revised over time to move in line with GDI. GDI was basically zero during the 3rd quarter of 2011 and we'll get 4th quarter government data by the end of January. Something GDI and GDP share is that they are reported in real terms using government generated inflation statistics. As I've commented on for years now, government calculated inflation statistics have become a joke, as there has been an explicit campaign to understate inflation in order to try and cut entitlement benefits like Social Security. There have been two major changes over the past 30 years, and there is a new bipartisan movement currently underway to change the calculation once again as part of "budget reform."
The specific inflation number used in the GDP report is called a deflator, which is different than the consumer price index (CPI) in some ways - and mostly in showing lower inflation. But to keep things relatively simple, I'll use the CPI for the purposes of this post. The US government has reported a CPI for 2011 of 3.2%. When the government reports GDP of say 2%, that is in real terms. One would need to add the 2% plus the inflation rate, 3.2% in this instance, to get nominal GDP growth. Obviously, the inflation figure plays a huge roll in this calculation.
If the government were still reporting CPI as it did prior to the Boskin Commission changing things in the 1990's, it would have been over 6% for 2011. If nominal GDP were to be 6% for all of 2011, this would mean that real economic growth ex inflation would basically be zero! In reality, that is about what I think happened in 2011. For example, in Q2, GDP and GDI were reported to have been 1.3% and 0.2%, and Q3 were reported at 1.8% and 0.2%. These were official numbers using current inflation calculations. If one were to assume real world inflation was actually 2%-3% higher than reported, that would have resulted in GDP of negative 1-2% during the 2nd and 3rd quarters and possibly around zero for the 4th quarter when it is announced. GDI would have been in the negative 2%-4% range, which certainly fits with the terrible consumer sentiment over that period.
This is all just an intellectual exercise, but I believe it does open a question as to whether an economic contraction in real terms (using realistic inflation rates and not trumped up government statistics) did occur sometime starting over the summer, with a trough occurring sometime between September and now. It is possible the current cycle may not result in the formal declaration of a recession by the government, as they are using phony baloney data.
Market Dynamics
The scenario I lay out is another that makes sense to me given how financial markets and coincident economic data have unfolded in recent months. Risk markets made what I described to be classic cyclical bottoms in August and October of 2011 and have been progressing since with classic cyclical dynamics. Early cycle sectors like housing, transports, financials and industrials have assumed market leadership in recent weeks. Government bonds in the US and Germany have begun to trade very weak recently, as interest rates have begun to head higher. Riskier currencies have begun to outperform, with emerging market currencies assuming leadership once again. European bank stocks have launched to the upside, much as US banks did during the spring of 2009. Commodity markets appear to have stabilized and begun to trend higher. The Chinese stock market appears to have finally exhausted to the downside - at least for now.
As we consider this backdrop, we believe it is prudent to continue giving risk markets the benefit of the doubt for now. Having said that, we are growing increasingly concerned that a correction/retracement of significance is likely to unfold at some point before Q1 ends. A 5-10% correction would be normal within the context of a cyclical recovery. Sentiment has become quite bullish in recent weeks and markets rarely reward excessive optimism without first sending a shockwave with which to endure. However, unless we see a significant shift in how markets are moving, we expect to maintain a bullish cyclical bias.
Finally, if the Fed and other central banks add additional stimulus into the scenario I've laid out in this post, it could be like adding lighter fluid onto an already burning cyclical fire. I think such a development could make precious metals and commodities explosive positions for the remainder of 2012.
Humor for the Weekend