TEAMThink 12-7-2012

Executive Summary

-    I apologize for not posting for over a month.
-    I plan on posting a fiscal cliff specific commentary next week.
-    Fundamentals continue to unfold largely in line with what we've been forecasting.
-    We believe markets have been ignoring fundamentals for a variety of reasons, but also believe those reasons are temporary.
-    We see structural risks in markets which have escalated massively since the summer. The result is an elevated chance of a major market dislocation once the madness of crowds can no longer deny the fundamentals.  
-    Our portfolio/performance journey has been a long and frustrating one, but we remain confident our destination will be very rewarding for clients/investors as the cycle completes - i.e. a recessionary bear market unfolds.

Cycles, Cycles, and more Cycles

The past few months have been particularly frustrating for us. Obviously, our poor relative and absolute performance is at the core of the frustration, but it is what we see as the driver of our poor results which compounds the frustration. For a number of years, we've attempted to integrate complex systems dynamics into our investment strategy/process. Our move in that direction was compelled by my frustration of trying to gauge the core driver of cyclical bull and bear markets within a secular bear market - i.e. the madness of crowds. For example, since the year 2000, the S&P 500 has been trading within a broad range between roughly 1500 and 700, which has included two 50%+ declines and two 100%+ rallies. It has been a relatively eventfull way for that index to go nowhere for about 12 years.

The business cycle plays a big part in the cycle dynamics, at least that is our belief. However, we'd argue that the business cycle itself is not some magical occurrance, but rather a product of the inherent cyclical nature of aggregate human behaviour. Societal risk appetite has its seasons, just as climate does. Expansions climax when risk appetite is at its peak, and recessions trough when risk appetite is at its low. The challenge we face is in gauging the "madness of crowds," as each cycle is unique in circumstances and it is impossible to predict in advance when precise inflection points will be reached. Our entire process has been constructed with these concepts in mind.

Since the spring of 2011, global business cycle dynamics have unfolded with reasonable normalcy. Many global markets peaked when the global economic growth rate peaked at that time. Since that point, various economies have entered recession (or experienced dramatic slowing from high growth rates) in a rolling fashion, with the associated stock markets falling significantly. Examples include some of the European countries like Italy and Spain, as well as large emerging markets like China and Brazil.

A standout performer both economically and stock market wise has been the US. US stocks made new highs following the decline in 2011 and went on to make new highs into the spring of this year, while the vast majority of other global markets made lower highs. The process we follow in forecasting the US recession began to flash warning signs of an approaching recession in the fall of 2011. By early 2012 we began to see significant warning signs, and by the spring the warnings were imminent.

The average stock market peak since 1900 has preceded the business cycle peak by about 2.5-3.0 months. By February this year our concerns about recession and financial markets beginning to respond to such conditions became acute enough that we significantly altered our portfolio positioning. The stock market proceeded to peak in late March/early April. We now have very clear evidence that a US business cycle peak occurred around June/July of this year, as reflected in the following chart:

Contrary to what many people say/believe, two consecutive quarters of negative GDP is not the official definition of recession. The NBER is charged with defining and dating official recessions, and the major criteria have to do with when the levels of industrial production, personal income, sales and employment begin to fall and create the negative feedback loop which is the essence of a recession. Lower incomes result in lower sales, which result in lower produciton, which result in layoffs, which result in lower incomes....and the feedback loop unfolds. As the chart above indicates, three of the four criteria peaked in July this year, which was about 2.5-3.0 months after the spring stock market peak. 

The employment data has not begun to contract yet, but that is not abnormal, as 3 of the past 7 recessions have involved employment continuing to expand months into the recession, including the two worst recession since the Great Depression - 1973-1975 and 2007-2009. This cycle has also included some labor market dynamics which are somewhat unusual. The data indicate that employers cut labor to the bone during the prior recession and were extremely slow the rehire. In addition, a large amount of the jobs that have been created are far lower paying than those they replaced, with a significant amount being part time. The result has been median house hold incomes contracting during the economic expansion from summer 2009  to summer 2012.

This three year period introduces another interesting dynamic to this cycle, which I'll call "back to normal." From 1900 to 1990, business cycles had averaged 37 months in duration. Starting in 1990, the US economy entered what some call the "great moderation," in which the US economy experienced a long expansions of 10+ years until the 2001 recession, and then the expansion from 2002-2007. The result was a 17 year period with only one relatively modest recession in 2001. Rather than any great advancement among the abilities of central planners (i.e. central bankers and governments), we'd argue that the "great moderation" was created by the formation of a credit bubble. The Fed anchored interest rates at artificially low levels for years, confronted each acute crisis with stimulus, and let the bankings system go nuts creating all sorts of debt and derivatives instruments. The result is what you see in the following chart:

We believe that the 2007-2009 Great Recession ushered in the end of the private sector credit bubble, and you can see on the above chart that total debt did dip some during the recession (highlighted in grey). Since then, consumer credit continues to be very week or even contract, outside of student loans. The US has printed several trillion dollars and run $1+ trillion fiscal deficits for four years, which has resulted in government debt growth offsetting the contraction in private credit. However, the growth in debt has been pretty pedestrian relative to the stimulus. Without the private sector credit creation, which is fueled by risk appetite, we believe the economy is likely to be back to a more normal "rhythm" - meaning cycles lasting 3-4 years. 

I go through this because so many peoples' life experiences are dominated by the past 20+ years, which within a historical context was a pretty abnormal period. The abnormality continues in many ways, with governments and central bankers deploying all sorts of experimental policies. While they may be able to delay things, they will not eliminate the inherent cyclicality of human risk appetite or the associated business cycle.

Madness of Crowds

As I mentioned earlier in this post, our analytical framework is anchored in complex systems concepts. We arrived at this area of analysis by concluding that to try and successfully navigate stock market cycles, we needed to deploy a framework focused on analyzing the cycle of human risk appetite. These cycles are variable, can be random and chaotic, but do display certain characteristics - as all complex systems do. At the crux of our process is determining when conditions have achieved what we call "critical" or "hypercritical" levels - i.e. the level of greed or fear has reached an extreme enough level that the liklihood of a cycle inflection point is elevated. 

As part of our process, we monitor traditional fundamental and technical indicators, economic indicators, policies, etc. We view these as a sort of matrix in trying to assess the chances of when a cycle inflection point has been reached. As more of these begin to show signs of criticality, we become more alert for signs of a cycle ending.

As I stated earlier, the global stock market and the global economic growth rate peaked in spring 2011. That was the beginning of our "cycle alert" period. However, such periods frequently last 12-18 months, as the pendulum completes its swing from fear to greed. By early 2012, we began to see a more pervasive amount of criticality amongst our indicators - often a sign that risks are acute. By April this year, we then identified what we call an "iteration" within markets which we believed, given the pervasive nature of the criticality within our indicators at the time, that a cycle peak had likely been reached.

Locked in Our Padded Room

Since May, we've encountered a confluence of developments, events and market conditions that we did not anticipate or navigate well. The initial rally off the June low unfolded in a very atypical fashion within our framework, and in hindsight that was a warning signal of what has unfolded since. We've seen a period of what I've called the "Rorschach market." Investors have been seeing what they want for months now, and have been fueled by a perceived backstop of central bankers and chasing yield as a result of zero % interest rates.  

As I chronicled in a prior blog post, two facets of the cycle we did not identify until late this summer have been the impact of yield chasing on corporate credit and the wholesale selling of volatility across financial markets. You may have read/heard about how retail investors have abandoned stocks and flooded bond funds with their money, and in part this is correct. - retail has been selling stock centric funds overall and buying bond funds. However, an unprecedented amount of that money has flowed into junk bonds, which have historically more in common risk wise with stocks! We've heard/read countless anecdotal reports from bond fund managers who feel pressured to "put money to work" even as they know the current yields are very low. 

This massive demand for yield has resulted in Wall Street doing what it does best - creating products and supply for the demand. I'm sure you may have also read/heard that corporate America has "tons of cash," and in some cases that is very true. However, if corporate America is so rich in cash, then why has corporate debt issuance exploded this year? Part of it is that some companies that are cash rich are issuing debt just because the terms are so silly - some have borrowed for less than 1% for 5 years. However, the slowdown in the global economy has also caused some to require more funding to sustain operations, and these marginal businesses continue to get funded at what we would argue are artificially low rates. 

One could ask, "Isn't this igniting a new credit bubble?" Macro data show that business investment has been dropping (and in recent months sharply). If the proceeds from debt issuance was being used to invest in economic activity, I think that argument could hold some water. However, the data shows that businesses continue to pull back from investment, which is to be expected when a recession is unfolding! The following chart helps show where a good bit of the money is going:

As the old saying goes, one thing we've learned from history is that we've learned nothing from history. The "wisdom" inside corporate executive suites continues to astound me, as they collectively seem to be obsessed with buying their stocks back at high prices and then issuing shares at low prices! Buybacks are all the rage again, as well as issuing debt to pay dividends to investors. This is financial engineering and effectively just passes money from one pocket to another minus the Wall Street VIG as it passes through the system. 

Following the experience in credit markets in 2008-2009, we underestimated how stupid markets would get in such close proximity to the prior cycle. We certainly expected things to move towards silly again, as all cycles do as they mature, but did not anticipate a full blown move into the stupid zone. In hindsight, it is now clear that the zero % interest rate policy by the Fed has helped encourage stupidity once again.

The other major factor we didn't account for was something we simply did not consider in advance. It appears that the confluence of zero % interest rates combined with strong policy actions, and even stronger rhetoric from central bankers, has resulted in other dangerous behavior. It is widely perceived that central bankers have both the willingness AND the ability to backstop financial markets and prevent any major declines in risk assets. The Fed has now explicitly stated that one of the targets of its money printing is to force stock prices up. It appears that many market participants have taken the Fed at its word.

We certainly believe the Fed is targeting stocks, but that their ability is limited. Implied volatility, which is really a way of gauging the cost of insuring a financial instrument, has plummetted near or to record lows all over the place. Investors have been "selling vol" endlessly, as they collect premium/income for offering what they believe is flood insurance in the middle of the Sahara desert. Conceptually, the consensus believes that central banks have created a sort of desert for risk - flooding is "impossible" because the Fed and other central banks will print money if anything bad begins to happen. The result of this perception is that investors have continued to sell this flood insurance at lower and lower levels - why wouldn't they since it is "free?" Rather than being in the Sahara Desert, we believe investors are selling flood insurance on the Gulf Coast as a category 5 hurricane is barreling their direction.

Portfolio Implications

There have been various implications for the portfolios we manage. The cost of our hedging has been a big drag on separate account portfolios since February, as US stocks remain above the levels at which we began hedging. As the level of criticality continued to grow into the summer, we began to deploy a more aggressively bearish allocation within the mutual fund. This has resulted in poor performance for the fund, as we've continued to purchase flood insurance policies without a flood having occurred.

The situation has created a paradox of sorts, as we believe the longer this inherently unstable market situation continues, the more explosive the eventual resolution is likely to be - and hence the potential profits of deploying an aggressively bearish portfolio. However, it has been, and continues to be a costly exercise to continue "reloading" as we've experienced what we thought were the beginning of the hurricane, when in fact they were only passing thunder showers. We must balance what we see as increasingly large potential gains with the size of our drawdown and the recoverability of what we expect to be temporary losses. This has already progressed longer than I/we would have imagined to be likely. However, despite the fund's volatility and drawdowns, we remain confident they are recoverable and that the potential gains large enough for us to maintain our course.


We entered 2012 with an outlook and forecast, which I believe for the most part has been validated by fundamentals. We've anticipated the actions of policymakers pretty well, but have not done a good enough job of anticipating and timing the fullness of the implications of those policies in the near term. Our forecast has largely turned into reality, as incoming data validates what we had been expecting.

To date, the madness of crowds continues to ignore and/or rationalize what we see as clear factual evidence, and it is difficult to know when that will end. Our process suggests it is likely that a important inflection point was reached in October, but it will be important to monitor whether it appears the madness of crowds will extend for a significant period from this point forward.  

Humor for the Weekend

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