The equity markets surged to their best December performance in 20 years due largely to the Federal Reserve and the second round of Quantitative Easing. Since the Fed announced QE in August, the S&P 500 has rallied by 24% as market participants (note my avoidance of the word “investors”) gobbled up risk wherever they could find it – from commodities to stocks. For December, the Dow Jones UBS commodity index tacked on 11%. And for the year, small cap stocks (as measured by the Russell 2000 Index) gained over 26% — besting its large cap counterpart by 12% for the year. A full 80% of the S&P 500’s gains for the year came in the third quarter.
It seems that market participants are fully embracing the concept of the “Bernanke Put.” The idea of the Put being that the Federal Reserve will do whatever is necessary (in whatever amount necessary) to prevent a decline in the value of risk assets
One theme overrode all others during the market’s fourth quarter rally. That is, low-quality, low-yielding, higher risk assets performed demonstrably better than their higher-quality, dividend-paying, less risky counterparts. This is not so much a matter of opinion, as an objective look-back on the market favoring cyclicals, small-caps, commodities and stocks characterized by high betas (sensitivity to market risk) and low stability of earnings. In the overused parlance of market pundits, “The risk trade is on.”
Any time our portfolios diverge materially from passive benchmarks (whether that divergence is a good one: as in ‘07 and ‘08, or not-so-good: as in ‘09 and 2010), it becomes even more important for me to state our investment thesis in succinct and definitive terms. The remainder of my comments will be directed to doing just that — followed up with a discussion of the factors we are focused on as we enter 2011.
As for our thesis: We believe we are experiencing a bear market rally, rather than a legitimate bull market.
The stock market has rallied over 80% since its March 2009 lows, which represents the most rapid rally of this magnitude since 1955. While it is easy to be cognizant of these immensely positive near-term returns – particularly since they are trumpeted on a daily basis — it is just as easy to lose sight of the infrequently spoken risks. This rally was not built on the stuff of prior secular bull markets: namely, favorable post-war demographics, technological innovation, booming economic growth, or revolutionary industrial changes. Rather, this rally is built on the questionable foundation of extreme stimulus designed to force money out of low risk assets and into “riskier” assets to create a wealth effect. This wealth effect, in turn, is expected to ignite consumer consumption, spurring economic growth and a commensurate uptick in employment. We do not believe this is a strategy that permits the fair price discovery of securities nor is can it persistent as global government debt burdens reach the critical level. So, in what has become a shop-worn continuation of a theme we’ve discussed many times in the past, we do not intend to increase our beta (that is, the amount of return we expect to capture from moves in the stock market) in this environment.
Now to turn our attention to a few factors we are observing that lead us to maintaining our low beta position. These factors can be broadly characterized as follows:
• Macroeconomic Risks
• Sentiment – which we use as a contrary indicator
Sovereign Debt problems – as I write this, Greek bond spreads versus the bund have exceeded their previous all-time high of May 2010. Following a very poor bond auction on January 5, spreads on Portuguese bonds have continued to widen. Spreads on Spanish 10-year bonds, which reached their historical peak on December 16, continue to hover in record territory. Clearly, the bond market is trying to say something but it seems that few people are listening. Despite this evidence, risk assets continue to trade higher. As one of our managers pointed out to me a few days ago, global equities ignored the subprime crisis and rallied right up to the onset of recession in the 4th quarter of 2007. We are aware that the same may be true in the Eurozone.
Municipal Debt issues — I’ll begin the discussion of Municipal debt with a few quotes. First, Warren Buffett, in reference to the current state of municipal bonds, predicted, “There will be a terrible problem [in municipal bonds] and then the question becomes, “will the Federal government help?”. Meredith Whitney, now famous for her bearish call on banks leading up to the 2008 financial crisis, is predicting 50 to 100 sizable municipal defaults amounting to hundreds of billions of dollars. Once again, she believes that in the next 12 months, the US Government will face pressure to bail out struggling states. While I will concede that pundit predictions have only limited value (sometimes, in fact, only as a bad example), the anecdotal evidence is there for the viewing. All in, American states have spent a total of $500 billion more than their tax receipts, and face an additional $1 trillion gap in their pension liabilities. The state of Illinois is six months behind on making its creditor payments at the same time it owes $400 million to the University of Illinois. Implied from derivative trading, the state of Illinois has a 21% chance of defaulting on its obligations. The state of Arizona was forced to sell its Supreme Court and Capital buildings to help bridge its deficits. California has raised tuition fees by 32%. So, if the Feds are needed to step in to help the states, will there be the political will? Will there be the money available for a Federal bailout? What will be the effect on consumer spending if municipal employment and benefits are reduced?
Emerging Markets – one thought that has been almost universal during this rally is that the emerging markets have decoupled from the developed economies and will be the new growth engines for the planet. Ultimately, we suspect this will prove to be true. In the more immediate term, however, despite the relative rebalancing between the developed and the developing world, exports remain the predominant factor for emerging market growth. Economic difficulties in the developed world, at a point in history where the emerging markets have yet to develop significant domestic demand, could prove the decoupling theory to be premature.
China – having been selected by default to save the global economy, China’s health should be of high importance in assessing the near-term outlook for risk assets. China’s Premier Win has been surprisingly candid about his own assessment of China’s situation. A few years ago, he claimed, “The biggest problem with China’s economy is that the growth is unstable, unbalanced, uncoordinated, and unsustainable.” More recently, he warned of the twin dangers of overheating at home while the global recession persists. He specifically pointed to the precipitous rise in housing prices due to overinvestment.
To understand why the housing issue is so important, you have to deconstruct China’s GDP. While common perception is that China’s GDP is largely driven by exports, the fact is, in recent years, only 5% of GDP is export-based. Surprisingly, 60% of China’s GDP is generated by real estate construction. Jim Chanos, founder of hedge fund Kynikos Associates, reports that China constructed between 12 and 15 million residential units in 2010. Compare that to the US construction of 2.5 million units at the height of the 2006 housing boom. These units have been constructed in the areas where poor, houseless migrants have been moving. Unfortunately, they do not have the financial means to buy these homes at the prices necessary for the homebuilders to maintain their razor-thin margins. Further, as China battles to hold inflation in check, the prospects that rising wages will make housing more affordable seems like a long shot. Finally, many of the houseless migrants are employed by residential construction companies. If the housing industry begins to shrink, these people will be jobless and move back to the country. In that scenario, demand for city housing will take a big hit. In our opinion, China may be late, but it has a fair chance of having a housing-based economic crisis in the near to intermediate term.
Now, moving on to…
Smart buyers are leaving the market — for some reason, the US Government decided that now was the time to have secondary offerings in GM and Citigroup. I doubt they would have chosen a point near the market’s bottom to undertake such massive offerings. While I’ll agree that calling the US Government a “smart buyer” could be the subject of lively debate, they have been consulting with some of the finest capital market experts leading up to these sells. A second indication of smart money leaving is the fact that over 84% of open market transactions by insiders have been on the sell side. On average, that number is more like 64%. While there are many reasons insiders sell apart from share price, the extension of the Bush tax cuts removed favorable capital gains treatment as an obvious rationale. Yet insider selling continues.
Long Exposure Index – Ned Davis’ Long Exposure Index is a contrarian indicator combining sentiment, overbought/oversold conditions and monetary indicators. The thought being, when sentiment is overly optimistic, the markets are well overbought, and rates are likely to rise, there will be a lack of available buyers in the future. This Index is reaching extreme levels and is beginning to generate a sell signal.
Mutual Funds are fully invested – during the financial crisis; mutual funds were carrying nearly 6% of their assets in cash. Today, they are carrying slightly more than 3% — the lowest cash levels since the 1960’s. There just isn’t much fuel left in the mutual fund complex to drive stocks higher.
Individual cash balances are down – at the peak of the crisis in 2008, individual investors had a ratio of cash to mutual fund investments of about 125% (per Rydex). That ratio had dropped to 25%. To lend some context, during the “irrational exuberance” days of 2000, this ratio bottomed at 12%. I would take these low cash balances as an indicator of overblown optimism.
Margin Debt – Speaking of the tech bubble days, in March 2000 margin debt reached $278.5 billion as investors borrowed money to increase their tech stock holdings. At the end of December, margin debt stood at $274 billion. Once again, it begs the question… “Where will the new fuel come from for future stock gains?”
The picture I painted in reviewing these selected factors is bearish. Perhaps overly bearish to make a point. That point being: against this backdrop we do not see many reasons to grab for broad market beta entering 2011. I would like to stress, however, that we do see many areas where profits can be made both in and out of the stock market in 2011.
Within the stock market, we like the following themes:
• Merger arbitrage
• A rotation from low-quality, low-dividend stocks into high-quality, high-dividend stocks
Outside of the stock market we also like these themes:
• Preferred Stock
• Senior Floating Bank Loans
• World Inflation Protected Securities
• Sovereign CDS
We also are optimistic about the shorting opportunities that will evolve as the stock market stops trading in a monolithic manner and begins to price its constituents closer to fundamental value.
While I haven’t received much feedback regarding our 2010 returns, I anticipate getting some as our final numbers are released. It’s not an understatement to say it has been painful to be tugging on the reigns of our portfolios as the stock market rocketed upward. Everyone likes a party, and those who know us know we’re no exception. But, we broadly view our job as the weighing of three factors when making our allocation decisions:
The Probability of Outcomes
The Magnitude of Outcomes
And The Timing of Outcomes
• We believe there is a moderate-to-high probability that global fiscal and monetary policy will lead to market consolidation at best, or a secondary financial crisis at worst.
• We believe that, should any of the factors I spoke of come to pass, the result would be one of moderate-to-high magnitude. Furthermore, the tools available to deal with another high magnitude event are scarcer today than they were in 2008.
• We have no confidence in our (or anyone else’s) ability to time the probabilities.
The last point is the one that leads us to keeping our directional exposures low. History has shown that our firm has generated far more wealth by avoiding speculative rallies and capitalizing on dislocations than by trying to catch each wave… and hoping to jump off at the right time.