Altair June Commentary

The End of QE2 and the Probability (Possibility) of QE3

 

During the run of QE2, the end of which is rapidly approaching, we discovered an interesting phenomenon.  There would be days when the stock market would open lower, only to begin a major bounce-back around 10 a.m.  This was occurring with such frequency that “buy the dip” became the mantra of many traders.  What we noticed, while visiting the homepage of the NY Fed on these days, was that Permanent Open Market Operations were being conducted at the same time the markets were finding their bottom – with regularity.  The point being…  QE2 arguably added artificial price stability to equities (and to other risk assets) and its ending in June should remove some of this stability.  I emphasize the word “should, ” because the normalization of the market’s pricing mechanism will be largely dependent on whether there is a QE3 or some form of a stealth extension of QE2.

 

The idea of a potential QE3 moved to the front over the past few weeks with declining ISM numbers, weak Non-Farm Payroll numbers, dismal housing numbers, and faltering consumer confidence.  Additionally, by falling for the past 5 consecutive weeks and 5 consecutive sessions, the stock market returns seem to be “suggesting” to the Fed that additional QE might be desired.

 

While it’s doubtful that the American people have an appetite for an overt QE3, we believe that the Fed will, for the foreseeable future, maintain the size of its balance sheet by reinvesting the proceeds as bonds “roll-off” its balance sheet.  In this way, they can “keep interest rates exceptionally low for an extended period, ” as has been the Fed’s repeatedly quoted position.  And while cheap money is unquestionably a stimulant for the stock market, the fact that the economy remains so weak that a Zero Interest Rate Policy must be perpetuated should give everybody a reason to pause.

 

We are likely nearing an inflection point as QE2 winds down, so we are keeping our betas to a minimum.

 

The European Bailout and Long-Term Viability of the Euro

 

Here are a few headlines from the past few days (in no particular order):

 

  • Greek Government Faces Revolt Over Second Wave of Austerity Measures
  • Seven Years for Ireland to Fully Recover, Warns Banker
  • S&P warns EU over Greek Debt
  • Obama Says European Debt Crisis Must Not Endanger Recovery
  • Riots in Greece Over IMF-imposed Setbacks to Workers

 

In our analysis, Greece has no choice but to default – either via debt restructuring, technical default, or outright failure to pay.  A recent Moody’s downgrade places the likelihood of a Greek default at 50%.  While many pundits argue that Greece, and Ireland for that matter, are too small to matter, we would argue that the impact on the Eurozone as a whole and the Euro as a currency could be severe.  The fact that Trichet recently began pushing for a European fiscal union to pair up with the existing monetary union would support our point.  It was the lack of a fiscal union that allowed Greece to spend into oblivion while more fiscally conservative countries, like Germany, were left holding the bailout bag.  Now, the citizens of each country have little appetite for what needs done to correct this deficiency (assuming to can be corrected).  The May 5 riots in Greece that resulted in the deaths of 3 bank employees present an ominous example of the friction between workers and their government.  There is a real chance that it may be too late for the fiscal union idea to be of any use in this crisis.

 

We continue to be short European banks in Hedged Equity as a hedge against what we believe to be an upcoming elevation in the crisis.

 

Housing in Double Dip

 

In May, the Case-Shiller Home Price Index fell below its April 2009 low to officially enter the area of “double-dip.”   For the month ending March 31, 2011, 19 out of the 20 cities in the index saw price declines.  Washington D.C. was the only market to post a gain on both a monthly and an annual basis – Washington is growing while the rest of the nations is shrinking…is anybody shocked?   Minneapolis saw a 10% decline for the year, indicating that the housing crisis is being felt hard in the Midwest.  The quarterly annualized decline for the overall index was 5.1%.

 

As home prices continue to decline and the pace of foreclosures hastens, we expect the real estate market to remain soft for the foreseeable future.  Such softness would be a bad thing for consumer confidence and consumption, as well as the financial sector as a whole.

 

We believe there is a silver-lining to housing issue that should show itself in the next 2 or 3 years.  The excess supply of homes is shrinking – currently at about 1.3 million units down from 1.8 million only 6 months ago.  Factoring in new home construction, 2011 should come up roughly 1.25 million homes built short of what should be needed to keep up with population growth.  That trend is unsustainable.  Additionally, the laws of supply and demand are becoming a factor.  As more people seek to be renters, the cost of rent is rising.  There will be a cross-over point somewhere in the not-so-far-in-the-future-to-care, where the price of rent will make homeownership an economical venture once again.  The convergence of reduced housing supply with increased rental costs could provide a significant tail opportunity in the coming years.

 

China May Be In Trouble

 

Stealth Bailout in Progress

Earlier in the week I read an article from Societe Generale’s Dylan Grice about a Reuters’ report regarding China’s Local Government Financing Vehicles (LGFV).  It was reported that China’s central government was “taking on responsibility” for up to $463 billion of bad loans made to LGFV to fund various infrastructure and development projects as a part of the stimulus package. Basically, this amounts to a stealth bailout.  It’s not clear yet how this will be done, but if it is handled in a fashion similar to that used during the recapitalizations of Chinese banks, asset management companies will buy up the bad assets, which they will pay for with non-tradable government-guaranteed bonds.  These bonds do not show up in the official measures of government debt.  Since the bonds are off the official records, it’s like the bailout never happened.  But the problem hasn’t gone away. As Grice noted, a bail-out of $463 billion is half the size of the TARP for an economy which is only one-third the size of the US’.  So adjusted for GDP, China has enacted a bailout equal to one and a half TARPs.  If we calibrate the magnitude of the economic crisis with the size of the bail-out, one and a half TARPs implies a financial crisis one and half times the order of magnitude of 2008.  With China quietly buying up its own bonds, there is a real possibility that their demand for US bonds may wane – causing US interest rates to rise.  One more reason we are short US Treasuries.

Says Grice: “The critical issue in both cases is the artificial suppression of volatility in the name of stability. We know that the longer volatility is artificially suppressed, the more emphatic will be its release when it does come.”

 

Energy and Food Inflation

With energy and food prices rising at a heady pace, China has had no choice but to restrain credit and money growth.  Protests such as the recent truckers strike indicate this is not going to be an easy sell to the population. Chinese consumer expectations have been plummeting, and are now at their lowest level since late 2008.  Car sales, which were exploding during the massive stimulus injections, are now growing at low single digit annual rates.  And finally, housing starts are running at +40% year-over-year, but sales are falling at a -5% annual rate. There is a lot of faith being priced into the market that the Chinese authorities will be able to engineer a soft landing for the economy, but given the extraordinary imbalances that have built up, that will be increasingly difficult.

Altair February Commentary

The Middle Eastern turmoil that began in Tunisia and Egypt spread to Yemen, Bahrain, and Libya in February, driving oil prices to $100 per barrel. At the same time, bond spreads in Greece, Ireland and Portugal continued to widen (albeit under the radar) as investors demand a higher premium to embrace the risk of these sovereign issuers. In fact, as I write this, the Greek 10-year yield has surged to 12.76% while the Portuguese 10-Year moved to 7.66%. The tumult drove gold prices up by nearly 6% in February, closing the month at $1, 411 per ounce. In February, the US Government racked up its largest monthly deficit in history — $233 billion. To put this into some kind of perspective, February’s deficit was larger than deficit for the entire year of 2007.

February brought with it, however, some encouraging news. People seeking unemployment benefits fell to the lowest level in nearly three years during the last week of the month. Both retailers and the service sectors have posted positive reports, and the unemployment rate dropped below 9% — ending February at 8.9%. Manufacturing activity (as defined by the ISM report) rose to its highest level in nearly 7 years; marking the 19th consecutive month of expansion for the economy as a whole.

Against the backdrop of these conflicting ominous and encouraging indicators, and a nearly 2% stock market decline during the last week of the month, the S&P 500 managed to add 3.4% to its already massive (+28%) gain since the Fed’s Jackson Hole meeting last August. For yet another month, Quantitative Easing coupled with pockets of good news pushed investors into risk assets with little regard for macro-environmental risk.

Our position has been (and remains to be) that the forces driving the economic recovery are not particularly solid and based almost exclusively on massive amounts of liquidity. Further, we continue to contend that the global financial issues that were exposed during the crisis remain largely unresolved, and for the most part, politicians and policymakers have merely attempted to push the problem into the future rather than structurally repairing it today.

To quote Citigroup’s Steven Englander, “It’s hard to argue with this line of analysis except that it has been dead wrong in market terms.”

Englander also made an observation that is dead-on with what we have observed in this uni-directional market: Investors have grown tired of being told to hedge against risks that have not emerged. In fact, he opines, the downward trend in volatility (as the stock market continues to melt up) may reflect that too much capital was dedicated to hedging risks that didn’t happen and that capital is now being deployed back into the market.

Since 2007, we have taken the position that the probability of a high magnitude, negative event (or a series of such events), remains higher than normal. We were rewarded for that observation in 2008 and penalized for it in the succeeding years. Like Mr. Englander, we have increasingly heard from more clients and prospects that either resist or reject the notion that such events may occur in the near- or intermediate-term. Basically, the line of reasoning is that they have heard this song many, many times since 2009, while the markets for all things risky have marched onward and upward.

If you subscribe to the theory that the ending of the financial crisis of 2008 and the subsequent recovery in risk asset prices is almost exclusively the result of trillions of dollars of money creation, it begs the question as to what policy tools remain to address a future crisis. Do countries simply print more and more money? Do they draft new, more restrictive and cumbersome legislation? Do they try to find new and creative ways of deferring the painful solutions to yet a later date?

I am not confident that policy-makers possess the tools required to address another significant crisis; and as a result, the absolute magnitude of a negative event has risen while the probabilities have, at best, remained the same. At worst, the probabilities have increased as well.

I will not go into itemizing the specific risks we see in the present environment. Those who have read our monthly letters or listened in on our prior calls should be acutely aware of the factors we view as problematic. Rather, I’ll conclude my prepared remarks with another quote from Mr. Englander: “When we see volatility so cheap in a world that appears to be so risky and in which policymakers do not hold a terribly strong hand, it makes a strong case for hedging tail risk, even if price action is apparently indicating otherwise.

Altair January Commentary Expanded

The liquidity-fed rally in domestic stocks continued in January with the S&P 500 gaining 2.3%. Smaller stocks, however, did not fare as well; with the Russell 2000 actually falling by 1.1%. Internationally, monthly returns were a mixed bag, with the UK, Brazil and China falling (-0.3%, -3.2%, and -3.5%) France and Japan were the strongest regions with their indexes rising 5.5% and 0.1% respectively.

January was characterized by increasing macro risks, juxtaposed against a demonstrably improving US economy. On one hand, turmoil in the Middle East, continued European bond downgrades, and runaway pricing on agriculture commodities provided ample worries for the near-term future of global growth. On the other hand, solid earnings from US corporations, coupled with upgraded GDP projections for 2011 (3.2%) counterbalanced the scales nicely. The factor that tipped the scales in favor of the equity bulls, in my opinion, was the continuing Open Market Operations by the Fed. As the Fed continues to dump billions of new dollars into the markets, risk assets like stocks will have a tailwind in the form of the “Bernanke Put”.

That said, it is hard (if not impossible) to predict how long this US stock rally will continue. QE2 is set to end this summer, but if unemployment continues to persist, might we see QE3? Conversely, if QE2 is allowed to expire, how does the Fed begin mopping up all this excess liquidity without causing a dislocation in the bond markets and precipitating a spike in the US Dollar? Finally, how much of our exported inflation (prices in cotton, corn, wheat, oats and soybeans) can the developing world tolerate before social unrest becomes even more widespread? While I don’t pretend to know the answers to these questions, we keep our portfolio positioned to shield our assets against these uncertainties while looking to gather gains in a prudent way.

I’ve spent a good deal of time during the month of January insuring that, as a firm, we are not falling victim to “confirmation bias” – that is, the tendency to favor information that confirms your preconceptions or hypotheses regardless of whether the information is true. Confirmation bias is more difficult than ever to avoid, given that, if you have any idea you can likely find information to support it on the Internet. Confirmation bias is one of the primary factors we investigate when deciding to terminate a manager from our Fund-of-Funds. To quote Wikipedia, “Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Hence they can lead to disastrous decisions, especially in organizational, military, political and social contexts.”

Our investment hypotheses have been presented openly in numerous past letters and monthly calls, but they basically boil down to this kernel: The various macro risks confronting the stock market, while having only modest probability of occurring, are embedded with such high magnitude negative outcomes that the risks outweigh the potential rewards.

If this were a ballgame that began at the March 2009 stock market lows, the score would emphatically indicate that our hypotheses were wrong. That said, I can easily provide mountains of evidence from reputable sources reinforcing why our hypotheses are correct and why the market is behaving temporarily irrational. But, that would be the very definition of confirmation bias! I believe my time would be better used trying to gather data regarding the source and timing of the market’s divergence from where we believe it should be.

I began by investigating the “where” and the “how much” relating to the cash flows that are driving the markets upward at nearly a 45 degree angle. Looking at the Investment Company Institute’s data of weekly net flows into or out of US stock funds, we found that over a 36 week period ending in January, 35 of those months’ showed net outflows amounting to nearly $110 billion. Recently, this trend has changed, with net inflows of $6.7 billion. So, all-told, $100 billion or so has left the stock mutual fund complex. Just since August, retail investors have taken out $38 billion more than they have added. So I think it’s safe to say that the retail investor has not been the driver of market gains. (As an aside, the recent re-entry of the retail investor could be viewed as an indicator that this rally may be getting “long in the tooth.”)

At the same time, the Federal Reserve has “created” nearly $400 billion of new base money within the financial institutions of this country. It stands to reason that these institutions are (much to the Fed’s pleasure) fueling the upward bias. To quote Chris Martenson, “the stock market has become a liquidity gauge first and a discounting machine second.” The liquidity explanation for the market’s performance helps to clarify our recent relative underperformance, but it does not provide much evidence of “staying power”.

Another impact from all this “new money” is a major decline in the US Dollar. Since its peak in June, the US Dollar Index has declined 12.8%. Partially as a result of this decline, and partially due to demand changes, agricultural commodities have soared. In the past 12 months, cotton is up over 150%, corn +85%, oats +73%, and soybeans +57%. Gold was up a mere 21%. The global social impact of these price hikes is beyond the scope of this writing, except to say it may be exacerbating the unrest bubbling in the Middle East and elsewhere. What is relevant is the impact on the share values of commodity-based stocks. Here are a few examples of performance over the past twelve months: Gold Miners ETF (GDX) + 31%, Agribusiness ETF (MOO) +42%, Base Metal Company ETF (XME) +55%. Even the financial sector is posting record profits on the back of free-money spreads. These profits are reflected, for example, in the 23% 12-month gain in the Financial Sector ETF (XLF).

So, what are our conclusions from this exercise? First, the Fed has thus far accomplished what it wanted by elevating asset prices, setting the stage for improved corporate profitability, and generating positive GDP. Second, corporations have enough excess capital to continue improving productivity, thereby increasing margins, and ultimately profits. Third, our decision to avoid making a bet on the height and duration of a liquidity-based market rally has muted our performance.

Circling back to confirmation bias… Spending a month focusing primarily on research that refutes our position has been an interesting exercise. Sometimes it was downright uncomfortable. But, in the end, I find our position to be largely unchanged.

Structurally, we continue to believe that the stock market is damaged. Few lessons were learned from the Flash Crash and fewer actions were taken to prevent it (or even a more severe version) from recurring. From a macro perspective, we continue to believe that inflation is a global problem as evidenced in commodity prices. Geo-politically, we are in the midst of happenings that history may well consider being watershed events. We also think that when the Fed ultimately is forced to remove liquidity, the impact on stock prices and bond yields will be dramatic – and not in a good way. To analogize, the broad picture is akin to a rubber band being stretched: Solid US profits, growth, and share prices being tugged upon by inflation, structural flaws, and geo-political strife. Since people who invest with us seek consistent returns and vigilant dedication to preserving capital, this is a tug-of-war on which I choose not to bet.

I’ll conclude by sharing an anecdote about the Egypt ETF (EGPT). On January 28, during the height of unrest, money began flooding into this ETF – an ETF with an average volume of about 51, 000 shares. The money flow was apparently buying, driving the ETF up 14% while volume spiked to over 1 million shares. Be mindful, during this time the Egyptian stock market remained closed, causing the fund to trade, at its peak, at 14% over its Net Asset Value. This is indicative of how free capital presently views risk. It’s also evidence of why we choose to look elsewhere for investment returns.

Legendary value investor Benjamin Graham observed, “Speculators often prosper through ignorance; it is a cliché that in a roaring bull market knowledge is superfluous and experience is a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss.”

Altair Commentary – What we see for 2011

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

Macroeconomic Risks

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…

Sentiment

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?”

Conclusion

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
• Technology
• Energy
• Agriculture

Outside of the stock market we also like these themes:

• Preferred Stock
• Senior Floating Bank Loans
• World Inflation Protected Securities
• Energy
• 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.

Altair December Commentary

On the heels of the Federal Reserve’s quantitative easing, the equity markets surged to their best December performance in 20 years. 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 engaged with 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. A discussion of the wisdom of the Bernanke Put is beyond the scope of this post, but would make for interesting discussion during our monthly conference call.

The gains in risk assets came largely at the expense of fixed income assets, as December saw net capital inflows from fixed income fund to equity funds for the first time in two years. Declines in the value of 10-year Treasury Bonds pushed yields up by over 16% in December, to 3.33%. Nearly all bonds shared a similar fate, with losses in mortgage backed securities, emerging market debt, investment grade corporates and TIPS. World Inflation Protected Securities (WIP) stood alone among bond winners; posting a 2.6% gain in December.

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’s embracing of cyclicals, small-cap stocks, 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.”

During times like these, which I would characterize as speculative (unless you believe the cumulative value of the entities comprising the “market” are fundamentally worth 25% more today than they were less than 100 days ago), we continue to source our returns from non-beta investments. The investment choices confronting us under the current circumstance boils down to a simple dichotomy: Momentum or Fundamentals. We have always been, and will continue to be, fundamental investors. We like the fundamentals of mergers and acquisitions for 2011. We like the fundamentals of energy and agriculture. We like the fundamentals of senior floating bank loans. And, in what might be construed as a contrarian theme, we like the fundamentals of high-quality, dividend-paying, multi-national, large cap stocks. Those are the themes we will be pursuing as we enter 2011. We will not, despite the visceral urge to do so, increase our beta in an attempt to “ride the wave.”