American (or European) Py

This morning the European Central Bank made some very accommodative moves.  While the details are a little wonky, here is a rough summary (emphasis on “rough”):

  • Targeted Long-Term Refinancing Operations (TLRTO):  These operations are designed to “grease” the monetary policy transmission mechanism so accommodation becomes reflected in the “real” economy.  To make the operation more attractive to banks they may eliminate the premiums charged to banks and lower the benchmark rate.  Today’s announcement lowered the cost of funding to 0.10% above benchmark.
  • ECB to purchase ABS:  The idea here is for the banks to bundle various securitized loans and sell them to the ECB.  Today’s plan includes both new and existing Asset Based Securities and Residential Mortgage Backed Securities.
  • Lowered Rates:
    • Rates on main refinance operations were lowered to 0.05%
    • Rates on marginal lending were lowered to 0.30%
    • Rates on deposit facility were cut by 0.10% to -0.20%.  Yes.  Those little dashes in front of the percentages indicate that banks will be paying interest on the money they deposit at the ECB.

In the wake of this, rates on 2-year paper in eight European countries went negative; with the lowest negative rate being paid to Switzerland (-0.119%) and the highest negative going to Austria (-0.049%).  I think I’d balk at the privilege of paying the Swiss 0.119% to give them the use of my money.  But hey, that’s just me because apparently someone is willing or the rate wouldn’t be where it is!

As I write this, the EUR/USD has fallen 1.60% to 1.2939 – the ECB having (at least for now) the desired impact of hammering down the Euro.

In Europe, reactions in the equity markets were generally positive.  The DAX gained 1.02%, the FTSE gained 0.06%, and the CAC 40 gained 1.65%.

That’s a pretty healthy reaction.  It seems that draconian fixes are considered bullish while the underlying problems necessitating these fixes are ignored.  A money manager has to make his numbers each quarter, so I suppose that’s understandable on some level.

The US markets were generally positive early in the day, but the gains faded after the 159, 648th rumor came out of Ukraine.  This was the most recent of the 79, 824 bad news rumors, and it took the markets fractionally lower.

Early this week I linked an article about “liquidity traps.”  Roughly (again) defined, a liquidity trap is where injections of cash by a central bank into the private banking system fails to decrease interest rates because there is a prevailing belief that interest rates will soon rise.  Similarly, if the cash is not being deployed due to “hoarding” there is little impact on creating inflation (which a few countries could use right now…  Italy, I’m talking to you).  This is described as M * V = Py, where M is the money supply, V is the velocity of money, and Py is the product of price and units.  An increase in Py would be evidence of inflation.

Since there is no question that the Fed and the ECB are ramping up the “M”, and there is little evidence of an increase in “Py”, one could deduce that “V” is the lollygagger.  To wit, here is a quote from the St. Louis Fed’s website:

“During the first and second quarters of 2014, the velocity of the monetary base was at 4.4, its slowest pace on record. This means that every dollar in the monetary base was spent only 4.4 times in the economy during the past year, down from 17.2 just prior to the recession. This implies that the unprecedented monetary base increase driven by the Fed’s large money injections through its large-scale asset purchase programs has failed to cause at least a one-for-one proportional increase in nominal GDP. Thus, it is precisely the sharp decline in velocity that has offset the sharp increase in money supply, leading to the almost no change in nominal GDP.”  – Economist Yi Wen and Research Associate Maria Arias in a St. Louis Fed article:

Now, in full disclosure, the concept of the liquidity trap is a construct of Keynesian economics.  The Austrian School would argue that the lack of velocity during these periods of low interest rates is a result of previous mal-investment and the discounting of an assets value at an extremely low rate (time preference).

I wish I definitively knew the cause of the flaccid “V”, but after witnessing 5 years’ of ramping up “M”, I’m beginning to side with the Keynesians on this one.  It would seem that much mal-investment would have worked through the system at this point, resulting in some juicy Py.

Mmmmm.  Juicy Py.



Of Hydrogen and Stupidity

It’s been said the two most common elements in the universe are hydrogen and stupidity; and stupidity has a longer half-life.  Not being a scientist, I’ll withhold comment on the 1937 zeppelin reducer.  Sitting in an office that plays CNBC all day, however, I can certainly attest to the widespread availability of stupidity.

This is the channel featuring pundit after pundit bleating out priceless nuggets like “at the end of the day, ” “fiscal cliff, ” and “wall of worry.”  If it weren’t for the cliché’s (and the constantly running ad in which a guy dramatically impales his eardrum with a Q-tip) the programming day would be about 90 minutes long.

But, during those 90 minutes, we’d be treated to some of the most repeated and inaccurate comments imaginable.  During the past few weeks, the topic du jour has been a listing of the reasons the market rally will continue.

 1.      “There is a ton of cash on the sidelines.”

This is commonly cited as a catalyst for increasing stock prices.  While there may be 2, 000 pounds of cash on the wrong side of the chalk line, its existence alone is… well… meaningless.  To make the point, follow this example:

Let’s assume that the entire stock market is made up of three people.  Here are their current holdings:

  • Andy holds $450 in cash
  • Billy holds $451 in cash
  • Carl holds 1 share of Apple (AAPL)

That means our market contains $901 in cash and 1 share AAPL.

Both Andy and Billy want to buy a share of AAPL.  Carl sells his share to the highest bidder, Billy, and collects $451.  Once the trade is completed, our investors hold the following positions:

  • Andy holds $450 in cash
  • Billy holds 1 share of Apple (AAPL)
  • Carl holds $451 in cash

$901 remains on the “sidelines” and 1 share of AAPL rounds out our market.

Look familiar?

There is an identical amount of cash on the sidelines after the transaction as there was before the transaction.  The only difference is that the holders of the sideline cash have changed.

What matters is not solely the amount of cash available for investment (with the exception of initial and secondary offerings), but the velocity in which the cash moves from person to person.  In other words, inflation in security prices is driven by the same factors that drive overall economic inflation:  

Money Supply x Velocity = Inflation

 As our national economy is illustrating so well, money supply can be increased indefinitely, but if velocity is zero, inflation is zero.  Stock prices are driven higher when a group of buyers look to increase the velocity of the cash they hold.  As velocity increases per unit of cash, prices inflate.

  2.      “Retail participation in the stock market is far below what it was in the 1990’s.”

While this statement is unquestionably accurate on its face, the implication that the participation deficit creates room for the markets to grow is misleading.  Here’s why:

  • Baby Boomers:  People born between 1946 and 1964 are typically defined as Baby Boomers.  In 1999, the oldest Boomers were 53 and the youngest were 35.  Arguably, this giant population bulge was smack-dab in the middle of the investment phase of their lives.  Presently, that population spans ages 49 to 67.  At that age demographic, particularly post-crisis, it is likely that the Boomer appetite for equities has diminished at least as much as their appetite for Big Macs.
  • Generation X:  people born during the 1960’s and 1970’s constitute this class.  Gen X arrived at the investment phase of their lives right between 2000 and 2010.  From January 2000 through January 2013, the stock market (S&P 500) has delivered a 0.15% annualized return with two major collapses (the worst being 52.6% peak to trough).  This is a generation that has never seen wealth accumulated via the stock market, yet they witnessed the near collapse of the global financial system.  Many lost their jobs as a consequence.    Convincing this generation that buying stocks is a good idea is a very tall task, indeed.
  • Pensions:  In the 1990’s, defined benefit pension plans were prolific – assuring a steady and predictable flow of cash into equity markets.  In the 20-odd years since, defined contribution plans (like 401(k)’s) have become a much larger share of the retirement savings market.  Participation in these plans is voluntary and the allocation to equities is up to the individual investor.    This problem is compounded with high unemployment and low participation rates constraining the number of plan participants.  Circling back to Gen X, it is unlikely we’ll see contribution levels like those that existed in the 1990’s.
  • Lower levels of personal wealth:  After the financial crisis and housing collapse, personal net worth in the aggregate has taken a massive hit.  And while the stock market has regained all of its 2007 – 2008 losses, it is unlikely that equity investors’ en masse held on through the bad years in order to fully participate in the recovery.  More likely, they sold out on the way down and failed to reinvest on the way back up.

 The evidence?

 There is a ton of cash on the sidelines.

  3.       “We are witnessing a rotation out of bonds and into stocks.”

This is the first derivative of “There is a ton of money on the sidelines.”  In the interest of time, I won’t go through the entire example, but here is how it sets up:

  •  Andy holds $450 in cash
  • Billy holds $451 in cash
  • Carl holds 1 share of Apple (AAPL)
  • Dave holds 1 Treasury Bond

No matter who sells what to whom else, the owners change but the market remains the same.


If I’m forced to hear these memes too many more times, I may very well impale my own eardrums…  if for only the sake of my sanity.



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.

Pimco’s Gross Eliminates Government Debt From Total Return Fund

While this has likely already been priced in for now,  it says a lot about where Pimco thinks rates will be going over time. Also, it takes one of the largest domestic buyers out of the market. That can only cause bond prices to fall over time, both leading to higher rates.  

Pimco’s Gross Eliminates Government Debt From Total Return Fund – Bloomberg.

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.”