Traditionally, the investment advisory industry has recommended two main types of investments for client portfolios, equity (stocks) and fixed income (bonds). In most environments, high quality fixed income investments carry lower risk (as measured by price volatility) than high quality equity investments. To make a portfolio more conservative and less risky, a higher percentage of bonds is recommended, and to make it more aggressive, a higher percentage of stocks is recommended. A third category of investments has risen to increasing prominence over the past 20 years or so, going by the name of specialty fund or alternative investments. The category of specialty funds that we find most compelling at Meritas are those that seek to mitigate or decrease risk while generating additional returns per unit of risk that they are taking. Long/short funds are one example of specialty investments. Many specialty fund types appear first in the private Continue reading
With the markets on a roll, our prose may at times appear overly cautious as we assess the markets, but remember that’s our job. Portfolio managers are essentially professional worriers, looking around every corner and under every data point for the hint that a major shift is on its way as our primary job is to protect. These days many of us feel like we are in a CNBC version of a thriller, with the ominous music getting louder and louder as our handsome hero approaches the dimly lit house. When is the boogeyman going to jump out!? Continue reading
The negative news about the economy continues and yet the stock market has kept going up. This divergence reinforces one of the key lessons of active management, which is that the broader the financial instrument, the less predictable the movement of its price. For example, let’s consider the shares of a single company, a very narrow financial instrument. Apple (AAPL) shares gained 90% in value from November 2011 to September 2012. From September 2012 until now, AAPL shares have fallen 40%. An active manager has to effectively analyze an enormous number of factors affecting the perceived value of AAPL in order to benefit from some of the rise in the share price and avoid some of the fall in price. If an active manager bought AAPL at a good time in the past 18 months, the value of the investment nearly doubled in less than a year. If an active manager bought AAPL at a bad time in the past 18 months, the value of the investment was nearly cut in half in less than a year. A concentrated, actively managed fund has 30 to 60 stocks in it, so in order to do well for investors, the manager needs to maximize good decisions and minimize bad ones. While the best active managers make some mistakes every year, it’s important to limit those mistakes in both quantity and magnitude. If the active manager’s expertise and skill are great enough, and their area of concentration is focused enough, they have the potential to add value to an investor’s portfolio. Now imagine a broader instrument, such as the S&P 500 index. The amount of factors affecting whether the value of the shares of Continue reading
Equity markets are being propped up by impressively cheap money: central bank liquidity injections and the overtime-price of money, interest rates. Typically during times of rising equity prices, merger and acquisition activity ramps up. Most expected 2013 to be a banner year for M&A activity and began trumpeting the return of such with the Heinz deal involving Warren Buffet. That deal warrants a closer look however as Buffet didn’t invest in the equity side, that side is primarily coming from Brazil. Buffet provided debt financing to the tune of 9%, not exactly a ringing endorsement of longer-term growth. Right now M&A activity continues to be in a noteworthy low because M&A is not dependent on cheap money, but rather on long-term growth prospects and confidence. The lack of such activity is yet another signal that the recent rise in equity markets warrants caution. If we look at market volume, the number of shares traded on a daily basis has fallen almost 60% since 2007. This shortage of volume implies that there is little conviction in today’s directional trends.
The Federal Reserve has been under considerable pressure to provide details for just how it will control all the excess liquidity that it has created through quantitative easing. The Fed’s balance sheet, which can roughly be thought of as a proxy for the potential money supply, is almost 2.4 times the size it was in 2007. Last month we discussed how excess bank reserves have skyrocketed to nearly $1.7 trillion after having historically averaged near zero since the inception of the Federal Reserve. The Fed has argued that it will be able to slowly raise interest rates and carefully reign in those excess funds to prevent rampant inflation. This is something that has never in history been accomplished, so there is no clear roadmap for how to do this successfully, but for argument’s sake, let’s assume that the Fed is indeed capable. The question then becomes, “How will rising interest rates affect the economy and investing?” One of the largest impacts of rising interest rates will be on the financials of the federal government. The chart above shows the U.S. National Debt from 1950 to 2012 (left hand axis) and the annual deficit/surplus (right hand axis). The current national debt is over $16 trillion. Over the past 5 years, the annual deficit has averaged $1.4 trillion. The national debt as a percent of GDP is almost double what it was in 2007. The annual deficit is 9 times the size it was in 2007. The recent sequester cuts sent D.C. into apoplectic fits with dire warnings of impending doom, however those “cuts”, according to the Congressional Budget Office, represented a decrease in the amount of spending increase that is less than the total increase, which means there will still be an increase in net spending after the sequester, (see Congressional Budget Office “Final Sequestration Report for Fiscal Year 2013″ published March 2013). Given the emotional hoopla and doomsday rhetoric, it is reasonable to assume that the current level of deficit spending is unlikely to decrease significantly anytime soon. Continue reading
With such slow growth, it isn’t possible to get the employment situation to improve significantly, despite the attempts at upbeat headlines. On April 5th we learned that March experienced the biggest monthly increase in people dropping out of the labor force since January 2012, with 663,000 no longer looking for work. This means that we now have 90 million working age Americans who are not in the labor force. Of those, 6.5 million want a job and want to be in the labor force, (Bureau of Labor Statistics). The labor force participation rate has now dropped to 63.3% of the population, a level not seen since October 1978. The number of Americans officially unemployed has almost doubled since the market hit these levels in 2007 while the number of Americans on food stamps has risen to levels never before seen, with an almost an 80% increase since 2007. It is no wonder that consumer confidence continues to sit in recessionary territory. What is most troubling is that a full 40% of those unemployed have been long-term, (see chart below). Remember that the growth of our economy is dependent on the quality and quantity of labor and capital in the economy. With so many leaving the workforce and so many others out of work for an extended period, both quality and quantity are being materially reduced, which is a detriment to future growth prospects.
None of the four major components of the business cycle, (real income, sales, production and employment) have managed to get back to their 2007 highs, even now as we enter the fifth year of the recovery. This is truly a record, if an unfortunate one.
The chart above shows the continual stop and go pattern that has been GDP growth since the financial crisis. Never before in modern history has the U.S. experienced this many post-recession quarters without having at least one back-to-back 3% plus growth in GDP. The first quarter of 2013 was reported on Friday April 26th to have grown by 2.5%, while the second quarter of 2013 is currently forecasted to be below 2%.
As we head into the first quarter’s earnings season, 78% of companies have issued negative earnings preannouncements, the highest percentage of companies issuing negative earnings guidance since FactSet began tracking the data in Q1 2006.
The chart above shows in red, the percent of negative preannouncements by quarter and in green the percent of positive preannouncements with the S&P in blue. This is a troublesome trend to say the least and has us watching the market movement carefully. Eventually, stock market growth must be supported by corporate earnings growth and the trend for the past 11 quarters has been fewer and fewer positive corporate earnings surprises, as this chart clearly illustrates. The quantitative easing objective of driving up stock prices in order to create a wealth effect that leads to consumers and businesses spending more is not translating into better than expected corporate earnings.
The financial repression exemplified by the Federal Reserve’s zero interest rate policy (ZIRP), that was begun on Dec 16, 2008, has many side effects. One of these side effects is to drive down the interest income that savers and investors receive from their bond and fixed income investments. For example, many bank deposits are paying only 0.01% today. Similarly, locking up funds in a 5 year CD yields a paltry 1% to 1.5% today, which results in a negative return after inflation. In this yield starved environment, that recently entered its 5th year, having some skillful active bond managers in your portfolio can be very helpful in seeking to generate returns above the fund’s relatively low yields. The fund managers do this by trading bonds in addition to holding them. For example, a domestic corporate and government bond manager that we like is running a multi-billion dollar fund that is currently yielding just 2.54%. Last year, the fund generated a total return of 9.3%. The additional return beyond the yield came from a combination of realized gains on bonds sold throughout the year, plus unrealized capital appreciation of the bonds the fund holds. Similarly, an international bond fund that we like is currently yielding 5.6%, while holding approximately 50% of their $68Bn in cash and the other 50% in foreign government bonds. In 2012, the fund generated a 15.8% total return for investors, including both the interest income from holding bonds plus the returns from trading them.
(as of Feb 22nd, 2013)
It took the federal government around 200 years to accumulate a trillion dollars in debt. Within the following decade it tripled that number, then doubled it again in just twelve years, and doubled it again in another 8 years. Overall the national debt has increased sixteen-fold in just 30 years. Incidentally, this period coincides with the complete delinking of the U.S. currency to the gold standard.
So how are we managing all this debt? In 2013 the Federal Reserve will buy approximately 90% of the country’s issuance of Treasuries and mortgage bonds! That’s one way to explain how a nation facing such a growing mountain of debt, a slowing to stalling economy, and a paralyzed political process is able to maintain such incredibly low interest rates. Treasuries have long been used as the standard for the risk-free rate. With only 10%
of the issuance to float freely in the market, the Fed is able to generate considerable demand for this “risk-free” asset class, driving prices up, which means driving interest rates down.
The massive distortions from the various Quantitative Easing programs have damaged the market mechanisms for understanding the true price of risk, which gives markets an understanding of the appropriate cost of capital. A market that no longer can obtain this information has a big problem, because mispricing of risk leads to misallocation of capital.
The proverbial saying goes that markets love to climb a wall of worry. We’ve seen corporate earnings and revenue growth slow sharply through the past year, with corporate guidance for future performance continuing to be rather grim, yet equities have had quite a run. This is due to expanding P/E multiples as we discussed in last month’s newsletter. This expansion is 85% correlated to the Fed’s ongoing balance sheet expansion, as it is now adding about $85 billion of relatively secure fixed income securities to its $3 trillion portfolio on a monthly basis. Such an enormous level of buying in the markets, leaving only 10% of new issuance available for purchase, is forcing investors into other assets, pushing up prices.
How is this level of Fed activity going to end? David Rosenberg of Gluskin Sheff described the situation well by saying,
“I am concerned over the unintended consequences of these experimental policy measures that have no precedence, but perhaps these consequences lie too far ahead in time from a ‘tactical’ sense, but we should be aware of them. The last cycle was built on artificial prosperity propelled by financial creativity on Wall Street and this cycle is being built on an abnormal era of central bank market manipulation.” January 17th, 2013.
Bottom Line: When one looks over the past 12 years of active Federal Reserve monetary policy in which we experienced repeated bubbles followed by painful pops, why does anyone believe this time will be different? Particularly when this time we experienced monetary activism on an unprecedented scale: we are truly in uncharted waters.