Category Archives: 2012

November 2012 Commentary: The Fiscal Cliff (or not)

November 2012 Commentary
The Fiscal Cliff (or not)
Complex Adaptive Systems

In October of this year, Jason and Elliot had the privilege of attending Santa Fe Institute’s (SFI) conference in conjunction with Morgan Stanley called Risk: The Human Factor. It was a fascinating day, with many great lessons that can be applied to our investment process (for a complete summary, check out Elliot’s review on his personal blog). Rather than discuss any of these specific lessons, we wanted to take the time in this November commentary to highlight a theme at the heart of what the Santa Fe Institute studies: markets, a complex adaptive system.

Complex adaptive system. What exactly does this mean? We know what each word means in isolation. Markets are complex, meaning they are “complicated” and have “interrelated parts.” Markets are adaptive, such that they adjust to circumstances “by modification.” Markets are systems, which consist of “regularly interacting …group(s)” joining together to form a “unified whole.” This is very much our prevailing philosophy towards financial markets, and the reason behind our interest in the Santa Fe Institute. Such systems are found in many places, including nuclear physics, biology, anthropology, social structures, genomics, chemistry and drug discovery. What’s particularly neat about the SFI is that it brings together leading researchers and practitioners from all of these disparate areas to share their ideas for the benefit of each other.

We believe the complex adaptive system is the framework and lens through which everyone should perceive broader markets, yet despite that, the mainstream media does everything in its power to prevent people from adopting this approach. Why is this? Because when you take this perspective towards markets, you inherently destroy the need for a financial media altogether. Financial media thrive off of attributing market moves to a narrative. What the media does is fit a story to the events that have transpired, and yet all too often in the 24-hour news cycle, stories are crafted to fit facts without any clear connection between correlation and causation. Providing a narrative for market moves is almost never a good idea.

The Fiscal Cliff (or not)

Again you might ask why we are talking about this topic today, and now we will finally answer: the fiscal cliff is one of the more media-friendly stories with all kinds of narratives crafted around its fate. These stories are good for little more than pageviews and TV ratings. If the media were to be believed, this past November’s stock market action was completely attributed to the rumors and whispers about the fiscal cliff negotiations. Each day, the wiggle waggles of the market were portrayed as a direct result of the he-said-she-said negotiations between Democrats and Republicans.

Considering markets are complex adaptive systems, we know that this is a venue where many simultaneous crosscurrents meet and drive the action of the entire system. If you followed the fiscal cliff madness too closely, you may have missed the most important happenings of the month: we are finally seeing “green shoots” in the global economy, with China and Europe looking for better than they had been in a long time. That brings us to our next big point of the month—there has been a massive performance spread in stocks with a purely domestic revenue base vs those with a more diversified international base:

Hat tip to Bespoke Investment Group for the chart.

This chart is important for several reasons. First, it shows the strength and resilience of the US economy against the globe; second, it shows just how narrow the strong performance in the stock market has been this year. You can see clearly that from the end of November last year, until May of this year, all companies basically moved in lock step. That relationship broke down in May and has continued to stay that way since then, with the spread only recently starting to narrow. And it’s been narrowing for all of the right reasons.

The Forces Driving the Market:

While the fiscal cliff is A force driving markets today, it is not THE force. Along with this one issue are perhaps the far more important forces of the global economic slowdown, which accelerated in the first half of 2012 and is finally abating, and the shift in state-level spending from contraction to expansion. This latter point is an important one that we almost never see mentioned. Since the recession ended, state and local government spending has provided a major headwind to GDP growth. The following chart shows state and local government spending as a share of GDP (note: the rapid growth during the shaded area is reflective of a decline in GDP more so than an increase in spending):

While the federal government has been stimulating the economy with deficits, the state and local governments have been effectively removing this stimulus with contraction of their own. Now, the fiscal cliff, whether we “go over it” or find a resolution will provide a headwind to growth in its own right. Yet, states are finally starting to spend more again and recently we see the first signs of an uptick in this chart. Further, we see confirmation coming from the corporate sector, as evidenced by John Chambers discussion in Cisco’s Fourth Quarter conference call this past August:

We first signaled slowing of the market almost 15 months ago, the initial indicators of the slowdown occurred first in the U.S. state and local government followed by large, large global enterprise accounts, then general enterprise accounts in the U.S. then U.S. Federal and then into the commercial marketplace.

In Q4, with the exception of Federal government, we saw positive growth and/or uptrend especially in the second half of the quarter. Now I want to say, it is way too early to call this a trend, but if this were to continue through Q1, this would be a solid indicator of potential future market improvement in the U.S. (emphasis added)
So we have confirmation from a company known as a bellwether of economic growth both of the contraction, and then expansion in spending on the state and local level. Why is this important? Well no matter what, we will have a headwind coming from the spending level of the federal government, but at the same time, we will also have a tailwind from the shift on the state level from contraction to expansion. Importantly, the shift from contraction to expansion has a far bigger multiplier than simply an acceleration in growth.

Getting complex, let’s adapt:

So we’ve covered on some level three major forces impacting the stock market: the fiscal cliff, the global economic slowdown, and state and local government spending. And these are three of many forces driving markets. We can add to this the trend in consumer spending, corporate profit margins, the housing market, and/or the employment landscape, etc. This is far from an exhaustive list. Then we can factorize some of these areas. For example, global economic slowdown can be broken down into emerging markets vs developed markets; we can look at Europe alone, or we can break Europe down into core versus periphery. Each of these areas have distinct trends of their own.

But let’s tie it together. No one point can be viewed in isolation. A change in any one of these disparate areas, for example, China, can influence many of the other areas, which in turn can then influence China again. George Soros called such phenomenon “reflexive processes” and that is the essence of a complex adaptive system. Changes beget changes, which beget further changes, and no one factor is ever strong enough to be THE factor.

While the fiscal cliff does loom large in the media, the other stories that have a major impact on the global economy, with reflexive processes, are not nearly as sexy and don’t sell headlines. It’s important when looking at markets to take an entirely holistic approach in the grand scheme of things, but also to do extensive research into each individual security in order to insure that over the long run, their core business operations are in a position to succeed. This is how we overlay our micro-level company analysis with macro-level economic analysis, amidst our search for companies trading at a discount to their intrinsic value in areas where the overall outlook is best.

Please call us directly to discuss this in more detail. You can reach Jason or Elliot directly at 516-665-7800. Alternatively, we’ve included our direct dial numbers below.
Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director

Elliot Turner, Esq.
Managing Director

Past performance is not necessarily indicative of future results. The views expressed above are those of RGA Investment Advisors LLC (RGA). These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views. Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice. The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria. In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of: (i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.

2012 Year-End Investment Commentary: Looking forward to 2013

2012 Year-End Investment Commentary
Looking forward to 2013

“Saw things clearer, once you, were in my rearview mirror” – Pearl Jam

“It is better to be roughly right, than precisely wrong” – John Maynard Keynes

With 2012 in the history books, it time to take a look backwards at the year that was, and forwards to the year that will be. Obviously the benefit of hindsight makes reflection an easier exercise than forecasting; however, we think this year brought some significant catalysts to the fore which will shape things for the economy and many companies moving forward. In the pages ahead, we will use what we perceive to be the five most meaningful series of charts in order to tell a story about what has happened and how it will impact your portfolios moving forward.

In our 2012 Investment Outlook we used a chart of the market’s long-run P/E ratio in order to outline our case for equities as the place to be investment-wise over the long run. Our case was premised on the following excerpt:

At today’s prices, owners of stocks should think of them more like perpetual bonds with outsized yield, where the annual cash flow yield in percentage terms is the coupon, and any growth from here pure upside. The reason that equities work in this way right now is that good companies generate a certain percentage of their market cap in cash earnings each year. That is called the cash flow yield, where the stock price is the equivalent of the principal in a bond, and the cash flow yield is the equivalent of the interest. The principal yields in perpetuity, or so long as you own the company. Companies can use that cash flow yield in one of three ways: dividend it out to shareholders, conduct share buybacks, or invest in the organic growth of their business.
While the market’s P/E multiple has contributed to more of the market’s appreciation in 2012 than organic earnings growth, the case remains strong for stocks, particularly in relation to bond yields today. While some would take issue with asserting a valuation based on comparables, we think the significance runs far deeper into the fundamentals and we will outline the case using some of the charts ahead. In essence, the crux of our argument relies on the fact that the low interest rate environment has enabled households to delever via lowering their debt burden (without necessarily paying down debts), and for corporations to increase their leverage, without increasing the cost of that leverage.

2012 began with a heightened focus on Europe and ends with Europe largely an afterthought with the Fiscal Cliff here on the tip of everyone’s tongues. We think this is a mistake. Ultimately it’s far easier for catalytic negatives to make headlines than pervasive calm, and as such, the mainstream “story” of Europe’s increasing stability has been lost. On that note, let us begin with our #1 chart chart seriesfor 2012:

Series 1: Europe gets better

Italy 10-year bond yields:

Italy and their substantial long-term budget deficits has been the subject of much consternation over the course of the “Euro-crisis.” In fact, at the end of the day, it wasn’t corruption or solicitation of prostitute charges that brought down embattled Prime Minister Silvio Berlusconi, but rather, the bond yields on the country’s sovereign debt in 2011. This happened despite Italy running a primary surplus on their budget. Yet as you see in this chart, Italy’s bond yields cratered early in 2012, then suffered a mid-year relapse, they continued to settle at levels not seen since 2010-2011 to end the year.

Throughout the year, we argued that it was Europe’s prerogative to escape crisis mode in order to build the enduring infrastructure necessary for stability in a more constructive environment. 2012 was a monumental year with progress on both fronts, and as such, we have allocated an increasing share of your portfolios to the region. One of the factors that gave us conviction on the European region is the immense wealth that’s located even in the “worst” of countries. When seeing this in visual form, it’s increasingly clear how this crisis was borne out of political, rather than economic concerns:

As a result of the improving political situation in Europe, we see that the odds of a break-up of the Euro have declined substantially (with the caveat that Intrade is merely a proxy, not a definitive authority on the true odds of a breakup):

We will caution that this was not without some reservations about the political will necessary to cement in stone the crisis solutions.

As such, we focused on companies who derive a significant portion of their revenues outside the Euro zone. This is something we are very happy with, for high quality European businesses are far more globally oriented than their American brethren, and are an outstanding source of exposure to emerging markets in Asia, Latin America and Africa. Further, in our inquiry into European businesses, we discovered several elements on the corporate governance and capital allocation side which we think offer tangible long-run benefits in contrast to the American way:

a) European businesses pay far better dividends, and do so by targeting payout ratios, rather than gross values. This offers more flexibility to adapt to varying economic environments, and encourages paying out excess cash when it’s there.

b) European businesses that undertake share buybacks actually highlight their buyback progress front-and-center on their investor relations pages. This is in stark contrast to American businesses, which frequently announce buybacks and sometimes never even buy back a single share.

c) European businesses report earnings only twice a year (though some that are dual-listed in the US report quarterly). We find that even amongst those who report quarterly, there is a much more long-term oriented management culture, in contrast to many companies in the US who focus on meeting quarterly thresholds, rather than building long-term shareholder wealth.

Series 2: Household balance sheet improvement accelerates

In our mid-year outlook this past June, we introduced you to a chart labeled “Household Debt Service Payments as a Percent of Disposable Income.” Now is a great time to revisit:

This chart just keeps getting better by the day. Up until June, the vast vast majority of improvement occurred via the reduction in interest rates; however, just this past fall, we shifted even more beneficially towards a double-edged improvement. Right now, disposable income is finally on the rise for the first time since the initial bounceback from recession, AND interest costs continue to plummet as Americans refinance their mortgages. As you can see, debt burdens are as low as they have been throughout the recent past, and they are consistent with levels that have precipitated strong economic booms. While we would caution that risks do remain, this certainly does bode well for the economy moving forward as it increases the balance sheet flexibility of households, and affords more of a cushion should the economy experience another negative shock.

What many fail to acknowledge is that the debt burden is ultimately more important than the gross level of debt, for debt with a 3.5% interest rate is not nearly as harmful as the equivalent amount of debt at an 8% interest rate. But let us take a look at household debt over the long-run:

We are just about near the long-term trend line. Factor in the reduction in gross debt levels, with a low interest rate environment and it’s hard to be as pessimistic about the economy as the press will have you believe. One force we know drives markets over the long-run is the “reversion to mean” whereby certain critical indicators cannot stay elevated (or depressed) in perpetuity, and ultimately return to the normalized level given enough time.

Real estate, the subject of our next chart series, is a major beneficiary of this improvement, but a lesser-discussed area where we see measurable levels of progress is the auto sector. And let us not underestimate the influence of autos on the economy at large. Autos are the largest capital good purchased by households, and over the past few years, consumers didn’t buy nearly enough cars in order to maintain the age and state of the existing stock of vehicles. This calls for a period of catch-up demand in order to replenish and restore, and this is a mean-reversion which has been consistent ever since the mass adoption of the motor vehicle as the primary mode of transportation. Let the charts do the speaking:

We can see that this recent shock to the economy saw car sales plummet well below the scrappage rate, to levels not seen since the late 1970s/early 1980s. Only recently did we get above the break-even level, and this improvement started by real positives, but was accelerated by the damage wrought by Hurricane Sandy. We would argue that the Sandy impact is largely transitory, thus the real improvement should continue to accelerate. This is but one reason why we recently purchased a holding company which owns a large stake in a global automaker.
Thus far however, the improvement in real estate has been much more pronounced than in autos:

Which leads us to our next point…

Series 3: Real Estate, real resurgence

Declining interest rates are no-doubt an important driver for real estate markets. Yet even still, there are other drivers. As we referenced above, markets have important mean-reverting tendencies over the long-run and it just so happens that the bust phase of the boom-bust cycle in real estate has now lasted longer and been more pronounced than the boom phase.

This means that over the past five years of crisis in real estate, there has not been enough new housing built in order to match population growth. One impact of recessions is that household formation slows through a variety of forces, like college graduates living with parents for longer periods of time. These numbers are only now starting to bounce back towards normalized levels.
Further, even college grads who did move out, did not have enough certainty in order to be serious buyers of real estate. This uncertainty stemmed from higher turnover in jobs, as well as a general unease about the economy, thus many who would have bought real estate in years past became renters:

Renting now has taken preference to home ownership, a rare historical occurrence:

Sources: Department of Commerce, U.S. Census Bureau.

Supply and demand are the two driving forces behind price, and right now we have both a tight supply and a growing demand. Housing starts are picking up, and should help boost the supply, but we are only now seeing a pickup in household formation.

Household Formations vs. Single-Unit Housing Starts
(in thousands)

Source: Silver Bay Form S-1

And here is just how far off trend this important number has been:

Meanwhile, over the very long-run, prices of real estate tend to correlate pretty tightly to per capita income, and while prices leaped tremendously ahead of that rate during the housing bubble, they now have reverted to, and are moving tightly in conjunction with income. This should provide considerable stability to the real estate market moving forward:

In fact, for those who look for mean-reversion to “overshoot to the downside,” we did see that with house prices, and only now are we back at the per capita income level.

With stability in the housing market, we see this key economic driver shifting from a 5 year drain on GDP to a significant tailwind. Importantly, as those who have bought real estate know all too well, housing comes with an important multiplier force, i.e. people don’t just buy real estate, they buy to support it. New home purchases come with significant needs, ranging from furnishings to installation services, which all employ many people in their own right. This is but one reason the economic slump has been so pronounced in the recent past, and another reason why things look considerably better from here on out.
Now we need to caution: we do not think the real estate market will approach the lofty levels of the prior decade any time soon. There is a strong case to be made for the permanence of some would-be homeowners to renters. Further, there remain a considerable number of underwater homes unsold and waiting to hit market should prices reach their purchase levels. But this is a constructive development overall. Stability in housing provides much stronger footing for economic growth than does rapid escalation in pricing.

Series 4: Energy independence is here

This has been both a political and economic theme for decades. The US has been reliant on international energy for years, and considering the location of global oil supplies in some of the most politically volatile regions, this has caused dangerous price volatility to a key US economic input. We all know this story, but do we all know that 2012 marks the year that it finally breaks down? A key tell of the breakdown is the pronounced spread in the two global benchmarks for energy. In the US, crude oil trades as West Texas Intermediate (WTI) and globally it trades as London Brent. The sources for these two supplies vary, with WTI a domestic supply-base and Brent a global one. This chart shows the spread between the two:

We see pretty clearly how tight this spread has been over time, with Brent trading at a slight discount to WTI more often than not. Recently, this spread has surged, with Brent becoming far more expensive than WTI. Because the US has been an energy importer for so long, we don’t have the requisite infrastructure to export oil, and thus the excess supply created within the US has been driving down domestic prices, without changing the global balance of supply and demand.

Granted, some of this oil supply isn’t purely “domestic,” as it comes from Canada, it is however trapped on the North American continent. Meanwhile, along with the oil boom has come a natural gas boom. This has driven natural gas prices to multi-decade lows, and has created a powerful ripple effect through the economy. During this past election, one of the most manipulated and misunderstood discussions centered around energy, natural gas and coal. Our growing natural gas supplies are the primary reason why coal is in a state of decline. It is not due to any regulatory change:

Abundant supplies and low prices have led to a major shift in capital investment by utilities into producing more energy from natural gas. This makes sense in basic supply and demand. And it’s not just coal that’s suffering as an energy source. The boom in natural gas has hindered the development of alternative energies, and has further helped prevent the new nuclear power-plant development curtailed following the Japanese Earthquake fallout.

The surge in natural gas hasn’t just helped drive down utility energy production, it’s also helped lower the cost of manufacturing and refining in many industries. Natural gas is a key input in industries ranging from fertilizer production to mining to steel production.

Increasing natural gas use by industry has several important positive ripple effects for our economy. The lower cost of energy has been a major force behind making American manufacturing more competitive globally. In fact, while off-shoring was a topic in the presidential election, 2012 saw some major global manufacturers like General Electric and Boeing “re-shore” industry back to the US. It would be great to see re-shore enter the vernacular of economic punditry in the US, and our abundant supplies are proving to be an important catalyst.

We expect to see more such talk during 2013, and more investment in infrastructure through which the US will ultimately become a net exporter, rather than importer of energy in the years ahead. Capital investment in these areas should continue, and provide a beneficial ripple effect for the long-term US outlook.

Series 5: Technology’s technical woes

We are living in the technologicy age, yet for some reason, no sector in the stock market is more unloved than technology. In fact, industrials, perhaps due to the natural gas renaissance in America, are far more loved at the moment:

Source: Business Insider

Meanwhile, Apple the stock has been, and continues to be the only technology story that hits the mainstream media headlines. It’s a sexy story for many reasons, including the untimely passing of Steve Jobs, the company’s resurgence from the brink of extinction, and its status (or already former status) as the largest company by market cap in the world. Yet Apple is only part of the story.

The sorry state of technology is the story that brings this New Year commentary full circle from last year to this. We highlighted the multiple contraction in the broader stock market last year, and nowhere is this more stark than in the technology sector. Sure enough, that trend not only continued this year, it accelerated:

Tech once was a premium sector, with investors willing to pay above-market multiples for decades on-end due to its faster growth rates, and leaner capital requirements. Today, tech is valued just like any other sector, begging the question as to whether it is now nothing but a normal part of the economy (it is) requiring average market multiples (maybe so, maybe not). There are a few forces driving the multiple contraction in tech, two of which we think are pronounced and important: the remaining fallout from the dot.com bust, and the accelerating rates of disruption and obsolescence in and from technological advancement.
We saw this first force of a period of over-investment leading to under-investment in the real estate series above, and we see this second force, disruption, all the time in our everyday lives. Remember the Zach Morris cell phone? Remember your first cell phone? Are you even still using your first smartphone?

But technology is also becoming more normal, and many everyday companies are engaging in what were formerly technology’s core domains to enhance their own businesses. We see this with the internet’s growing share of the total retail market:

Perhaps one force behind tech becoming just another sector in the S&P is that the index itself is increasingly composed of technology companies:

And this is certainly true as well. But we think this effect has been enhanced by the decline of some former stalwarts of technology (like Hewlett-Packard, Dell and Intel) and is embodied by both the rise and fall of Apple this year. There are crucial subdivisions in technology which require varying perspectives, and at no time in history is the case more pronounced for reshuffling or even scrapping the “tech” sector designation altogether.
Hardware companies are prone to one of the most powerful economic forces—direct competition. When a period of disruptive innovation is recently passed (think the iPad), then in hardware in particular, profit margins come under attack as competitors are able to undercut price without asking the consumer to take a substantial hit in the quality and efficacy of the product. Over the long-run, technology hardware in particular has barely above-average returns on invested capital (ROIC):

Source: faculty.unlv.edu/phelan/MBA795/Lecture%202.ppt

Yet semiconductors as a tech-subsector have far better ROICs. We think these are two specific sub-divisions in tech that make sense. Computer software and services also enjoy great long-run returns, though labeling gets a bit difficult. For this reason, we would argue that the labels of some traditional technology companies need to be redefined outside of the tech sector altogether, for how is Amazon not a retailer who simply retails via technology, and Google a media company who advertises on the Web, rather than a tech company first? That is how these companies earn their revenues after all. If you see these companies redefined for their relevant sectors, it is clear that you can gain a better understanding of the returns investors should expect over the long-run.

Due to these technical forces driving the technology sector, we have continued our above-average allocation to the sector via high quality companies that have disrupted traditional industries, and in our opinion, should enjoy the benefits of the returns enjoyed by those traditional industries in larger scale. Further, we have added exposure into the semiconductor sector, while largely avoiding traditional hardware altogether, as it’s evident that semiconductor companies can earn higher ROICs over time for good reason.

On to 2013:

2012 has certainly been an interesting year. While 2011 saw decent earnings growth, the market was stagnant. In 2012, we saw decent appreciation in the market, but earnings growth was stagnant. While we can never know for sure what 2013 will bring, we do have a clearer picture of the powerful forces which will drive our economy moving forward.
2012 has been an exciting year of growth at RGA Investment Advisors, with the addition of Elliot Turner to the practice, and the continued development and refinement of our technology platform for our clients. We look forward to the continually evolving our practice for the benefit of all our clients, and to building a happy and prosperous future together.

We wish you and your families the very best in 2013. Thank you for your trust and confidence, and for selecting us to be your advisor of choice. Please call us directly to discuss this in more detail. You can reach Jason or Elliot directly at 516-665-7800. Alternatively, we’ve included our direct dial numbers below.

Wishing you and your family a happy and healthy New Year!

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director

Jason@rgaia.com Elliot Turner, Esq.
Managing Director

Past performance is not necessarily indicative of future results. The views expressed above are those of RGA Investment Advisors LLC (RGA). These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views. Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice. The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria. In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.

October 2012 Commentary: In the Wake of Hurricane Sandy

October 2012 Commentary
In the Wake of Hurricane Sandy

The Month of October

The month of October was as spooky a timeframe in markets as it was in real life. Often times, particularly in the financial industry, we conflate the general state of being and mood of society with the fluctuations in markets. While this month the two aligned for the negative, it’s important to maintain perspective and remember that markets, while important for financial planning purposes, mean little in the grand scheme of life. Family, friends and community are all of the utmost importance and instrumental in structuring our ways of life.

While our job is primarily to help navigate markets, we have spoken to several of you in the wake of Hurricane Sandy and are sorry to hear about the catastrophic damage in our region. Many of you live in the most affected of states, and we would like to offer our assistance in any way possible dealing with insurance claims, FEMA aid requests and whatever else might be needed in these challenging times. Please do not hesitate to give us a call.

How Financial Crises are Like Hurricanes

There are many parallels between the preparation for, arrival of, and devastation wrought by financial crises and hurricanes. Considering right now we are living in the wake of both, it’s worth discussing some of the common threads between the two and some important lessons learned which can actually be deployed in order to better prepare for inevitable problems, and to mitigate risks if/when they actually occur. Typically before each, there is little concern about the prospect of a problem, even when close calls do provide a wake up call.

As it turns out, we are psychologically geared in such a way that these close calls end up causing more damage. Why is this? By definition, a close call is a situation in which disaster was averted, albeit by a close margin. When this happens, in our human quest to develop explanatory narratives for the world around us, we focus far more on the comforting than the concerning. Let us relate this to two real life examples: one in the sphere of finance, the other in weather.

Long Term Capital Management Takes a Dive

In 1998, a top performing hedge fund called Long Term Capital Management (LTCM) led by an all-star team of investors, traders and economists, including two Nobel Laureates found themselves on the brink of collapse. The fund operated using complex strategies and considerable leverage, and focused on mean regression applying historical data to a variety of markets. LTCM had quickly gone from top performer to the brink of collapse, and worse yet, LTCM was so highly levered, so broadly situated across markets, and so intertwined with other financial institutions that its failure alone posed the real risk of bringing down our entire financial system with it.

Things at LTCM already took a turn for the worse before Russia defaulted, sending global markets into a tailspin. As a result, LTCM suffered over $4 billion of losses in less than 4 months. Here is a chart plotting LTCM’s performance from inception, through the Russia crisis aftermath:

For a far more thorough summation of the events surrounding LTCM’s collapse, we recommend reading Roger Lowenstein’s outstanding narrative that reads like a financial thrilled called When Genius Failed. For our purposes here however, we will focus on our interpretation of the misapplied lessons from 1998. LTCM itself represented the first major threat of a global financial collapse in a long time, and a short decade later, that threat of collapse became near-reality. In fact, it is particularly striking to us how in the aftermath of LTCM, the very risks that brought LTCM down multiplied throughout the financial system because people viewed the lack of collapse as proof of the system’s stability. The real causes behind LTCM’s failure, which were really quite simple, were overlooked in favor of more complex, narrative-driven explanations.

At the end of the day, conventional wisdom viewed the failure of LTCM as a case of overconfidence by some prestigious academics. Further, it viewed the Federal Reserve’s actions to simultaneously orchestrate the bailout of LTCM by the major players on Wall Street and flooding the system with liquidity as a “panacea” for deeper economic woes. In fact, in the wake of LTCM the financial sector pursued further integration and interconnectedness under the guise of “spreading risk” as a way to prevent fragility, while ramping up leverage due to the false confidence inspired by this newfound scale and diversification. In reality, LTCM was a preview of what was to come, whereby no substantially large market crisis could be “contained” (like subprime) when leverage and complex interconnections are involved. Especially when the players involved turned out to be far larger and even more intertwined than LTCM.

Uncertainty vs. Risk

Hurricane Irene last summer offered us a “preview” for Hurricane Sandy this year. Irene was nowhere near the size and scope of Sandy in the days leading up to landfall, yet while watching the news preceding Sandy’s arrival we saw far too many individuals say that they were “staying put at home, because last year Irene wasn’t that bad.” (Link) Even Mayor Bloomberg seemed reluctant to issue the evacuation order too early for fear of the “over preparedness” backlash slung by critics following Irene’s relatively mild impact. Some attributed the overreaction to purely political reasons following Bloomberg’s lack of preparedness in the wake of the 2011 blizzard, others called it “laughable” and proof that New Yorkers are no longer “tough as nails.” (Link)

The reactions to Irene and its impact on preparations for Sandy cut at an important distinction for both disaster preparation and financial markets, and are a theme which Michael Mauboussin of Legg Mason has been teaching for quite some time: uncertainty and risk are not interchangeable terms. Mauboussin described the distinction as follows in a 2006 paper entitled Interdisciplinary Perspectives on Risk (Link).

Risk describes a system where we don’t know the outcome, but we do know what the underlying probability distribution of outcomes looks like. So think of a roulette wheel—when the croupier spins the wheel, you don’t know where the ball will land, but you do know all the possibilities and their associated probabilities. Risk also incorporates the notion of harm—that is, you can lose.

In contrast, uncertainty reflects a situation where you don’t know the outcome, but you also don’t know what the distribution of the underlying systems looks like. Uncertainty also doesn’t necessarily imply harm, although it often does. So it’s not hard to see that most systems we deal with in the real world are really uncertain, not risky.

Hurricanes fall into this category of uncertainty. We have all too good an idea of what the damage inflicted by a hurricane would look like in our region (risk); however, we have a great deal of uncertainty as to if/when/how a hurricane would actually hit. It is under this cloud of uncertainty that our elected officials must make decisions on how aggressively to prepare for a disaster. Considering the level of risk to this region in the event of a hurricane making landfall (and let’s be clear, Sandy hit not as a hurricane, but as a tropical storm in New York), when a storm is actually barreling our way with even a mid-level probability of a direct hit, we should prepare as much as possible.

In finance, this lesson is little different. With LTCM we learned that one relatively small institution (relatively small in the grand scheme of things, though large in absolutely dollar value) had the potential to bring down our entire economic system. With ever-larger institutions, and increasing global ties, these risks were exacerbated tremendously. Yet, on the cusp of crisis, many economists and pundits alike took comfort in the size and diversification of these very institutions. We knew the risks (i.e. the damage that could be inflicted) of a large, interconnected financial institution on the system; however, we greatly misunderstood the uncertainties of the outcomes. It turns out that these risks were far more likely to come to fruition than we originally thought. Herein lies the danger of uncertainty.

Building up Crisis Immunity

A related consequence, and a theme which we have discussed at length in prior commentaries, is the way in which people respond to crises. People have a strong tendency to fear calamitous events far more in their aftermath than in the period leading up to them, despite the warning signs. In financial circles this is most clear with the abundance of those claiming the “next crisis” is right around the corner every step of the way, despite the fact that no one was concerned about crisis when one was in fact imminent. This asymmetry isn’t necessarily a bad thing, because this asymmetry itself is one of the strongest forces in helping to either prevent and/or mitigate the damage from the next problem.

Since 2008 we have had the opportunity to restructure our financial system such that it entails far less systemic risk, and we can see this clearly using the Federal Reserve’s St. Louis Fed Financial Stress indicator:

Notice the massive spike in 2008-09, and the continuing decline in the stress index of late despite increasingly loud and urgent words of alarm. This is so because the system has reacted constructively to the damage inflicted in the recent past. And this is despite the significant stresses placed on globally connected financial institutions by the Euro crisis—one that many caution has the potential to bring down our financial system here in the US.

We are optimistic that the response to Hurricane Sandy will be equally constructive in rebuilding our infrastructure in such a way that we are far less vulnerable to the next hurricane. Since forecasts by definition involve considerable uncertainty, the next one may be a year, a decade, or century away, but we know it will happen at some point. In the interest of sustainability, it’s worth preparing for this inevitability. Our problems can never go away entirely, but we can responsibly build our institutions and infrastructure in increasingly better ways so that when the next one does come, the risk will be far less. This is part of the fabric of democracy and capitalism: the lessons learned from the past become important bedrock foundations for a better tomorrow. We don’t just rebuild, we refine, optimize and strive ever-upwards.

Please call us directly to discuss this in more detail. You can reach Jason or Elliot directly at 516-665-7800. Alternatively, we’ve included our direct dial numbers below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director

Elliot Turner, Esq.
Managing Director

Past performance is not necessarily indicative of future results. The views expressed above are those of RGA Investment Advisors LLC (RGA). These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views. Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice. The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria. In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased

September 2012: Commentary Politics, QE, and more

September 2012 Commentary
Politics, QE, and more

The 3rd Quarter

The third quarter of 2012 could very well go down in history as a pivotal moment in both Western Democracy and economic theory. As the quarter draws to a close, the world is essentially in the test-tube phase of whether two grand 20th Century experiments inevitably will work. In one petri dish, you have the European Union moving closer towards a “United States of Europe” structure, and in the other you have the continued evolution of monetary policy and the role of a central bank. With both Europe and monetary policy, market participants had been waiting nearly five full years for an impactful and powerful end to the present dual crises. While neither party took what can be deemed a conclusive step towards ending crisis, both took what is far more substantial than a half-step towards resolving crisis.

As is so often true with historical events, there is a substantial amount of misinformation and a seemingly willful lack of understanding about the primary causes and effects driving the course of events. We will take a little time to expound on our understanding of where thing stand today, for it won’t be until we are all blessed with the benefit of hindsight that any clear linear narrative could emerge.

Last month we alluded to the short-termism that frames our political debates. This month we want to explicitly highlight how that effect is playing out, before delving deeper into the impact of the aforementioned historical events. We want to do this, because since we are in the middle of a heated presidential election season, even formerly unbiased investors and commentators are interpreting events through their political lens rather than their analytical. This is pervasively and frustratingly clear whether it be the deca-box screen on CNBC with ten pundits shouting out one-another, or in the business and finance sections of the Main Street news publications. Here is the proof:

This chart is the result of a poll that asks voters by party affiliation whether they are “hearing mostly bad news about the economy.” The gap is massive and clearly demonstrative of the impact of partisanship on interpreting the state of the economy. Our next chart to that end is a gauge of consumer confidence broken down by party affiliation. Those who follow markets, or have an interest in behavioral economics know that consumer confidence is a lagging indicator, which in theory should confirm a directional shift in the economy. Considering the influence of election season, we think it’s clear that today’s consumer confidence number is almost meaningless and reflects little more than the question: “is one a Democrat or Republican”

Now that we have effectively established a partisan tint to today’s economic analysis, let us offer some of our own interpretation on the historical events of the past quarter. In our commentaries throughout this year, we have continually referred to the European Crisis as a constitutional crisis. This stands in stark contrast to the mainstream interpretation of the European situation as an economic one, with a cause based in economics and a solution coming via economic reform. Considering the failed attempts at economic solutions to the crisis, we believe our thesis has been empirically confirmed by the course of events. Why and how this matters is an important point.

The European Union started as a common free trade zone in the aftermath of the devastation wrought by World War II. Powerful visionaries, through back channels, orchestrated the framework for a much tighter political union over the course of decades, using economic union as the means for implementation. Implementation happened gradually over the years, commencing with six countries in an alliance to trade coal and steel, and evolving to include 27 member nations, a common currency and central bank, and a supranational governing body. This evolution was no accident, yet the evolution had essentially stalled since the adoption of common currency.

Typically in this world, it requires a crisis in order to effect change. In periods of extended successes, the powers-that-be are lulled into a sense of complacency, during which many take victory laps for achieving a new plateau of prosperity. Those who had been lulled by success have now been shaken by crisis.

It’s become painfully clear that the euro currency works very well in the good times, but horribly wrong in the bad times. The nature of these flaws manifest themselves most clearly in the economic arena, thus leading to the misdiagnosis as an economic crisis. Yet in reality, these problems are the reflection of a flawed political design, lacking the requisite institutions to weather a storm. A common currency imposes a unified monetary policy on a region, however, such a structure factually cannot work without some kind of centralized mechanism to redistribute imbalances within the currency zone. The resistance to a redistributional mechanism is that any such means to redistribute would force certain political constituencies to cede concessions to others via a centralized fund-raising and budgeting body. We all need to be cognizant of the fact that this is a process, not an event, and as such will require a decent amount of time to “finish,” but we strongly believe it will inevitably get there. Importantly, during this past quarter, several substantial steps towards an end-game have been taken, and markets have reacted accordingly.

What QE is and is Not

As we all know by now, the Federal Reserve Bank recently announced their latest effort to stimulate the economy—the indefinite open-market purchase of $40 billion per month of mortgage backed securities (MBS) until the labor market improves. Sure enough, the commentary seen about QE has been grossly misleading and tinged with emotional and political bias. Some have asserted that QE3 itself is a political endeavor, some have insisted it will cause hyperinflation, others have said QE is creating a bubble in US Treasuries, and a few have declared it will do nothing whatsoever. Sadly, none of these proclamations are remotely close to the truth. Let’s do some mythbusting.

QE in reality has no influence on politics and no influence on the capacity of the US government to issue debt. This is important. Many have used QE as a launching point for declaring US Treasuries the “next” bubble, and again, this analysis could not be more wrong. In bubbles people are buying assets seriously detached from their intrinsic value, with the permanent impairment of capital (i.e. substantial losses) being the ultimate outcome. With Treasury bonds, while its possible (and in our opinion highly likely) that long-term Treasuries will not out-earn the pace of inflation, the odds of an impairment of capital are effectively nil. The distinction that we make here is between the permanent impairment of capital and an inadequate return. One situation is clearly far worse.

How does this tie into QE? The Federal Reserve Bank added a new wrinkle to this latest round of quantitative easing—in addition to expanding their balance sheet they have declared that such action will be done indefinitely, until the job market improves. This is akin to what some economists call nominal GDP (NGDP) targeting and in or opinion as professional investors and amateur economists is a bold, constructive, and historic event in central bank history. Think of the rate of change in NGDP as the rate of real GDP growth (or contraction) plus the rate of inflation. Therefore there are two ways to increase NGDP: either via higher growth or higher inflation (or a little bit of both). The implicit embrace of NGDP targeting is a statement by the Fed that they will accept a higher rate of inflation until the economy returns to its trend rate of growth. The following chart highlights the gap created by the Great Recession, also known as an “output gap”:

The blue line represents the long-term trend of US GDP growth that traces back centuries, and demonstrates where GDP would be today had we not entered the Great Recession and maintained trend. The red line shows us where GDP is actually at right now. Ever since the Great Depression we have had recessionary periods where the red line drops beneath the blueline; however, not since the Great Depression have we experienced a substantial output gap that does not close within the first couple years out of recession. What the Fed’s latest action says is that we will accept higher inflation in order to close that gap between the blue and red lines, and only then will the Fed focus on keeping inflation in check.

Let’s leave the debate aside as to whether nominal GDP growth ultimately translates to real GDP growth and talk about how this impacts your investment portfolios. The message is clearly that we all must accept higher levels of inflation, and in this context, we insist that the aim be to understand inflation rather than to fear it. We want to caution that higher inflation does not mean a repeat of the 1970s, and further, we want to make clear that the chances of hyperinflation are non-existent. These are two points we will elaborate on in the future, but for now, let us assert that the Fed has far more tools at its disposition to fight inflation than they do to prevent deflation.

As far as investments go, we believe there is one outstanding way to take advantage of the present economic landscape. Two of our purchases during the last quarter are most reflective of this—Walgreen Co. (WAG) and Siemens AG (SI). Both companies recently issued a blend of short, medium and long-term debt in order to fund different corporate initiatives. For Walgreen, the debt issue allowed the company to acquire Alliance-Boots, with a present cash flow yield over 9% at a long-term cost of capital of 3%. Walgreen very conservative balance sheet affords the chance to constructively take on more long-term debt in order to immediately benefit from a 6% arbitrage opportunity. This is a situation where even if Alliance-Boots’ impressive growth slows, and no synergies are realized, the company makes the spread in the capital structure arbitrage.
As for Siemens, the company similarly issued a blend of short, medium and long-term debt. Instead of making an external acquisition, Siemens will use the proceeds to buyback nearly 5% of their outstanding shares. Considering the companies weighted average cost of capital is well above ther cost of debt, this should drive down the cost of capital and greatly increase the value of their shares over time.

Many in the value investing camp believe that the macroeconomy is not all that important to investment analysis, but we would beg to differ. We believe it’s extremely important to both understand the prevailing forces driving the economy, and to be intimately familiar with the framework within which policymakers are operating. It’s not our job to ascertain the best policies in any given situation, but it is our job to anticipate the most likely course of action and its implications. Both Siemens and Walgreens highlight an area where the macro-catalysts (in the form of lower corporate debt interest rates) is driving increased value in an already attractive value investing opportunity. Beyond the investment front, we think it’s increasingly important to discuss these historic events as they unfold, because we are in an environment where media commentary is framed by the prevailing bias of the news source, rather than a serious interpretation of the consequences of policy initiative. As always, feel free to reach out to us if you would like to discuss these events in any more depth, as we welcome the opportunity to help further elaborate on our thoughts.

If you know of anyone who might benefit from our investment selections, please send them our way; we will be happy to extend them a free one-month trial subscription.
Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director

Elliot Turner, Esq.
Managing Director

August 2012 Commentary: Politics Are Short-Term, Focus Long-Term

August 2012 Commentary
Politics Are Short-Term, Focus Long-Term

August closed with equity markets spending 18 days in a tight consolidation—the S&P 500 spent most of those days with prices holding in a 1.5% range. For the month, the S&P added 2.5%, the Dow Jones Industrial Average tacked on 0.92% and the Russell 2000 climbed 3.5%. Notably, August saw substantially less volatility across global equity markets compared to the May through July period.

In both February and April of this year, we focused on the need for “digestion” after making large, volatile market moves. Once again, we believe this to be the prevailing near-term theme. What should now become immediately clear is after volatile periods, we tend to have periods of minimal volatility. We in the investment management business like to anthropomorphize markets, and this is true because markets often do have human-like characteristics.

People work exceptionally hard throughout the year, yet come August, we see many individuals take much-needed vacation time. It is during these down times that we set the stage for our next period of activity. Equity markets began this August with a continuation of the action that began in June—mainly a bounce-back rally from May’s decline—and ended with one of the longest streaks of apathy we have seen since the dawn of the Great Recession.

Along with digestion, there is one tangential and new theme we would like to highlight: lumpiness. Markets expend considerable energy in bursts around these periods of digestion. Not only do markets do this, but so too do stocks. Returns tend to occur in a very non-linear fashion over the short-to-mid-term time period. This sits in contrast to the many planners who draw hypothetical return scenarios which move neatly from the bottom left of a chart to the top right. The typical path moves in fits and starts, often for long stretches without any visible trend, before a powerful spurt moves the needle. The same came be said for the actual fundamental growth (or contraction) in the underlying earnings of equities.

This is a fact lost on many participants in, and observers of the financial industry. And it’s ever more true at the shorter time-frames. One of the foremost reasons we prefer long-term investment to short-term is that we can smooth out this lumpiness and mitigate what is referred to as “noise.” Operating over the long-term affords us the opportunity to focus on what we perceive to be only the most consequential of signals. It also allows us to focus more specifically on the trend of earnings in our core holdings, rather than monthly economic data, which correlates to intraday returns, but not long-term growth.
This highlights a key failing in the financial presses today. The pundits focus far more on heat maps and headlines than they do long-term trends, and strengths and weaknesses of actual businesses. In fact, there is very little focus on real businesses themselves, and even less a focus on the longer-term time-frames. This is one of the many reasons we prefer to focus on company-specific factors rather than broader economic ones. Note that this does not mean we forsake broader economic factors that drive our companies’ bottom lines. Instead it means we don’t make portfolio decisions based on guessing the direction of the economy, if/when there will be Federal Reserve Action, and we certainly do not hold positions solely on the basis of their placement in the broader economy.

Beware of the Macro Tourist and the Veiled Political Pundit:

There is a new phrase being slung around, and we couldn’t be happier to see it called out for what it is: macro tourism. Macro tourism is a term geared towards those investors who built long-term track records on the backs of prudent company-specific financial analysis, or arbitrage strategies, who now focus much attention (and risk capital) on broader economy-based trades. This macro tourism is both a cause and an effect of heightened market volatility and it poses significant dangers to investors. Economics is far more complex than the financial presses highlight and involve considerably deeper levels of understanding beyond purely the numerical analysis.

There are behavioral and social forces, and political processes which cannot be factorized by models like company-specific drivers are. Perhaps one of the largest causes of macro tourism today is the presence of a hotly contested political environment. Intense partisanship drives the desire to impose political beliefs on market facts. Which brings us to another point about both the state of the financial presses and investments today: beware of those with strong political opinions cited as the basis for an investment approach today. There are many examples of people attempting to pass political opinion for investment advice, and in this context it’s often hard to distinguish opinion from fact. We see this from those urging the indiscriminate selling of equities in order to avoid “imminently rising capital gains taxes” to those constantly harping about the “fiscal cliff.” It is no surprise that the rise of the political cooing happens as campaign season heats up, but it is frightening how little these harsh-sounding gripes truly dig into the economic realities of the situation.

Pursuing Long-term Value:

In times like these, with a heightened focus on the macro, we look for something specific and important in our portfolio companies. Our ideal company is one that we can buy today for its present earnings power value, with all the growth as a “free” option on top. There are a few terms here that require further definition. A company’s earnings power is the valuation of that business’ sustainable level of income. While sustainable income is typically a subjective metric, we have a great objective quantity to use in order to ascertain a worst-case-scenario income target—that objective numbers comes in the form of the Great Recession. As we all know, during this time period, company earnings were suppressed as the global economy went into tailspin-mode. The trough in earnings was the most severe since the Great Depression. We can use these numbers, with a look at five-year average earnings in order to confidently surmise a sustainable earnings power number.

Once we can comfortably quantify our sustainable earnings power value, we want to target the company’s stock at or near that price level, but preferably at a discount. When we buy a company at its earnings power value, we want to make sure that the company not only has been growing through the past, but has a reasonably high likelihood of continued growth. This insures that we will own at worst, a fairly valued company whose cash flow yield will justify its present valuation in order to generate a decent return for shareholders. Plus it leaves open the growth element to add incrementally on top of the bottom-line return.

A simpler way of stating this is we like to buy growing companies who are fairly valued based on today’s earnings and zero future growth. The reason we took the time to elaborate is that it’s an opportunity to provide a little more insight into how we think about investment situations, and to demonstrate that we approach this analysis as conservatively as possible in order to protect our downside, and put ourselves in position considerable upside. When things are bad, companies tend to be valued on their worst case scenario—typically the earnings power value sans growth for a “growth” company. Companies that are fairly valued based on their sustained earnings tend to have rapid revaluations when growth opportunities are reincorporated into a stock’s price.
And that takes us back our point about lumpiness from earlier in this letter. We aim to expose ourselves to one particular kind of lumpiness and that is the fairly valued business, priced for no growth, which gets “repriced” to once again reflect its growth prospects. When we see such companies, the change in price happens exceptionally fast and need not require a commensurate market move. It takes much patience waiting for the fairly valued business to work out the issues of perception that lead to an attractive valuation, but over long stretches of time it is an effective investment strategy through which to mitigate risk and gain exposure to superior returns.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director

Elliot Turner, Esq.
Managing Director

Past performance is not necessarily indicative of future results. The views expressed above are those of RGA Investment Advisors LLC (RGA). These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views. Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice. The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria. In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.

July 2012 Commentary: Bulls and Bears

The Month of July

The month of July saw the Bulls and Bears engaged in a brutal bout of tug-of-war on two crucial battlegrounds: the global macroeconomic and the US earnings landscapes. Each battleground saw neither side gain a crucial edge, although we believe there was a crucial qualifier that deserves attention. From April to May, expectations amongst analysts and investors alike took a beating. The prophets of doom and gloom (like Nouriel Roubini) once again plugged their microphones into the mainstream presses, leading to financial commentary with a decisively negative tone around the globe.

As of the end of July, according to a survey by analysts at Bank of America Merrill Lynch, strategists held the most decisively negative tone on equities in their recorded history, which goes back to 1985. This includes events like the 1987 Crash, the Savings and Loan Crisis, the Gulf War, the Dot.com bubble and bust, the Great Recession and the Flash Crash. Never has it been more negative than today, and that is something that we view as highly constructive.

There is a reason why we view such gloomy predictions through a contrarian lens: first off, contrarianism is well documented to work in capital markets over time, second, and perhaps most importantly is the role of markets generally speaking. Markets are a discounting mechanism. They are supposed to discount the known, and herein lies the essence of the efficient market theory (please note: we are not subscribers to the EMH, but we do acknowledge some of its merits). When all information is known and available, markets price things relatively fairly compared to their value (this statement cuts at the distinction between price and value, a very important distinction which we will elaborate on over time).

Whenever something is well known by market participants, understood, and foreseen, it will not move a market. For this reason, we have sayings like “it’s priced in” and happenings like “buy the rumor, sell the news.” What moves markets then? Well, it’s the unknown, it’s the unforeseen. This is precisely why today the doom and gloom is inescapable, whereas in 2007 economic pundits were slinging around terms like “the goldilocks economy?” In 2007, no one knew what was about to hit them. Today there are thousands of pontificators with well-articulated negatives.

Again, we reiterate that this is not to say that all is well in the global economy and that stocks can only go up. Rather, we are merely pointing out that known negatives are not the problem, it is the unknown negatives that keep us awake at night. Moreover, when expectations skew so strongly in one direction (i.e. the negative), it is only natural that the next surprising moment will swing the pendulum in the opposite direction of what the crowd expects. This is how it almost always works. Surprises, by and large, run counter to the general tone.

The Tug-of-War:

Let’s turn our attention on the battlefields of July. On the global macro front, we had one of the worst months on record of economic activity throughout much of Europe, including England, and persistent weakness in Asia, albeit with signs of improvement. Further, we had the U.S. economy itself show continued signs of deceleration, driven primarily by events from abroad. What does this all mean? Well things are about as bad as they can be on a global level. It’s as simple as that. And typically when things deteriorate like this globally, we get coordinated action from both governments and central banks. The problem at this juncture is that the Europeans are incapable of navigating through what we continue to describe as a Constitutional crisis.

The entire continent is handicapped by the fact that the bodies, which should have the capacity to counteract the pervasive weakness, simply don’t have the necessary authority to take action. Towards the end of the month, Mario Draghi, the President of the European Central Bank, through muttering a few words, sent global markets higher by more than 2%. And you know what they say: “actions speak louder than words.” One can simply deduce that with the capacity for action to back up his words, Draghi could reverse a serious coefficient of the problem that is plaguing Europe right now. Herein lies the predicament of the asset allocator: how much faith should be instilled in the European leaders to do the right thing at the end of the day? There are countless competing constituencies in Europe, and while U.S. politics are messy with just two competing parties, imagine a continent of competing countries with their own chaotically messy competing parties.

How does it ever end? We think the end looks a bit like the month of July. We are most likely not quite there yet in Europe, but what’s happening takes us substantially closer to the end game—cementing the “irreversibility of the Euro,” to borrow a phrase from Draghi. The end, in our opinion, involves the core countries (those that are relatively ok economically and low cost of government borrowing) joining in on the pain and this is happening on several levels. First, with the decline in the price of the Euro, the core countries are losing much of their purchasing power. Second, and most importantly, with the continued collapse of the periphery in Europe, the core countries are losing one of their primary sources of demand, thus driving the strongest economies into the ground with the bad. Once the strongest economies experience this pain, they realize precisely what is at stake, and are induced towards action. Inaction thus will be broken.

Looping into Earnings

This negative feedback loop rippling through the Eurozone has made its way to the US through two global channels. First is the obvious: Europeans do buy plenty of goods and services from the U.S. and there is a notable drag on earnings here both from the lack of demand, and from the falling value of the Euro. As the Euro moves lower, the value of U.S. exports declines apace, and this was one of the more cited reasons amongst U.S. companies for lackluster revenue growth.
The second substantial factor is Europe’s role in emerging markets. Europe is a major end market for China in particular, and further, European banks are some of the primary financiers to the emerging world. European banks are far more global than our American institutions and with market dislocations plaguing the Eurozone, banks are reigning in on their activities outside of their home domiciles. Some of this is pure risk management, while some is mandated action at the hand of concerned regulators. With Europe slumping, many of these emerging markets have stagnated in growth due to the drop in demand.

Meanwhile, earnings out of the domestic markets for US based companies remain fairly good. As we have been hammering home lately, the housing market has registered notable improvements in recent months, and this has a serious multiplier through the economy. Indicators ranging from home prices, to rail traffic paint a far more optimistic view of the U.S., and were it not for the global woes, earnings would look quite good hear. While the global woes are inescapable right now, such a drastic fall-off in economic activity leads to growing pent up demand for when activity reaches the right side of a trough. In the meantime, multinational firms have lagged the market immensely, but when pent up demand inevitably returns, there will be a slingshot effect that drives global earnings for U.S. multinational back upward.

Early in the recovery, U.S. manufacturing roared ahead, actually surpassing the pre-Great Recession peak, and emerging markets grew at a rapid pace, while housing continued to drag. Today that scenario is reversed, with housing starting to recover, while manufacturing and emerging markets cool off. Perhaps for once in this recovery from the Great Recession we can get all economic engines pointing in the same direction.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director

Elliot Turner, Esq.
Managing Director