Tactical Update

Here are a few good lessons.  Perhaps describing his oracle, from Warren Buffett in 1979, “The future is never clear,” and ”You pay a very high price for a cheery consensus.”  And from Frank Napolitano, the irascible head of the firm who bank rolled my trading career in 1996..”Dougie, always remember…Cash is King!”

If you’ve been following our weekly analysis, you’ve noticed that we’ve begun to question the ravenous risk appetite displayed in financial markets, an 11% S&P 500 rally since mid-November.  We are currently concerned that the price we see is reflective of “cheery consensus.”  And if this turns out to be true, it would sure be nice to have some cash on hand to pick up some bargains.

Let’s pause for an assessment.  Fiscally, both spending cuts and tax increases are still in the debate, as the delayed dawn of another debt ceiling approaches.  The government has already voted to take a higher percent of current income from some households plus direct more current income to the health care sector.   On the monetary side, we continue to have policy that is extremely accommodating.  This is neither comforting nor beneficial.  The fundamentals in the private sector of the economy show pockets of strength; but, on the whole, they are not inspiring.  Sentiment is extremely bullish accompanied by upside is momentum.

  • Monetary and Fiscal Policy:  At Alhambra, we like good growth.  Q4 S&P 500 reports show EPS growth of only about 4% on revenue growth of 2.3%.  Revenue growth of 2.3% in S&P 500 companies looks, to me,  a lot like “just inflation.”  As the government reduces its role in the economy, the Fed fills the void.  If Atlas steps aside, will the sky fall?  Bernanke has forced the market into an unfamiliar and uncomfortable place,  ZIRP.  We have flown below the horizon, real rates are negative.  The cost of money and the cost of capital are not just blurred they are intangible.  Risk, especially the probability for future volatility, is elevated.

As the government steps aside, will we still grow GDP?  The following graph shows construction spending since 2008 (red bar = private sector spending, blue bar = total spending).  The private sector has seen 20+% annual growth for the past 5 months.  But, the blue line is falling.  The government sector is taking a step back and more than offsetting the strength in the private sector.

The Fed’s balance sheet continues to grow, now over $3 tln.
  • The Real Economy:  The world feels awfully cheery to me right now, it is a nice feeling.  But, contemplating the recent rally in stocks and all the positive sentiment, we are caught wondering…could the media be, just as easily, writing stories of the US trying to script a “soft landing.”

Here are some trends to watch:

Yes, there was escalated growth post recession.  To a certain extent, this is the math of normalizing.  It is partially Keynesian stimulus (excessive spending by a government borrowing at cheap rates).  And, at some point mom and pop had to replace their mid 90′s gas guzzler and buy some new underwear, at least for the kids.

As the government steps away, there are signs of private sector strength.  Recent strength in private construction spending is a good sign as this industry has a vast reach in the economy.  Income is showing some signs of  improvement, but wage growth is still below inflation.

This week we sold some risk assets.  At the end of the day, this trade was much about sentiment.  Sentiment and market rallies can persist.  Admittedly, this rally may be in its infancy.  But our research shows empirical evidence that in the presence of extreme positive sentiment, markets tend to under perform mean return expectations at the short to medium term time horizon.  We would not refer to the current environment as mass euphoria, or irrational exuberance.  But, we would describe this as a small psychological bubble. Here are 2 of my favorite sentiment indicators.

We see an economy challenged by political and monetary decisions, both past and yet to come.  As a result, we see elevated future risks; especially from monetary policy which could be described as concerted experimentation, because “Yes we can.”

Investing can be a relative value game, but we also must step back and assess value for value’s sake.  Would you loan money to Russia, Turkey, Brazil and Croatia to make 3.4%?  This is the current SEC yld or essentially the Yield To Maturity of the portfolio of bonds in EMB, the most widely held emerging market bond ETF.  To put this in perspective, the yield on US 10 year treasury bonds was never this low from 1962 until 2003.

We took some money off the table during the election.  We unfortunately balked at adding risk during the post election ebb as cliff debates and other fiscal headwinds had us concerned and looking for a lower buy point.  And, this week we did a bit more selling.  Here are the portfolio moves made in discretionary accounts.

Global Bond – Sell Emerging Market Bonds add Short term European debt.  The primary motivation was to get out of EM bonds and lower duration (interest rate exposure).   Fed policy adds risk and we feel a dollar hedge in the bond portfolios was the prudent move.

World Allocation – Sell WOOD, EMB and 20% of the QQQ position.

Global Opportunities – Rebalance top performing stocks back to target weight, proceeds to cash.  These include Aflac, Amgen, Bank of New York, Celgene, and Dassault.

Select Countries: – Sell Brazil, Sell 20% of South Korean position, sell gains in Taiwan and rebalance to a slightly lower target.

As always I welcome your comments and my phone line is open for any questions or concerns.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Douglas R. Terry, CFA is reachable at: dterry@alhambrapartners.com

2 Responses to Tactical Update
  1. On macro-economic policy, the two levers have been pulled. We can debate the effectiveness until the cows come home, but I think everybody knows where professional economists with PhDs stand. Doing nothing wasn’t a serious option.

    Now the debate centers on pace at which we normalize policy. Namely, how fast we bring down the deficit as a percentage of GDP, and the speed at which the Fed unwinds its balance sheet. Both processes will take years, namely because the tax increases and spending cuts to balance the budget now would almost certainly send us well into negative growth territory, and the Fed can’t exactly sell trillions of dollars in securities in one month or even one year.

    The market is certainly being driven by sentiment, as evidenced by EUR run since August despite the bad fundamentals. Sterling is probably overvalued as well on a strictly fundamental basis. Sentiment is being driven by the dissipation of major tail risk. The Eurozone is not breaking up, and the US will muddle through its own fiscal nightmare. That said, we still are years away from 4 percent growth or 4.5 percent transitory unemployment.

    • On macro policy, I tend to agree, a bit begrudgingly. We have the means/wealth to do bailouts and monetize poor speculation (Capital Allocation), but that doesn’t erase the fact that we found ourselves in a regrettable position. I would think prevention/disincentives would have some place in the debate.

      I also caution on lumping PhD’s and professional economists into one camp and/or declaring the bailouts and monetizations unanimous. What of the path unchosen? What might our country look like in 100 years if there is a larger (market) penalty to those (banks) who were given certain privilege and used such to speculate or even prey. An alternative path may be more painful (politically undesirable) in the short run, but what of the long run?

      On normalizing policy… fact, someone is taking the loss for the misallocation of capital, speculation, malinvestment, boondoggles, shenanigans. It is merely a question of who, and over what time period. The government and the Fed are attempting to script slow losses over time (the new normal). We do have the liberty to say, “oops,” but that doesn’t make the situation desirable. What is $3trln? It’s a loan against the fact that we have fertile soil, natural resources, property rights, smart people, hard workers and a plethora of savings and capital investment. It is now a line item in the budget. It is a burden against income, past, present or future. The future generation doesn’t get a vote, so, of course, why not push the burden? We could very easily charge every resident $1000, raise taxes or sell something…do you think someone would pay $425,000/acre for Hawaii?

      I don’t care if the Fed never unwinds its balance sheet, I just never want a repeat of 2008. I want neither to set a poor example for future generations nor saddle the innocent generations with the burden of this indiscretion (greed).

      So what really matters? I am happy to run a $4trln deficit if you can prove to me that it is “worth it” or provides value. Are we subsidizing junk food and artificially sweetened soft drinks and then subsidizing the treatment of the resulting ailments? Should medicaid pay for multiple 3 or 4D ultrasounds, or certain treatments in seniors, while 19 year olds can’t afford college? Do sales matter for a company who has negative margins?

      The Euro…is the run really sentiment? If you did a poll, would a majority say I must own Euros? What about short covering? How about a stronger deposit base in the banking system? Structurally Europe has been exploring sounder solutions than the US. Euro banks would want a stronger currency, but the rest of the private sector and the government would not.

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