Avoiding Safety as a Strategy?!
(Guest Commentary by Rick Konrad – November 18, 2010)
Dear Subscribers and Readers,
For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary. Rick has been a regular guest commentator for several years and offers his unique insights to us twice a month. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick highlights the futility of reading the “equity tea leaves” through macroeconomic analysis—citing a specific example of investors dumping US stocks because of woes in the Irish financial system. Rick also reminds us of the soundness of US corporate balance sheets—and that the US economy remains on the “cutting edge” relative to high-growth countries such as China and India. As I have mentioned in prior commentaries, I cannot agree more. Without further ado, following is Rick's biography:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “Being Optimistic Despite QE2” for his last commentary). Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years. A more complete profile of Rick is available on his blog. You can also email Rick at the following address if you have any questions or thoughts after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Rick has also run the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had graded CFA examinations.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
As I look back on this year, a few recollections really stand out.
My first observation is just how macro everyone's view has become, yet so few of us are equipped to discuss intelligently the current direction of the economy. I find myself very confused as to what it is, I should be rooting for.
About two years have passed since the world economy first felt the effects of the Great Recession. A significant part of the Federal Reserve's response in early 2009 was dramatic easing of monetary policy largely achieved by reducing short term rates to zero, and purchasing $300 billion dollars of Treasury securities and about $1.25 trillion in mortgage backed securities. These actions brought down long-term interest rates and stabilized the economy at a time when it was sliding rapidly into an abyss. Most importantly, these moves provided liquidity for an over-leveraged banking system.
Though much progress has been made, recent data leave little doubt that the economic recovery in the United States is anemic at best. There was much “Joy in Mudville” that accompanied the November jobs report released immediately following the mid-term elections. This showed a gain of 151,000 jobs. Though this release was undoubtedly much better than consensus expectations, against the background of an economy that must create 100,000 jobs a month just to stay even with the growth of the labor force, at the current pace, it would take more than a decade at this pace to reclaim the 7.5 million jobs lost in this recession.
It has become very clear that much of what we have learned from economic history really has little utility as a tool for what lies ahead. It seems that the experience of 2008 has changed everything, especially attitudes about risk.
Even as the FOMC ushered in QE2, fears of debasing the dollar and inviting inflation were on the minds of many economists at the Fed with apparently a great deal of dissent storming within those august minds.
The speed with which people's opinions of the world change also seems unprecedented. Whether it's too much data being displayed on too many screens, too many people glued to CNBC, this has become a live/die binary viewpoint.
Remember, in the first quarter of the year interest rates were backing up, the ten year Treasury went through 4%.(2.85% today but up from last month's 2.40%) Economists were cranking up GDP estimates. As a couple of quarters passed, as the economy was catching its breath, exactly what one would expect in most cycles, economists lost their nerve.
Fearing cataclysm, the Fed hit the alarm and pulled out the emergency kit, QE-2. In many ways, this seems entirely superfluous to me. Though many economists tend to heap praise on the Fed (remember when Greenspan could do no wrong,) as I look back, it seems that no organization is more married to the consensus than the Fed. Perhaps, they too are responding on too tight a feedback loop to the information that they “analyze.”
When I think about how the Fed collects its information, it frightens me. For example, pricing surveys are still conducted by sending staff out to stores to collect data. The Fed is still using methods that were perfected between 1960 and 1974 to put its finger on the pulse. Employment and production numbers are collected by companies and faxed to the Department of Commerce. Do you think most companies would be dedicating their best talent to filling out forms and faxing it into the government? If Sarbanes Oxley was applied to the Department of Commerce or the Fed, there would be a lot of economists detained for spreading falsehoods.
Though it may sound cavalier, when the Fed finally gets nervous, we as investors should be seeing confidence. When they are reaching for the emergency kit, it may well mean clear sailing ahead.
One of my clients called me in a bit of a panic this morning, concerned about the Irish banks and a potential bailout. Having no investments there, and a largely domestic equity portfolio, why should this be such a concern? Is there really much relevance in following the Irish debacles unfold? Should such events be a determinant of whether we will own equities in the US?
The lure of finding adventure and growth elsewhere seems to be on everyone's mind. Witness how investors have handled the equity rallies of the year:
As the chart indicates, emotionalism reigns. Investors are still chasing yield (though less so in the last few weeks) and safety. Many investors assuage their emotional concerns and fears by seeking securities that guarantee mediocrity.
The classic example, of course, was yields on TIPS going negative. Inflation became such an overblown fear that people were willing to pay almost any price for insurance.
Sadly, anyone who is willing to be completely risk averse in this period is becoming a willing victim to government's willful manipulation of the structure of interest rates.
Rather than putting savings in places where you provide liquidity for a 1% reward, it seems that we can deploy savings into a world economy that is still growing.
Though the last few years have belonged to the macro experts, and to the big picture hedgies, I suspect that the next few years will once again belong to the stock pickers.
The corporate sector has received a tremendous education over the last twenty years about restructuring and survival. It is no accident that the balance sheets of companies generally look far better than those of any other sector.
The consumer sector is still early in its restructuring. Government will restructure, no doubt because the bond vigilantes will force it, but clearly will be the last sector to learn its lesson.
As I look at investments that seem very vulnerable, I'd like to highlight the muni market. Back in 2009, Buffett expressed caution about relying on historical models for determining public finance defaults. So far this year (to August) there have been 60 defaults totaling $2 billion which seems like a trifling amount relative to the muni-bond market's size of $2.8 trillion.
Yet, it seems to me that the muni market is essentially a first derivative of the housing market. Put otherwise, it is the housing market writ large! When I read the information statements for many muni offerings or go through state budgets, well as one friend describes some state governance, “It's like Nigeria without the oil.”
In many ways, it seems to be the most illiquid market in the world. At least in 2008 and early 2009, if one wanted to get out of an equity, the stock market still functioned. The muni market in many ways represents a rather poor OTC market. Nobody is obliged to bid for anything.
The older the muni bond, the less likely it will be traded. Here is a very revealing chart from the Municipal Securities Rulemaking Board 2009 Factbook-link http://tinyurl.com/25kqq3b
Looking at this in tabular form:
I think it is quite revealing that for bonds which are 54-60 months into their “lives” , only about 3.4% of the issue's par value trades in that six month period. This is a market???
I think a key to decent investment performance over the next few years will be avoiding too much safety…too much lure in the low return asset classes.
Following most “normal” recessions, governments have two targets-a fiscal policy and a monetary policy that would jointly be sufficient to return the economy to full employment. But because of the severe credit crunch, which has been induced by the low state of confidence, such stimulus is not enough.
Though this country's problems are frequently depicted in sensationalist terms, we remain optimistic. Our resources are great. Our needs are great. Is it really rocket science for Americans to figure out how to match the two? We have the talent. What is lacking is political civility to cooperate on matters which benefit all and stop wrangling about matters on which we disagree.
We gain useful perspective from Council on Foreign Relations senior fellow Walter Russell Mead who wrote that “we are not like dozens of other countries who are struggling with the consequences of decades and even centuries of failures to keep up with a changing world. America's failures are the failures of a country on the cutting edge. Countries like China and India are doing some amazing things, but they are playing catch-up. They are trying to get where we are, while the United States is moving forward into unexplored terrain. They are building industrial societies; we are seeing what comes next.”
In many ways, we do seem to be at an important turning point for this country not unlike the end of the Depression and the period before the start of World War II. There is excess capacity galore with high unemployment, capital on the sidelines, and businesses operating well below capacity and potential. Rather than wringing our hands, it is time to roll up our sleeves.