Portfolio Update - 04/30/08
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Dear Clients,
The following is my Performance Update and Outlook for April. All prices and returns are as of 4/30/08.
The last two months have not been kind to my model portfolios but we are still well ahead of all the equity and bond market averages for the year. Even though the recent activity in your account might be discouraging, I am growing increasingly confident in my long-term strategy and the opportunities for your portfolio. While the current trends could last a little while longer, by Q3 I should be generating returns similar to those we realized in the first part of the year.
The fundamental case for my strategy is stronger than ever. I can’t find any evidence that the economy is improving or that inflation is cooling which are the trends I’m seeking to capitalize on. Stagflation, a unique economic condition that only occurs every several decades, will prevail as long as the Fed can keep the credit markets from crashing – a scenario far worse than what I’m expecting. We are currently experiencing a bear market rally in stocks and a bull market correction in commodities (except energy) but these trends should reverse themselves within the next couple of months. I think we are far closer to the end of the countertrend than the beginning.
The following essentially describes the action in your accounts over the past 15 months. Last year, every asset class (bonds, equities and commodities) was highly correlated which is not the historical norm. I’ve mentioned on numerous occasions over the past year that the historical correlations would be reestablished and now it is finally taking place. Furthermore, I have stated that the normal correlations between these assets classes must be reestablished for my strategy to truly provide significant returns.
Since every asset class was correlated for the first 10-11 months of last year, my long/short strategy was not very volatile as my long and short positions worked against each other. If my long positions appreciated, then my shorts fell and visa-versa. We made money on the margin but that was about it.
Starting in Q4 of last year, the commodity markets, specifically the Precious Metals (PMs), began decoupling from equities. While this decoupling took place, my long/short strategy became far more volatile as my long and short positions started moving in lockstep with one another. From December ’07 through February ’08, everything in the portfolio made money as equity prices fell. Conversely, equity prices started rising in mid-March and all of my positions started to fall in unison. The net result is still a fairly nice gain YTD but far from where we were at a couple of months ago.
I went through a similar rough patch in Q2 of last year but I stuck to the fundamentals and we outperformed the market handsomely in the second half of the year. I believe that the second half this year will be even better as we’ll make money both in falling equities and rising commodities rather than just on the margin as we did in ’07.
Here is how my performance measured up to the averages for the first four months of 2008:
| PORTFOLIO | ||
| The MAC’s Core Portfolio | ||
| The MAC’s Focus Portfolio | ||
| S&P 500 (VFINX) | ||
| NASDAQ 100 (QQQQ) | ||
| Benchmark |
As I said in the Introduction, everything went our way in January and February and practically everything went against my strategy in March and April. I did foresee the countertrend emerging so I liquidated some of our positions which served to partially mute the impact of the current countertrend. Unfortunately, I didn’t think the reversal would be so severe nor did I think the decoupling between the PMs and equities would be so significant. In addition to these errors in judgment, I added some equity exposure to uranium stocks that have historically rallied with other equities but failed to so this time around.
Although these same uranium shares have made us some money in the past, they fell precipitously over the past month. I “stepped into” these positions which served to average down your costs, but the losses in these shares still shaved 3% off our YTD gains. I’m still long-term bullish on this space for all the reasons I outlined in my recent Quarterly written update, but I fully admit it was a mistake to buy into these shares at this point. I will be adding to this space eventually but not until the technical strength for these shares improve.
My feelings from February were certainly validated as everything we were invested in plunged the next two months. But just as frustrated and pessimistic as I was in February, I am now equally encouraged and optimistic. While the current equity bounce and commodity correction may have a bit to go, they are both long in the tooth.
I’m encouraged because the fundamental case for my Stagflation strategy continues to improve. The economic data continues to be miserable while inflation pressures continue to heat up. In Q2 of ’07, inflation cooled off, so once we hit August of this year, YOY inflation data will not be easily ignored by Wall Street.
The current activity in your account is a necessary step to bigger gains in the future as equities and PMs had to decouple at some point. I wish the pullback in your account value was not so severe, but I knew that it would come at some point, which is why I was so nervous in February. Now that it is nearly over, we can look forward to some very exciting returns over the next few quarters.
One of the four pillars of my investment philosophy is to invest in assets that truly fill a legitimate need. There is a legitimate need for the real assets (i.e. commodities) that dominate your portfolio. Foreign central banks and SIVs have a real need for an alternative to fiat currencies, specifically the US$, and Gold and Silver offer the best alternative. The emerging middle class in developing countries are going to change their eating habits and the need for foodstuffs will be tremendous.
Conversely, the markets are learning that nobody needs the junk that banks have been producing over the past few years, mainly securitized debt. US consumers and companies are already so overburden with debt, there will be little need for banking services going forward. Being long non-cyclical commodities and short financials is still a solid fundamental play. Furthermore, the fundamental case for the other themes I’m focusing on, such as the falling US$ and alternative energy plays, are continuing to build.
In the next month or two, equities may continue to rally. Marc Faber has called for the rally in the S&P to end between 1400 and 1450. I am inclined to agree with him and would not be discouraged to see it go even a little higher. Thus far, the similarities between the current market and 1973 and 1937 are undeniable. These equity bear markets saw rallies of 11% and 14% after the initial sell-off which would put the S&P between 1413 and 1451. (This is not a call, just a point of reference.)
Here are several fundamental and technical reasons why the market rally will exhaust itself at some point in Q2.
Technical…
- Despite stable breadth, leadership is not giving us a bullish signal. Leadership has improved as should be expected during a rally, but only marginally, which is not what we should expect of a healthy bull market in equities. On May 1, the NASDAQ saw more 52 week lows than highs despite rallying nearly 3% and closing at its highest level since early January. The number of 52 week highs on the NYSE barely surpassed the new lows. This is not a technically strong rally.
- The relative strength in bonds is weak meaning bonds should begin depreciating resulting in increasing yields. This development is the lynchpin in my Stagflation strategy. I’ve been saying for some time, that in order for your account to appreciate substantially, we need to see bonds and equities fall in unison. (For more about this subject, please read Part IV of my January 2008 Update.)
- Commodities are severely oversold and will be entering a seasonally strong period in Q3. Now that commodities and equities have decoupled, commodity strength should result in equity weakness.
Fundamental…
It would be impossible to hit on all the fundamental issues pointing to further weakness in equities but I’ll touch on the big ones.
- Bankruptcies: Eight mid-sized retailers have claimed bankruptcy in the last 6 months. Four airlines declared bankruptcy in April alone!
- Consumer sentiment and confidence continue to tumble and are currently at multi-decade lows. We have not had a consumer led recession since the early 90’s but it is looking increasingly likely that consumers, who are responsible for 70% of our economy, are starting to throw in the towel. A very disturbing trend that I am noticing is several of my young clients are liquidating their IRA’s to fund everyday living expenses. These are not young adults who have lost their jobs or have experienced unexpected expenses such as medical emergencies and such. They just can’t pay the bills because their bills are going up. People aren’t making big sacrifices yet, but they will be soon as necessities such as food and energy consume more and more of their paycheck.
- Commodity Inflation: Over the last decade, commodity indexes have underperformed in Q2 and this year is proving no different with the exception of the energy space. Since 1999, the average change in the CRB index in Q2 is 0%, but averages a 3% gain in the other quarters. Last year, the CRB index fell in Q2, which reduced the pressure on PPI. Since July of last year, commodity inflation has been red hot. Once last year’s Q2 figures are cleared out of the inflation calculations, YOY inflation data will be excessive.
- Fed policy changes: The Fed pulled all sorts of tricks, some legal and some illegal according to former Fed Chairman Volker, to support the banks. Without that support, credit markets might have collapsed. A lot of the new lending facilities and notes will be coming due starting in Q3. When these issues are revisited and investors realize they didn’t magically go away, financials are likely to sell off and lead the market down again.
- Earnings: Earnings this quarter were absolutely terrible. The P/E for the S&P 500 is now over 23 - the most expensive equities have ever been with the exception of the 2000 tech bubble! Banks, airlines, retailers all reported significant if not massive losses. The market ignored much of the bad news for a couple of reasons. First, they perceived it as “baked in the cake”. Second, a lot of the losses were chalked up to “one-time items”.
One-time items is a little accounting trick I learned about back in my days at Arthur Andersen. Companies would defer taking a write down if they were going to make their numbers. Then when a quarter came around where they weren’t going to make their numbers, they would take all their write-downs at once. There are all sorts of tricks that can be played with financial reports and they should rarely be trusted. (BTW, after serving on an audit of an Oil and Gas client who was planning on doing just what I described, I resigned shortly thereafter.)
The market hasn’t priced in two consecutive quarters of abysmal earnings. The market can easily shake off a one-time event but when the data is reconfirmed a second time, it tends to take notice. For example, the market largely ignored the initial warning signs of a credit crunch last spring when a couple of hedge funds required emergency funding. It wasn’t until the meltdown in a couple of Bear Sterns’ funds in July that the market actually took notice.
Financial earnings were responsible for over 40% of our economy’s total earnings. These earnings don’t exist any more and there are limited means of replacing them. (BTW, government spending is ultimately responsible for a lot of the rest, so without banks and government, our economy is practically running in place.)
- Housing: The housing market is showing no signs of bottoming. Rather the depression in housing is seemingly growing and while some areas maybe protected from the malaise, far more areas will be hit by the housing downturn than will be protected from it. Despite the decade lows in housing sales and the all-time highs in home inventories, builders are still building more homes than they are selling, which is not sustainable. Eventually, homebuilding will slow even further causing more strain on our economy. Considering that over $650B of Adjustable Rate Mortgages will be resetting in the balance of 2008, repos and mortgage defaults are sure to increase.
When two of my favorite analysts address the same issue simultaneously I tend to take it under advisement. Both Marc Faber and Antal E. Fekete recently commentated on the relationship between Debt and GDP and I think it’s a very important wildcard that needs to be followed (and a very scary one).
The question is: Will an increase in debt provide an increase in the GDP? And why is this important? Very simply, if additional debt does not contribute to GDP, then all of the Fed’s actions are not only futile but in a high inflation environment, they will inevitably cause even more harm. The mantra “Don’t fight the Fed” is based on the idea that the Fed can magically increase the GDP by simply lowering borrowing costs which leads to more debt. But if increasing the amount of debt doesn’t result in a boost in GDP, then the Fed is impotent, an idea that I’ve touched on in several of my previous updates. (The term most often used to describe this phenomenon is that “ the Fed is pushing on a string.” )
Faber says, “Recoveries from other financial crises in the post WWII period have worked because they have reignited the growth in private borrowing.” In other words, The Fed created debt and that stimulated GDP. In the early 70’s, before Nixon nixed the Gold standard, a $1 increase in debt resulted in $3 of additional GDP. (Source: Fekete) Ever since the Gold Standard was overturned, the debt-to-GDP ratio has consistently declined. According to Fekete, “[The debt-to-GDP ratio] went negative in 2006, forecasting the financial crisis that broke a year later.”
If the debt-to-GDP ratio is truly negative (or at least zero), then this plays perfectly into my Stagflation theme. Increasing debt inevitably leads to inflation but according to Faber and Fekete, it may not boost GDP. (Technically, increasing debt increases the money supply which is the true definition of inflation, but in today’s political environment, inflation is commonly known as an increase in prices.) The end result would be Stagflation at best.
The reason why I fear this outcome is that it passes my “Irony Test”. Wouldn’t it be ironic if just when every last soul on Wall Street believes that the “omnipotent” Fed can bail the economy out by increasing debt, the Fed loses it’s ability to do just that.
The only time that the Fed significantly cut rates in the last 40 years and the stock market still fell was the most recent bear market in 2000. Couple that knowledge with the current equity market weakness in spite of unprecedented Fed actions and this provides some level of empirical evidence to support the thesis that Faber and Fekete have argued.
12 months ago, Wall Street was clamoring about a “Goldilock’s Economy”. Not too hot to stoke inflation but not to cool to cause recession. Now, we all know the story of “Goldilocks” was nothing more than fiction. Regardless of what was said by the financial media and our government, I maintained that we would see stagflation which now looks highly probable. Currently, Wall Street is making the case for a mild recession and not stagflation and unfortunately they have it wrong yet again. A recession maybe priced into the market, but you have to look no further than bond yields to know that Stagflation isn’t.
We need to understand that Wall Street and the US Government are living off of inflation; in fact, they are profiting from it. They will be the last ones to acknowledge it or do anything about it because it is not in their best interest to do anything about it.
The government is running up huge deficits estimated to be over $500B in 2008 alone (which is $1,786 per every living man, woman and child in America). Those deficits must be funded and there are only two ways to fund them – taxes and/or inflation. Debt is nothing more than deferred taxes and inflation. Since nobody likes raising taxes, inflation is the only other option – and possibly the least painful as much of the burden is exported to foreign investors. Wall Street makes a mint off the debt issued by the federal government, not to mention the commissions and fees off of nominal appreciating assets. (For a telling snapshot of the debt/money being injected into the system, click on this link to view a graph of the Discount Window Borrowings from the St. Louis Fed’s website.
Current market action can be chalked up to the commonly held notion that you “Don’t fight the Fed”. But as I said above, the Fed is growing increasingly impotent. In numerous interviews, legendary investor Jim Rogers has advised people to, “Short Bernanke” [Chairman of the Federal Reserve] and he might just be proven right.
Please, do not be discouraged by the recent pullback in your portfolio. This is a snap-back rally in equities and corresponding correction in commodities. This was a necessary step in the process that I’ve acknowledged for some time. I just wish it wasn’t so severe. I’ll admit that mistakes I have made over the past couple of months have contributed to the severity of your account’s losses in March and April, but I have still beat the market soundly YTD and last year I generated returns significantly above average. You can never bat 1.000 in the markets but I’ll continue do my best to beat the averages. I’m confident that as long as I stick with fundamentals and factor in technical indicators, we’ll do well. I should have you back on track by mid to late summer.
Within the next few months, the S&P will be back in the 1270 – 1300 range. At that point, if I’m wrong about Stagflation, the market will show technical strength and a new bull market will be born. If that is the case, hopefully, I will have the wisdom to acknowledge the strength in equities and we’ll buy shares cheaper than we sold them a couple of years ago.
If I’m right about Stagflation, the market will pause for a bit in that range and continue lower. If it follows the lead of ’73 and ’37, equities will fall precipitously for several months before gaining some traction.
As always, please call me if you have any questions or concerns about your account.
Matt
