I admit to being an addict (groupie?) of the smartest investors out there. From following Buffett to Bill Gross to Marc Faber, I pay attention to the select best. This is the week that many year end hedge fund letters are being disseminated, and I try to read the good ones.
Given that this bull market is two years old, I question how much longer the party can continue. Recent troubling events in the Middle East have pushed oil prices up 27%, just since February 15th! Valuations aren't cheap, but on the plus side, the economy has shown strong manufacturing activity, employment is improving a little, and margins are back to all-time 2007 highs. The market is up 5% this year already. What are the smartest guys doing now?
So here is what I have read lately by different investors or market cognizants. These aren't journalists, these are people that "get it" in my opinion. My conclusions on what I am doing are at the end.
Stephanie Pomboy, MacroMavens
She is "dubious" about the strength and durability of the US recovery. Stimulus is going away, and higher food and energy costs are hurting the consumer. Specifically, she points out that wage income has gone up $111 Billion in the last 6 months, but food and energy costs are up $116BB. Next we'll have a wave of adjustable mortgage rate increases in April, because rates have been moving up. That will also hurt. Not to mention that basic fact that we are still barely creating any jobs in this economy.
QE is creating a bubble in commodities as the dollar continues to be debased by the Fed. The irony is that now that oil prices have skyrocketed, there is talk of negative impacts to the economy here. Which means MORE aggressive monetary policy to offset higher prices! This is an endless cycle that doesn't end well.
Another interesting point she makes is that high food inflation rates have been a huge contributor to instability in the Middle East. And because of this, countries from Brazil to China are now stockpiling food to avoid instability in their own countries. This is only further increasing demand for food, and driving food prices and inflation even higher. Eventually something has to give in this scenario, but until it does break, investors should rotate back into Emerging Market stocks, and out of the US. These countries have more ability to absorb higher prices than the developed world. And the US economic recovery is not nearly as durable as people believe.
Small caps have been on fire recently, and now she recommends selling or being underweight these names against large caps. Her list in order: own gold, Treasuries. Short XRT, a retail ETF, or other discretionary retail stocks.
Seth Klarman, Baupost Group
If you have never heard of Seth Klarman, just know that along with Joel Greenblatt in the 1990s he literally wrote the book on value investing. Baupost shows great patience in investing, chooses stocks better than anyone, and is happy to sit on piles of cash when markets are irrationally high.
His letter starts by discussing that the 2008 collapse was the beginning of the way an economy normally heals. That is, in the Great Depression, thrift, saving your money, living beneath your means became the philosophy of a generation. This lead to great wealth accumulation for decades after we had recovered. This time around however, in 2008 after the recession hit, the government saw consumer saving (and less spending) as "cataclysmic" and stepped in to continue our living beyond our means.
"The imagination of our financial leaders remains so shallow that their response to a crisis caused by overleverage and excess has been to recreate, as nearly as possible, the conditions that fomented it, as if the events of 2008 were a rogue wave of financial woe that can never recur. It is only in Fantasyland that the solution to vastly excessive debt is more debt and the answer to overconsumption is less saving and more spending. Worse still, we have yet to see a serious assessment by policymakers of the causes of the 2008 financial market and economic collapses so that we might take action to ward off a repeat performance. The government’s knee-jerk response to contraction was to prop up economic activity by any and every means possible; the hole in consumer activity had to be materially repaired on the government tab. While Treasury Secretary Timothy Geithner ingenuously professes a belief that the U.S. will never lose its AAA rating, Moody's recently warned that, absent a change, a downgrading could be just around the comer. Or, in the words of David Letterman, "I heard the U.S. debt may now lose its triple-A rating. And I said to myself, well who cares what the auto club thinks."
He goes on to point out that we may have a repeat of what happened to Greece and Ireland if we don't right the ship soon.
He finishes his diatribe by pointing out that investment success is dependant on a number of factors: focusing on the long term, making informed decisions, asking the right questions, etc. Seth points out that the markets in late 2008 offered extremely attractive prices, but by late 2010, he sees "froth" having returned to the markets. I like his last two paragraphs:
Most investors take comfort from calm, steadily rising markets; roiling markets can drive investor panic. But these conventional reactions are inverted. When all feels calm and prices surge, the markets may feel safe; but, in fact, they are dangerous because few investors are focusing on risk. When one feels in the pit of one's stomach the fear that accompanies plunging market prices, risk-taking becomes considerably less risky, because risk is often priced into an asset's lower market valuation. Investment success requires standing apart from the frenzy – the short-term, relative performance game played by most investors.
The bond king writes that Quantitative Easing, QE's I and II, have been successful in artificially lowering interest rates, pumping up the stock market, forcing money out of negative real interest rate money market accounts and into riskier assets. The problem is, he believes that our QE program doesn't heal an ailing economy, merely covers up the pain temporarily. And, what are we going to do once QE II ends this June? Who will buy US treasuries? He writes:
"What an unbiased observer must admit is that most of the publically issued $9 trillion of Treasury notes and bonds are now in the hands of foreign sovereigns and the Fed (60%) while private market investors such as bond funds, insurance companies and banks are in the (40%) minority. More striking, however, is the evidence in Chart 2 which points out that nearly 70% of the annualized issuance since the beginning of QE II has been purchased by the Fed, with the balance absorbed by those old standbys – the Chinese, Japanese and other reserve surplus sovereigns. Basically, the recent game plan is as simple as the Ohio State Buckeyes’ “three yards and a cloud of dust” in the 1960s. When applied to the Treasury market it translates to this: The Treasury issues bonds and the Fed buys them. What could be simpler, and who’s to worry? This Sammy Scheme as I’ve described it in recent Outlooks is as foolproof as Ponzi and Madoff until… until… well, until it isn’t. Because like at the end of a typical chain letter, the legitimate corollary question is – Who will buy Treasuries when the Fed doesn’t?"
As a counter, one would argue (and I would partially agree) that the U.S. and indeed developed global economies must keep yields artificially low for some time if post Lehman healing is to take place. But that of course is the point. By eliminating QE II, the Fed would be ripping a Band-Aid off a partially healed scab. Ouch! 25 basis point policy rates for an “extended period of time” may not be enough to entice arbitrage Treasury buyers, nor bond fund asset allocators to reenter a Treasury market at today’s artificially low yields. Yields may have to go higher, maybe even much higher to attract buying interest.
Investors should view June 30th, 2011 not as political historians view November 11th, 1918 (Armistice Day – a day of reconciliation and healing) but more like June 6th, 1944 (D-Day – a day fraught with hope for victory, but fueled with immediate uncertainty and fear as to what would happen in the short term). Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets.
Marc Faber, Gloom, Boom & Doom
Faber starts off by writing that it is more likely that tensions in the Middle East will increase than decrease. It could easily spread to other oil producing countries such as Iran, Saudi Arabia, Nigeria, Angola and Venezuela. "If this nightmare scenario were about to unfold oil prices could really spike up."
He explains also that Walmart's stock has been suffering lately as consumers perhaps are pinched by high oil prices. It really though a stock that's a proxy for the US economy, and lampoons the statistics published by the US government as propaganda put out by the "Ministry of Truth."
However, it's not just the US that is force feeding easy money on its populace. His list of countries that are holding interest rates at sub-inflationary levels (ie negative real interest rates) is long:
Faber doesn't think that these countries will lift short term rates above inflation rates. Meaning more price increases and inflation. And if China or the Global Economy begins to weaken, it is likely they lower rates to stimulate growth. Either way, money supply growth will remain high under any scenario. He has chart after chart of money supply growth in Japan, India, China. They all look like the price chart of gold, which he then goes to discuss at length. (I wont rehash here, but needless to say he's bullish). However, he does believe that both gold and silver will correct here, and also recommends the gradual accumulation of both. "As I have said before, I am stilll a buyer and I shall never sell any gold as long as we have powerful fools running our central banks."
He generally thinks EM stocks are a better value now than US stocks, given the recent outperformance in the US. Overall, EM stocks are now trading at just under 12x earnings, with Russia at the low end at 7x earnings. He recented tauted Russia on CNBC as one where he thinks the market will bounce by 10%. Other countries to consider where dividend yields exceed cash & bond yields: Singapore, Thailand, Malaysia, Hong Kong, and Japan.
Regarding financial stocks in the US, he notes that insider selling is enormous. The ratio of shares sold in 2010 to shares purchased was 855:1. Wow!
Overall, Faber is postponing increasing exposure, believing that ALL asset markets could be due for a correction. Seasonally its a strong period, until late April, but if the S&P has failed to make a new high, then its likely markets have formed a significant top. Look to short RTH, retail holders ETF with a stop loss of $110. (It's at $105 today).
John wrote a great piece on the delusion of crowds. First he points out that voters in the US believe that the budget problems here can be fixed by eliminating waste & fraud, and that they also wrongly believe that the government spends more on defense & foreign aid than Medicare and Social Security. (These last 2 account for almost 50% of spending today with interest, going to over 100% in 20 years). Congress right now attempting to wring $61BB in savings is ridiculous, our budget deficit is $1.6 Trillion! Yet voters believe this $61BB is meaningful.
He highlights also that stock market performance isn't really correlated with economic performance. (great, that sends me back to the drawing board.). Growth leads to higher inflation, and tighter central bank liquidity. Which is bad for markets. So, while the economic cycle seems good right now, he points out that oil spikes almost always lead to recessions. The chart below shows high oil, almost always followed by a shaded region, meaning recession.
He quotes his freind,
“Here [in the charts below] is PMI vs. Dow 1966-1982 and 2000-today. Also, what worries me is that corporate profit margins are approaching pre-2007-crisis highs (see the third chart). A small slowdown in the economy, or just stagnation, will send profit margins down. Hopefully this helps. Also, as you normalize PEs for high profit margins (i.e., look at 10-year trailing PEs), the market is trading 30%+ above average PE – secular bull markets just don’t start at these types of valuations. In addition, the market did not spend enough time at below-average PE for this move to be the new secular bull market (in the 1966-1982 sideways market, PE was below-average half the time)."
He believes that stocks are priced to perfection today, in an imperfect world. The problem also is that we are not in the midst of a normal cycle, but a debt supercycle. This will inevitably lead to a correction in the market. Here is his post:
That is a lot to digest, but generally feels bearish. We might run til June when QE II expires, that has been my expectation for this year. Barron's points out that the 3rd year of a bull market returns an average of 3.4%. Not terribly exciting. I am taking today's up market to book some profits. I am taking off Ameritrade. I swapped some Wintergreen (WGRNX) for some Berkshire Hathaway last week, but am selling more Wintergreen still. Its my biggest position, even after I reduce it by 35%. I also added a little BP recently. I don't know the name terribly well I admit, but am going on the Ready, Shoot, Aim method of investing for now. I don't want to be completely out of oil if it does spike even more.
Finally I did buy some RBL a week ago. Its an ETF of Russian equities, and 57% of the ETF is long energy names (mostly Gazprom, and Lukoil). Its moved up 8% since I bought it, I don't necessarily recommend it here. But on a pullback it's probably worth adding a little. I sold NEM today, it's suffering from weak guidance reported on its call. I question now whether gold miners will work in an inflationary world. They are inherently short oil, and NEM is seeing $100 per ounce increases to its costs in 2011 compared to last year. I don't want to be short oil when its spiking. Long term there is no position to take except to be long it. I'll keep my GLD and my physical. Make sure you have 10% of your portfolio in gold and oil, because, as Seth Klarman points out, you cannot ignore the macro picture, you have to insure yourself against hyper-inflation risk and currency debasement risk.
I will sit on more cash for now, and hopefully wait for the market to stop throwing 90 mile an hour fastballs right down the pike.