Sunday, March 14, 2010

A Rainy Weekend or
a Prerequisite to a Future Bloom?

The continuous rain in the eastern part of the US is for many the number one topic in conversations. We have no doubt that it will stop, and at some point we will see a seasonal bloom in flowers and other crops. As is the wont of many investment market participants, I look at the rain as a metaphor for the market and search for the potential future blooms.

Are we just getting wet or are we “All Wet?”

Almost precisely one year ago the stock market indexes hit bottom. Prices recovered through most of the remaining nine months. Since the beginning of 2010, there has been the feeling that the market has been flat; either awaiting a potential Autumn sell-off or, discounting stronger economic and possibly financial results in 2011 and 2012, resuming the upward momentum.

Just because the market is not putting double digit returns in people’s portfolios does not mean that we are lacking progress. In the year to March 11th, 2010, the average US Diversified Equity mutual fund gained +4.53%, not bad compared with the average fifteen year gain to the same date of +7.55%. While I believe one should not annualize the current rate of gain, it could suggest an approximate 20% gain for the current calendar year. Cut that specious rate in half, and the growth in the value of equities would meet almost all the goals that have been set for various defined benefit plans and most tax exempt institutions’ spending requirements.

The Present Need for an Umbrella

Some economists believe that market valuations are related to the replacement value of the assets on corporate balance sheets, or the Tobin equity quotient. Historically this ratio averages about 65%, due to under-reported depreciation. Some believe that the current 10-year cyclically adjusted P/E ratio, known as CAPE, which is now approximately 100%, is worrisome. The significance of this belief is that it casts doubt on a wave of acquisitions intended to buy cheaper assets than replacing them with new equipment. (I view most large scale acquisitions as being driven by the calculus that for the acquirer it is cheaper to buy a new opportunity in the way of talented people, new products, enhanced market share or denying these to a competitor. Thus, I see market prices rising with the announcements of new acquisitions, particularly those for cash.)

The next rain cloud we are facing is the data showing an increase in the saving rate, or more importantly, a decline in the rate of spending. While this does have a short term impact on decreasing various demand levels, it has two positive impacts. First, with more equity on the part of borrowers there is less likelihood of failed debt. Second, and in the long run more significant, is that with the pay-down of present debt, which is counted as savings, more money will be available for investment through financial institutions in terms of loans and eventually in various forms of equity. From an economic view point there is a higher multiple on lending and investment than consumption.

The biggest storm cloud on the horizon is the recognition of sovereign debt problems. While the world was focusing on the problems of Greece, they should have been looking at the excessive use of derivatives by Italian local governments who are going to court to try to avoid repaying the various global banks the money they owe on derivative transactions undertaken for numerous years. The sovereign debt time bomb is ticking throughout the G-20 countries, where debt to GDP, on average, is over 100% and could approach 120% by 2015. One should point to the growing strength in the twenty largest emerging markets, where debt ratios are around 40%. If this rain squall does hit, domestic interest rates are likely to spike even above the US government inflation and legislative-induced interest rates.

What is going to bloom and when?

As a believer in examining popular views for opportunities to correctly bet against the consensus, my eyes fell on the Diversified Leverage funds. The performance of this group of funds that use leverage either through borrowing or the use of derivatives, on the year through March 11th is +9.59%, or more than twice the aforementioned average US Diversified Equity mutual fund gain of +4.53%. While there are only 51 of these funds, they are similar to an unknown number of hedge funds. (The selection of winning hedge funds is, if anything, even more difficult than picking winning mutual fund portfolios.) Numerous hedge funds style themselves as market-neutral vehicles. If they parallel themselves to equity market-neutral funds, they are up only +1.1% for the time period above. There are very few Dedicated Short Bias mutual funds, with the average showing a negative -7.51%. Shorting successfully is a difficult art form for both mutual funds and hedge funds that we know. All of these performance citations suggest a contrarian bet: to now explore increasing one’s exposure to leverage !!! (All of the performance data is derived from Lipper, Inc. my old firm.)

The contrarian’s view

What else does looking at mutual funds with a contrarian eye suggest? One of the reasons that I expect equities to bloom is the huge preponderance of money going into Taxable Bond funds over the relatively little going into Stock funds. With bond prices likely to drop as inflation rises, one could expect the new owners of bond funds reversing themselves into buying equity funds. My final reason to believe that equity prices will rise is my knowledge of the extent of underfunded corporate and government retirement plans.

If one wants to stay in the quality parts of the bond and stock markets, there is no question that stocks are a much better bet to meet the long term needs. If you are willing to be more aggressive today, you are back to looking at the intelligent and prudent use of leverage. In any case it is good to be an equity investor now.
I do not know when we will be in bloom, but I can wait it out as long as I am in a dry spot. Have you brought down your umbrella yet?

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