Jason’s 2011 Annual Letter: Fire Burn and Caldron Bubble
“What’s past is prologue”
-William Shakespeare, “The Tempest”
“(They got me) starin’ at the world through my rearview”
-2Pac, “Starin’ Through My Rear View”
FIRE BURN AND CALDRON BUBBLE
In the fall of 2004 I had a co-worker, a tax manager, hand in his resignation to leave New England for Las Vegas, where he had maintained a vacation home for several years. He was getting out of the private client game for good, off to semi-retirement and a try in the real estate market as a broker. At the time, this didn’t strike many of us as a daft enterprise for a youngish man; the Las Vegas Case-Shiller Home Price Index had just booked its fourth consecutive month of more than 50% annual price increases. Sure, some of us quietly mentioned that upon descent to McCarran there appeared to be unlimited surrounding land for Sin City to branch out and cause some oversupply problems, but that’s only because none of us realized most of the land around Vegas was owned by the federal government and the Southern Nevada Public Land Management Act had set up fairly rigid protocols for its disposition. So, Vegas had a finite land supply, desert heat, celebrity buzz, no state income tax and the adult playground and thought-to-be-recession proof Strip, because, after all, when times got tough people still gambled; all in all, not a terrible mix. We wished him well at the goodbye party and went back to work.
Of course, you know how this turned out; since January 2007 every single month of that same Las Vegas Case-Shiller index has booked a negative annual change, with a crescendo of negative -33.11% (!) in December 2008. Can you imagine losing a third of your home’s value in one year? That happened. It turns out gambling is by no means recession-proof as lack of job does equal lack of ante and Vegas had and has no other industry to pick up the slack. Nevada, Arizona, California, Florida, all of the “sand” states, followed the same hyperbolic trend of real estate assets surging beyond all normal measures of fair value, like income-to-debt, and then plummeting back through the entry bids of most recent buyers; the prototypical “bubble and bust.” Bubbling asset values always go higher and crash lower than you think possible.
Why discuss old news? Because the Barclay’s 20+-year Treasury Index rallied +34.0% in 2011 to drop the 30-year government long bond yield near 2.90% at year’s end. Think about that for a second; with the year-over-year Consumer Price Index averaging 3.0% in 2011, and the 1946-2011 CPI average at 3.9%, annualized, you have to have an incredibly pessimistic view of the American future to effectively lock in a zero rate of return in a 2011 inflation scenario and a 1% loss at the post-World War II average inflation rate for thirty more years. To our eyes, U.S. treasury debt is the present equivalent of a just-off-the-Strip condo. Of course, as we’re in the hyperbolic bubble phase this doesn’t mean treasury debt can’t appreciate to even further extremes in the event of, say, a complete debt death spiral in Europe. Also, the more extreme the crisis the more people will seek longer-dated safe assets. The aforementioned 20+-year index was trailed by the Barclay’s 7-10-year Treasury index up +15.6% and the Barclay’s 3-7-year Treasury index up +8.3%. We reason when the government debt bubble bursts the assets will unravel in similar tiered fashion, lead by an exit from the longest dated debt with the most painful losses.
The trouble with our treasury paradigm is timing; rates have stayed far lower, far longer than we ever could have imagined coming out of the ’08 chaos. Given our worldview, we’ve zero-weighted treasuries over the last four years and have even shorted treasuries off and on as things hit our perceived extremes, sometimes to great gain, sometimes to painful loss. It’s clear to us now the reversal of treasury yields is one of those frustrating financial ideas which will work at some point – and work brilliantly – but probably will bankrupt many along the way (just ask Japanese bond traders). In a surprise January 25th announcement, Federal Reserve Chairman Ben Bernanke pledged to maintain the short end of the treasury curve at effectively zero percent until 2014. Meanwhile, with the short end anchored by the Fed, longer dated treasuries are weighed down by sovereigns, pensions, insurance companies and large institutional players seeking risk-free yield; the irony of the search for yield forcing down yields and defeating the purpose. The old saw of “don’t fight the Fed” rings loudly in our ears so we won’t short treasuries any time in the near future but it also goes against our valuation principles to buy what we consider to be a clearly overvalued asset. Hence, in times like 2011 when treasuries surge, and the 10-year yield goes from 3.30% to 1.88% in the face of all reason, we won’t participate and will likely underperform in our fixed income mandate. Being sure of the upward direction of treasury rates, and sovereign rates as a whole, but having no good ideas on timing, we’ll maintain our worldview by owning intermediate duration debt, investment-grade corporate bonds, emerging market debt, MLP’s and the like. We must exercise caution though, as there is no way to achieve meaningful yield in fixed income without risk; Proctor & Gamble 10-year bonds just issued with a 2.3% coupon and top-rated 10-year municipal bonds yield in the 1.8% range. With a poor risk-return tradeoff domestically, we’ll stay shorter in duration than most indices and continue to seek international opportunities and niche spaces. Some years, like 2011, won’t have relatively pretty performance, but the long-term picture will pay off.
Fairly obvious to understand, though, why nervous investors might buy treasuries, and somewhat astonishing U.S. equities could eek out even modest gains given a broad sketch of 2011: Japanese tsunamis, Mid-East upheaval, Occupy Wall Street, U.S. government shutdowns, an aimless, ongoing war, much of southern Europe pushed to the brink of debt default and even the death of Steve Jobs seems like a deadly laundry list in even the best economic climes. As we continue to bounce along the bottom of tepid growth the world could have easily rolled over into global recession as confidence and optimism eroded. Working from the thread of our real estate intro, U.S. mortgage originations fell from $3 trillion in 2006 to $1.3 trillion in 2011. The negatives in the world are easy to come by, so why didn’t risk assets crumble?
As we go to print, 66% of S&P 500 companies had beat Q4 2011 earnings’ estimates and the index stands at a historically moderate ratio of 13.9 times earnings and a dividend yield just peeking north of 2%. Profit margins may be at or near all-time highs but don’t seem to be compressing in the near future. This isn’t screaming buy territory like March of 2009, but when you pair reasonable stock fundamentals and negative real fixed income yields with the broad trend of positive U.S. data including GDP, employment, manufacturing and confidence, all you need is the absence of cataclysmic news on the global front to catch rising bids. And Greece’s impending bankruptcy and our forecast of a decade-long workout like Argentina with multiple exchange offers and tender rounds would not be a newsworthy event in our estimation. Market prices have signaled Greece is a non-functioning financial entity for quite some time. Portugal, likewise, is an immaterial concern in the pan-European economic scope. What we do watch closely for is signs of stress in Italy and Spain; the two economies scale and depth of debt markets could overwhelm European Central Bank efforts if they were to spiral out of control. Our belief has always been that Europe (read: Germany) has invested too much financial and political capital to allow the European Union to fail and this crisis would ultimately lead to increased fiscal and monetary ties as opposed to the union’s dissolution. It’s our projection the ECB will allow Greece and Portugal to have somewhat disorderly defaults but will draw the line at Italy and Spain; as investors I think we have underestimated exactly how scarred global governing bodies are by the events in 2008 and how terrified they are of bringing the world economy to the brink again. They will literally do anything within their power to stop that seizure from occurring again. So far the markets appear to be agreeing with our worldview, as Italian 10-year yields have declined from their catastrophe-levels of 7.5% in late November of 2011 to the mid-5% range in early February. This is the backdrop of the risk asset rally we’ve seen since last year’s late summer panic; the global economy may be uninspiring, but it’s positive in spite of everything and the center of Europe’s economy will hold.
However, our optimism does not mean we’ve thrown caution to the wind and spent the cash hoard we built up through the end of last year’s 3rd quarter on broad, beta assets. We tried to have very targeted ideas as our cash levels come down into single-digit percentages. Tapping global turmoil we’ve made our first currency investment with a John Hancock feeder vehicle for First Quadrant management. Continuing global themes, we’ve picked up a pan-Asian dividend manager in Matthews and an emerging debt manager in MFS. Following positive forecasts from resource companies and commodity-consuming nations we selected a natural resources manager and the fundamental upward trend in U.S. data allowed us to hire a mid-cap U.S. equities manager. Further out on the risk curve, we also made a small investment in a European value manager to take advantage of some of last year’s massive sell-off across European bourses. We also hedged some of this long equity exposure with our first market neutral, publicly traded, open-end mutual fund.
To complete the story of my Vegas-bound coworker: He is not a straw man, but a real person I knew named George. After a few months of eastward-bound emails full of financial windfall and optimism, the communication stream dwindled and then stopped in late ’06. A couple of calls from people in the office went unreturned and even his e-mail address stopped functioning. Finally, in mid-’07, another co-worker received an email from George. He had moved on to Los Angeles and back into the financial industry. Prosperity in the desert had been a mirage and a bursting bubble scatters so many of its participants to the winds. Historically, on average, the length of time an asset class takes to heal from an irrational top is much longer than its euphoric rise in value phase; the pain lasts longer than the pleasure. We’re in about Year 31 of the bond bull market. Let’s just say I hope George isn’t investing his savings in treasury bonds. As always, we deeply thank you for your continued support and relationship with Capital Formation Group. If at any point time you have questions or concerns please don’t hesitate to contact a member of our team.