Jason’s Q1 2012 Letter: Holland & Hollande
“…mankind, when left to themselves, are unfit for their own Government.”
-George Washington, letter to Henry Lee, October 31, 1786.
Holland & Hollande
We tend to gloss over the Founding Fathers’ fear of the masses in the hagiography of early American democracy. By and large, the Fathers were middle-to-upper class property owners and professionals quite concerned with direct, unchecked democracy as they built America’s framework in the shadow of the French Revolution’s terrifying mob rule. Alexander Hamilton allegedly said, “your people, sir, your people is a great beast,” one of his many little gems in favor of a wealthy minority holding the bridle of the majority. But the push-pull of how much government is “for” the people and “by” the people is nothing unique to the American experiment. I remember spending a whole semester in middle school on the “Spring of Nations” revolutions of 1848, the sui generis pan-European collapse of traditional authority. Lately, we’ve spent a lot of time in the shop talking about that string of rebellions as some historians argue those few years of chaos wove patterns to dominate Europe for the next century; against the backdrop of a continental economic slowdown, food prices spiraled through poor harvests and population pressures while nationalism surged among minorities, all coinciding with dissatisfaction in the youth class. There were also asset bubbles bursting in the railway, iron and coal industries best illustrated by the British Panic of 1847 that continued to feed increasing tensions between middle and working classes. This all culminated in a series of violent demonstrations against monarchy. Does any of this sound somewhat familiar?
Of course, the danger of studying history lies in assuming a similar set of events creates an identical result. That rarely happens and, plainly, unequivocally, we are not stating Europe is devolving into chaos. However, there’s enough to worry about in the political arena to give an observer pause and we as investors concern. France has perhaps bought into a set of unattainable promises in Francois Hollande’s socialist program; in a rejection of immediate, German-style austerity his leftist French Socialist Party campaigned and won on public and education spending and a reverse of the departed Nicolas Sarkozy’s increase in retirement age. Frankly, pun intended, this is fiscally impossible, and perhaps the silver lining is Mssr. Hollande will become more centrist by default. Yet, these promises are still indicative of the sublime mood of disbelief present in Europe’s masses in regards to their financial condition. If there is further good news to be wrung from the change in French leadership it will be Hollande’s pledge to reevaluate the European Union’s (“EU”) fiscal pact with an eye toward fiscal as well as monetary agreement.
A complete lack of commonality regarding budgetary policy seems to be stoking the extreme ends of European politics. In late April, Holland’s Prime Minister Mark Rutte handed in his resignation after failing to find consensus on budgetary reform. The Dutch (not the Danish, I still get confused) government has been extremely critical of free-spending EU members but found itself under internal attack from the Far Right Party led by Mr. Euroskeptic himself, Geert Wilders, who vehemently denied any adherence to external rules. England’s Tory government continues to see the continent’s monetary union as a non-starter. Italy’s recently elected Mario Monti appears to be learning on the job without any definitive path. Troubled Spain’s Mariano Rajoy’s conservative People’s Party stokes Spanish nationalism above international entanglement; fiddling while Spanish industrial output appears to be burning. And Greece…poor Greece…Golden Dawn’s surprisingly strong electoral showing is about as hard-right fascist a party as Europe has seen in the modern day spotlight. Greek fringe entrants eroded enough support from the two major parties that another round of elections looks certain. I think it’s safe to say the European Central Bank’s Jorg Asmussen was tasked with delivering a not-so-subtle message with this quotation: “It must be clear to Greece that there is no alternative to the agreed upon restructuring program if it wants to remain a euro zone member.” In public communications, that’s about as blunt as it gets. So blunt that German Chancellor Angela Merkel had to play “good cop” the following day and assured Greece it was still welcome at the EU ice cream socials.
Generally speaking, the social network of Europe is broad and dense; income and value-added taxes are high but unemployment and retirement benefits are staggeringly good and early retirement is the norm. On an anecdotal basis, my 11-year old son has a friend whose family has recently moved here from France and his mother will have her job waiting for five years in Paris while she follows her husband to America. This amazes me, as I’m not sure I’d be employed if I took five days without checking into the office. Government spending, again in general, has hovered in the 40% to 60% of gross domestic product range with markedly lower tax revenues. This breeds deficits, so the pragmatist in me thinks calls for “austerity” are a logical conclusion to fiscal imbalances. Instead, this movement is skewing the power balances within EU member states as the perceived reordering of the social network has empowered the political fringes. When people are faced with an unpalatable choice they grasp for the extreme; Europe right now is personal psychology writ large.
All of this nation-state political mumbo jumbo is a shame, because corporations doing business in these troubled states are doing well. Really.
With more than two-third’s of the S&P 500 companies reporting quarterly results we’ve seen 67% beat earnings expectations and 65% outpace revenue expectations. There have been nice earnings upsides to the Materials and Consumer Discretionary sectors while revenue growth has been strong in the Health Care and Technology sectors. The average company within the S&P 500 has grown earnings by 14.1%, on a year-on-year basis. Admittedly, analyst expectations had been lowered to almost laughably low bars but equity and risk markets, generally speaking, anticipated the outperformance and raced out to healthy gains in the first quarter. So healthy that despite negative performance in April and the first week of May, the S&P 500 was still up over 9% year-to-date, with the developed market MSCI EAFE index up nearly 7% and the MSCI Emerging Markets index up over 11% in the same time frame.
But, you can only focus on trees like earnings and positive hiring and firing trends for so long when the forest is burning: The attention is on Europe. As market observers, we’ll say almost any corporate and U.S. economic data over the next several months will be trumped by European news flow and the concern we are headed for a dreaded “Lehman Moment,” and the announcement of a major banking or sovereign meltdown. Given the state of affairs as we publish, we’ll go out on a limb and prognosticate for posterity that this summer will see the exit of Greece from the European Union. Politically and economically, this appears to be the road we are travelling and a logical outcome. So although any analysis should strongly consider this, the actual breaking news will most likely be a source of major market volatility and a television talking head fiesta. Despite the extremely decent profit picture in the corporate space and a domestic economy that is churning its way through tepid but still positive data, we have taken some steps to lower the risk in our portfolios because: 1) Again, we think the Greek situation will come to a headline boiling point this summer even though actual disengagement from the EU will most likely take years and, 2) despite the decent corporate news, equities aren’t screamingly cheap – long term, inflation-adjusted ratios are still trending above their mean, for instance – and even with record forward earnings forecast for 2013, next year’s earnings ratio at 12x is fair but not a screaming buy signal with the possibility of the U.S. sliding back into recession if Europe boils over.
The above is our immediate political and fundamental framework and hence we’ve begun to trim back our traditional, long-only exposures. We felt the financial and energy sectors were the most at risk for European fallout and any slowdown in the global expansion hypothesis. To mitigate, we sold our active dividend value manager that naturally focused on financials and energy and our energy sector exchange-traded fund. We used those proceeds to purchase a market-neutral fund that hedges long-only individual stock exposure with individual stock short exposure and writes calls for premium income collection.
Combined with our existing market neutral manager our portfolios now feature two market neutral funds and a currency fund with a negative correlation to the S&P 500 index. In conjunction with our cash holdings we believe these moves have lowered the potential volatility of our portfolios heading into summer. We also used the cash from our sales to purchase an active global Utilities manager. Our analysis led us to the sector for decent valuations and an attractive yield relative to underlying debt. This was a trade designed to lower clients’ portfolios overall beta to the broad S&P 500 market, thinking very much in line with our market neutral purchase above. Overall, we’ve tried to skew the structure of the portfolio to active management over the last several months to theoretically provide some relative outperformance in negative markets. The climate for active equity management as a whole has been grim over the last eighteen or so months but we see a trend reducing equity-to-equity correlations so the theory is that stock pickers can enter a sweet spot.
On the fixed income side, we’ve continued on the path of short-to-intermediate durations and zero U.S. treasury exposure. It’s pretty obvious when you look at our performance how this works on a month-to-month basis. We underperform when investors flee risk or a third round of Fed-lead Quantitative Easing leads off the CNBC morning chatter and treasuries rally and the long-end of the curve dips. We also run the risk in our short-to-intermediate stance that demand for yield will cause underperformance as in the tax-exempt market in the first quarter; despite the low level of absolute returns investors extended to long maturities. To reiterate our pointedly stubborn stance: The 10-year treasury is the baseline for all fixed income and at levels at or below 2% we feel this is the most overvalued liquid asset we can find. As investors, we are and should be willing to trade short-term underperformance for long-term results, mainly protection of principal and the ability to reinvest at more attractive rates. We also believe there are more attractive opportunities in niche income spaces such as MLP’s and overseas, with sovereign and corporate debt in the emerging nations and their cleaner balance sheets. We also feel equities are the better relative asset class vs. fixed income for a ten-year forward time frame, and shift our allocations at the margins accordingly. If our allocations seem routine to our long time readers that’s because they are, and we’ll continue to tweak things at the margins for current events but we won’t endanger the long-term financial goals of our clients by ignoring rational financial principles.
In case you were wondering how the 1848 revolutions turned out; France got itself a Bonaparte nephew and a Second Empire. The German states took their first stab at a unified parliament, but wound up in failure as a power play between Prussia and Austria. The Danish (not the Dutch) started down the path to democracy, and the Dutch (not the Danish) followed. Switzerland took the opportunity to begin modeling itself after the United States and everyone took the wars and revolutions as a chance to flee to the actual United States setting off one of the world’s great immigration booms, including a brewer from Germany who used a small inheritance to open a brewers’ supply store in St. Louis, proving that from chaos could come an entirely new set of opportunities. We’ll continue to look for these opportunities while navigating the headline turmoil. Thank you, as always, for your continued trust in Capital Formation Group. Please contact us at any time with any questions or concerns.