Q3 Market Commentary from CIO Jay Morad
“You see, in this world there’s two kinds of people, my friend: Those with loaded guns and those who dig. You dig.”
-Blondie (Clint Eastwood) in The Good, the Bad and the Ugly (indirectly speaking to Greece)
Usually we start quarterlies with fluff, puff and bits of historical wonder (I even had an entire Halloween-themed letter penned as we waited until the end of October to get something more concrete out of Europe), but there’s too much going on right now for wordsmithing; we want to directly address how we see the market and what we’re doing so let’s get to the central question: How confused is the world when investors get back fifty cents on the dollar…and euphoria breaks out? Unfortunately that’s the scenario, as Greek lenders feared the Armageddon ending of disorderly default and total loss; facing with zero, any return seems preferable. News has French President Nicolas Sarkozy busily conferring with President Hu Jintao for China’s support in a European rescue fund and even Japan, beleaguered by decades-old deflation and natural disasters, stands poised ready to join once details materialize. Markets have temporarily gotten the heavily hoped for outcome of stability – or, at least, non-disaster – and October showed it: U.S. stocks posted the biggest monthly rally since 1987, with a roughly 12% monthly gain as we go to print, flying in the face of the doom and gloom of impending European implosion at the end of September. As our client and mentor, Tom Troy, always taught, “markets like to deliver lessons causing the most pain, to the most participants.” As of Monday, October 24th, 23% of mutual funds had underperformed their indices by more than five hundred basis points, proving the wisdom of Tom’s advice, and paving the way for a furious fund flow into equities by managers desperate to catch their benchmarks and a general “melt up” of the market. We went so far as to take some of the cash we’d begun to hoard since early August and purchased the biggest “bang for the buck” in a 2.5% position in the high beta MSCI Emerging Market exchange-traded basket of equities. Global emerging markets, in our opinion, have a valuation range compared to developed markets not seen for some time after the late summer sell-off. Summing it all up, we have European resolve, deep-pocketed international support, surging markets and plenty of dry powder for a rally tailwind. So why didn’t we do more? Keep reading.
In the short term, the simple fact Greece won’t outright default within six months is the removal of the type of chaos-inducing macro overhang that impairs sustainable rallies in risk markets. From late July through September fear of the domino effect of Greek default, world-wide capital raises by financial entities holding Greek debt, Italy and Spain forced into unsustainable borrowing rates by investors de-risking, and the general halt of smoothly functioning capital markets panicked global markets. With all of these very valid fears present and no resolution in sight, the S&P 500 bottomed on October 3rd at 1099 and marched straight up to 1278 in the next twenty-four days. We suspect global investors, faced with a 1.75% nominal return on U.S. treasury 10-year debt and a most recent year-over-year Consumer Price Index increase of 3.9%, decided Europe would muddle through some sort of resolution knowing full well the potentially irrevocable damage a second Fall ’08 could cause. The numbers also helped: Global prospective price-to-earnings, price-to-book, enterprise value-to-total assets – all the maths investors look for – provided an attractive jump-to point in equities. Excluding March ‘09, many valuation metrics were at lows not seen since ’03. Long story-short, it’s no mystery how a rally could occur and it wouldn’t surprise anyone for the sheer relief of not living the European nightmare before Christmas to power the markets into territory making those valuations not so sweet. But when the exultation ends…
As currently constructed, the world of investing is binary, oscillating from no-risk to risk, treasuries to everything else. Correlations among large cap stocks hit late-1920’s levels in September. It seems clear to our trading desk that high frequency participants at the margins of price action – and all prices are made at the margins – increasingly view the world as a collection of asset classes easily accessible through basket trading programs or products such as exchange-traded funds. When volatility peaks in times of turmoil these marginal price makers move assets in bundles of classes; equities, commodities and risky fixed assets out, and safe havens like treasuries, German bunds, gold and Swiss francs in. It would seem investors, to use a general term, are far less concerned with the academic benefits of diversified assets than the absolute total loss of a portfolio. Why?
We all witnessed as close to a systemic meltdown in ’08 as we think the world can bear and we have seen first hand how hidden bits of information from seemingly disparate entities are covertly interrelated. Hence, chain reactions across a multitude of asset classes can start from relatively isolated industries, with the notable exception that the press and populace now believe the financial industry to be the center of the entire web. So, when the bulge bracket banks continue a spate of earnings that are of poor quality or outright negative, investors will continue to look for macro risk issues that exaggerate the enormous trading ranges we now see. Financial volatility forces emotional and often irrational indecision-making upon investors and can lead to data points like the recent collapse in consumer confidence and forces a reconsideration of the multiple of earnings/sales/book an investor is willing to pay for what is essentially an “analyze and hope” asset in equities. For example, if fifteen years ago a fifteen times earnings multiple was considered averagely inexpensive for the S&P 500 in that investing world of unlimited growth and budget surplus, that same multiple begins to look very expensive in today’s world of low growth and overhanging debt. As markets re-rate multiple ranges and wrestle with volatility and the uneasy fact 2012 earnings estimates are turning decidedly bearish, huge trading swings are not only possible but probable and even logical. We feel this bound, jarring trading range is the fate of the markets for at least a few more years as we deal with sovereign debt and demographic issues.
And because of these huge price swings in assets and high correlations, we’ve been searching for something with low or negative correlation to both equities and treasuries and a bit more quantitatively based than our usual investment spec; we’ve long been interested in currencies as an asset class form our market thesis that currency pricing driven by at-the-margin trading is driving asset pricing, inverting the traditional model of asset valuations driving currency demand. We like this theory but the currency trading space is traditionally dominated by hedge funds and very large institutions with appropriately large barriers to entry. Fortunately, a well-respected currency manager, First Quadrant, has partnered with the John Hancock mutual fund company to create an open-ended, cost-effective and liquid feeder vehicle. Seeing the opportunity we had been waiting for, we instituted a 2.5% position in September. It’s a bullish bet on continued volatility, a case we continue to support.
What else is there to dampen this rosy October glow? Well, the Federal Reserve proved during the month how ineffective it’s remaining tools are by announcing Operation Twist on September 21st; a decades old re-hash of taking short maturing money and purchasing long maturity debt to effectively “twist” the long end of the curve down and make big capital acquisitions like mortgages more affordable. On the day of the announcement the U.S. 30-year bond stood at 2.99% and after all the central bank machinations, ended last Friday at 3.35%, the exact opposite effect. In truth, the only immediate solution both the U.S. Federal Reserve and the European Central Bank have is to issue more debt on top of the debt already owed and hope the emerging economies continue to lend…and the market is on to this game. This inability of central banks to tame the bond market, combined with at least a guarantee of mildly inflationary resource pricing from the spiraling demands of emerging economies and their need to eventually seek a higher rate of return on their lending is the central tenet to our zero U.S. treasury exposure and outright short of the long end of the curve through a liquid exchange-traded fund. However, this is a long-term thesis that may take years to develop and during high periods of instability the binary nature of the market will swing to risk-off and treasuries will perform very well, driving prices down to a 1.75% 10-year price in early October. During these periods, we will not perform well in the taxable fixed income space as short treasury exposure and spread-based fixed income is almost a virtual certainty to suffer, but over the long haul, if our forecast is correct, we should significantly outperform a treasury-only portfolio.
But, equities are volatile, treasuries are overvalued, the world is highly correlated…if you are masochist enough to read through any of our last couple of years of sermons we’ve beaten these themes to death; there’s nothing new so much as the specific observation that the underlying contagion of excessive sovereign debt continues to spread, and short-term haircuts to Greek bond holders is only a Band-Aid for a gunshot wound. We mentioned two quarters ago that Italy is the third-largest bond market in the world. Throughout the October euphoria Italian benchmark 10-year bonds continued to creep into unsustainable funding rates and trade at an excessive premium to German debt. Much like the origins of the Greek meltdown, two countries cannot share the same currency at markedly different funding rates, as the two are designed to offset one another. When this relationship breaks down financial instability will surely follow and the continued financial instability of Europe, minus headline-snatching temporarily bailouts, is the real elephant in the room that keeps our cash levels above 10%. Europe taken as a whole is the world’s largest economy and because we do not understand the entire global systemic effects of continued instability in the world’s largest economy we keep our cash levels high for a very simple reason: Wide trading ranges force marked dislocation in assets and we want the ability to take advantage of opportunities without requiring the sale of other assets that may be negatively impacted by those same dislocations. That’s a very fancy way of writing when times get crazy, we like to have a bit of cash on hand.
We continue to work on some interesting ideas for this type of macro market that we’ll outline in the year-end wrap up letter. The unnerving volatility and focus on globe-spanning events is a relatively new phenomenon for investors and we’ve been concentrating on modifying our analysis toolkit to help ground us through the news flow. Because of the frequency of market-shaking headlines we’ve begun expressing relatively weekly thoughts and you can follow our links to writing and conference calls on www.capitalformationgroup.com. As always, thank you for the continued trust in us during these most tumultuous of times. Please never hesitate to contact anyone on the team for questions and feedback.