A very interesting, disturbing, but perhaps unsurprising article in today’s FT, about how Russia may have tried to get China to simultaneously dump GSE securities on the market to exacerbate the US financial crisis. Sounds like a cross between international espionage and hostile takeovers, but scarier: Paulson claims Russia tried to foment Fannie-Freddie crisis
Jeremy Grantham and Rick Bookstaber debate Myron Scholes and Robert Reynolds on whether or not financial innovation boosts global growth. We found this particularly engaging since one of the debaters (Myron Scholes) was a principal at Long Term Capital Management and another (Jeremy Grantham) is a manager whose views we follow very carefully. As an aside, Grantham’s latest quarterly letter is a must read. There are a few particularly juicy exchanges towards the end, so it’s worth watching all the way through.
FT’s Tracy Alloway has a very intriguing post about excess profits in the banking sector, relying on Jim Reid’s work (Deutsche Bank strategist).
John Authers writes in the FT on the efficacy of crude regulation that clearly demarcates acceptable and unacceptable behavior and actions.
We are frequently amused by the myriad explanations pundits present for any moves in the market. Our view has always been that single day moves are largely inexplicable, and that it often takes investors time to incorporate events into their thought-process, and to translate them into action. An example is the market rose yesterday in the face of much bad economic news. The explanation from pundits was that investors were celebrating the potential victory of a Republican candidate in the Massachusetts special election to fill the senate seat left vacant after Ted Kennedy’s death. Numerous commentators noted that “gridlock in Washington is positive for wall street”. The thinking is that government action creates uncertainty, this leads to businesses spending time and resources trying to compensate for changing rules, and this slows down economic activity and lowers earnings.
Now that we know the results of this special election, we believe investors should be concerned about the Republican candidate’s victory. The US finds itself in a particularly delicate position three years after the bursting of the biggest credit and real-estate bubble in decades. The hesitant stabilization of economic activity and confidence we have seen so far has been brought about by extremely large amounts of government spending and aid. Regular readers will know that one of our concerns has been the manner in which this government support is removed. At this juncture, gridlock in Washington is more likely to bode extremely poorly for the US economy. Congress has to find a way to pass health care reform, renew the term of the Fed chairman, reform financial regulation and evaluate the need for continued fiscal support. Did we forget to mention it has to do all of this in the face of the largest budget deficits since the second world war and a rising tide of populist sentiment in an election year?
Risk assets have recovered dramatically over the past few months in response to a massive, concerted effort by governments the world over to inject liquidity and support aggregate demand for goods and services. This effort was led by the US and the UK, where the parties in power enjoyed comfortable majorities. With Scott Brown’s election yesterday and an election looming for Gordon Brown’s Labour party, political certainty is in short supply on either side of the Atlantic. At this sensitive moment, we believe this is a damaging development and that this uncertainty does not augur well for business or markets.
The Financial Times’ John Tasker writes about conflating economic growth and investment opportunity in Insight: Busting the myth of the Brics
We hope you enjoyed a restful holiday season and have had a good start to the New Year.
In this quarterly letter, our aim is to provide a review of Q4 2009 as well as a look ahead at 2010, which we’ve separated into an attachment titled “10 economic themes for 2010”.
In the fourth quarter of 2009, risky assets (stocks, commodities, low-grade bonds) added to mid-year gains, while safe-haven treasuries continued their descent from the panic highs of last year (the ten year yield has gone from 2.06% to 3.84% over the year as investors took on more risk). Strong government support remained the order of the day against a backdrop of continued economic weakness, as the unemployment level rose above 10% for the first time since 1983. The Federal Reserve kept short-term rates at 0.00-0.25% (boosting bank earnings) and fiscal stimulus continues (extended unemployment benefits, housing purchase credits, etc). The scale of government support in all forms is remarkable and we believe much of the economic landscape over the next few years will be determined by how this support is withdrawn, and how the long-term debt created by these expenditures is tackled.
Our view remains that high levels of unemployment, household debt-reduction and tighter credit standards will continue to keep growth rates at very moderate levels. We consider stock market valuations to be over-stretched and continue to believe the current stock market rally is unsustainable. Prior to raising equity allocations, we would like to see a sustained organic recovery (as opposed to one supported by government stimulus spending) or far more attractive values.
We look forward to speaking with you during the quarterly review and wish you the best over the coming year.
Retailers are in the business of parting consumers from their money and they have been remarkably successful at this over the past several years. However, we believe this holiday season will turn out to be very tough for most retailers as consumers will continue to maintain tight control over their spending. Consumer spending levels have been a concern since this recession started. Most observers predicted consumer spending would fall since households entered this recession with very weak balance sheets, high debt levels and low savings. Added to this weakness in household finances is the pace and extent of job losses, worse than any we have seen since 1983, with a real possibility that they may be worse than the early eighties. Consumption usually falls when unemployment rises, because people spend less when they aren’t earning. However, consumer spending has fallen further during this recession because of something called the wealth effect. When people feel less wealthy, they tend to spend less. And as home prices and investment valuations have fallen over the past couple of years, a lot of us (not just those unemployed) have begun to feel less wealthy, and as a result curtail spending.
A key portion of any recovery is the stabilization of consumer spending, and a crucial part of this spending occurs around the holidays. With this in mind, we have been looking closely at expectations and trends for retail sales over the holiday season.
A recently released ARG/UBS survey polled consumers about their anticipated spending patterns this holiday season is very revealing. They report that over 50% of survey respondents said they plan to spend less this holiday season on gifts, and most plan to buy fewer gifts for fewer people. Even children know they have to limit their expectations for Christmas gifts. ARG estimates sales will be down 2.9% when compared with 2008 (and those were down 2.7% over 2007).
We routinely look for unorthodox sources of economic data to complement traditional sources. One data source we’ve become interested in recently is Google Trends, which provides statistics on what people are searching for on Google. The Google team has made a number of different “canned queries” available and their research team published a paper earlier in the year examining how Google trends could be used as a measure of activity. What we found most intriguing were the luxury goods query statistics, which show a year over year decline of over 5%. Since Google trends measures the proportion of total queries (i.e. it accounts for the fact that the total number of queries on Google is growing) it may simply be that interest in things other than luxury goods has risen, or that more people have found the best online stores and visit them directly. However, we believe this data may augur poorly for luxury good sales this holiday season, and this view is reinforced by the ARG survey result that consumers are planning to trade down.
So, in our view the prognosis for retail sales this holiday season does not look good. Where then does that leave us? The chart below plots retail sales excluding-autos along the red line and retail sales and food services (a much broader measure) along the blue line. We adjusted for inflation to produce these charts, the nominal numbers look worse since we had some deflation in 2008/2009. The data is from the census.gov and bls.gov.
Retail sales are declining at a slower pace, but at -3.04% the rate of decline for September’s retail sales (ex autos) remains worse than any other seen over the past 15 years. The remarkable story though, is in the level of sales, which we plot below.
In real terms, the broadest measure of consumption is in the same range as it was in 2000-2002. Real retail sales excluding autos and food service are at 2004 levels. These numbers look far worse on per capita terms since the US population is growing by 2.75 million a year. What makes this picture even gloomier is that the current levels are being propped up by massive amounts of government support. Unemployment benefit periods have been extended for the longer-term unemployed, and auto-sales have been propped up with incentives. We shudder to think where consumption expenditure would be without these supports, yet at some point consumers and businesses will have to confront the reality that this government assistance cannot last indefinitely.
So where does this leave us? We believe this will be another difficult holiday season for retailers, and the medium-term picture doesn’t look any better. Consumers have cut back spending to real levels last seen 5-9 years ago, and there is no prospect of a quick rise to pre-recession consumption. We see a slow, halting recovery over 5-7 years for the following reasons:
We now know that we had too many mortgage bankers, home construction workers, and investment bankers than natural growth could sustain. It may well be true that we had too many retail stores and salespeople. If retail sales do not recover for years, we will have to become accustomed to shuttered stores in many areas. Many people formerly employed in retail trade will have to look to other industries for employment. The big structural question confronting us is how US businesses are going to produce productive employment for these workers and resources. This will require retraining, and it may require the movement of labor across geographies. It will definitely take time.
The extent of the market’s shrinkage in 1969-70 should have served to dispel an illusion that had been gaining ground during the past two decades. This was that leading common stocks could be bought at any time and at any price, with the assurance not only of ultimate profit but also that any intervening loss would soon be recouped by a renewed advance of the market to new high levels. That was too good to be true. At long last the stock market has “returned to normal,” in the sense that both speculators and stock investors must again be prepared to experience significant and perhaps protracted falls as well as rises in the value of their holdings. — Ben Graham in “The Intelligent Investor”
For years, investors have been told there is an easy, simple way to invest, requiring very little effort, by using index funds. Many amongst us have been seduced into believing that we can safely invest in stocks, or stay invested, as long as we have a long enough time horizon. This claim is generally based on analyzing the unique market trajectory of the United States, where stocks have outperformed other investments over most long-time periods (20 to 30 years). Of course, over shorter periods (say 5 or 10 years), returns from stocks have been painfully small or even negative, and as Keynes said: “In the long run, we’re all dead.”
In addition to being told that stocks are the best game in town, investors are relentlessly advised to buy large numbers of stocks, via index funds. Too many have taken this easy way out and bought stocks without any sound analysis and we fear the market has begun to reflect this laziness.
I have a parable for you, or perhaps a fable. Imagine market participants as a herd of buffalo on the plain. The herd moves together, often quickly. In the past, it has never run off a cliff because enough buffalo are looking around for the tell-tale signs of a drop-off and slow it down. One morning, a buffalo has the bright idea that since the herd has never run off a cliff (at least not in living memory, or as far back as the data is readily available), it would make sense to simply follow the herd and stop looking for signs of cliff-edges. Once enough buffalo buy into this strategy and become free-riders, the herd itself becomes less aware. As a result, the herd has fewer and fewer buffalo actively participating in picking direction, alert individuals get pushed into the center of the herd, effectively blinding them. This blind herd runs willy-nilly all over the plain, and eventually it will run off a cliff.
Sometimes it makes sense to cut oneself out of the herd in the interest of self-preservation and go your own way, so you can see clearly.
I’d be a bum on the street with a tin cup if the markets were always efficient. — Warren Buffet
We wrote earlier this year about the debate surrounding the Efficient Market Hypothesis (EMH). The EMH, roughly speaking, claims all relevant information that is presently known is incorporated into market prices. For some time now, we’ve viewed the EMH with some skepticism. Two recent editorials, one by Jeremy Siegel in the WSJ, and the other by Martin Wolf in the FT, prompted us to revisit the subject and reiterate our skepticism about the EMH. We think part of the reason these two camps disagree is that they are not trying to answer the same question.
The EMH camp asks the question “what are stocks going to do tomorrow”, and says (with some justification) that it is difficult to predict tomorrow’s moves because the sum total of all market-moving “information” is reflected in the price. In our view, this is not a particularly insightful observation, partly because the question itself is largely irrelevant for an investor (as opposed to a trader).
The Value camp (Ben Graham, Warren Buffet, Jeremy Grantham) believe the right question for an investor to ask is “should we buy stocks today”, or “if we buy stocks today, do we stand a reasonably good chance of achieving an acceptable return”. We believe this is a far more crucial question. The value camp has developed numerous mechanisms to measure the value and risk of an investment based on expected returns.
By convincing many investors that “the market is always right” and that evaluating investment opportunities for themselves is not worthwhile, the EMH camp has successfully encouraged many market participants to become lazy. And if these multitudes ARE the market now, the market itself has stopped evaluating investments on their merits. This is how markets get to be wrong and their self-correcting nature is undermined.
A public-opinion poll is no substitute for thought. — Warren Buffet
In his article, Siegel says the fault for the bubble is not with the EMH, but with market participants (ratings agencies and investors) who failed to do their homework on their investments. That’s pretty rich coming from someone who has been telling investors that doing homework is futile because the market already incorporates all known information. The folks who buy into this notion have stopped looking for information and see no value in doing their own analysis. I am not suggesting that Mr. Siegel and his friends in the EMH camp were the first to promote laziness amongst investors and unknowingly encourage the markets to run off cliffs. Many others before them have touted the same tactics, see the quote from Graham we started with. We’re also certain this won’t be the last attempt to lull investors into believing easy gains are possible from investing in stocks, or houses, or any other asset for that matter. As we’ve seen over the past year, this is the stuff of which tragedies are made.
An article in the Economist reviews a number of the more interesting reasons some strategists remain bearish on stocks.
The Economist has an article tucked away in their special report on the world economy which provides one of the best overviews of how the financial crisis has exposed the strengths and weaknesses of various banking models. Despite the turmoil experienced by the global financial system, a market-based economy remains the ideal way to nurture economic growth. The market-based banking model has advantages, as well, particularly when it comes to funding disruptive technologies and projects. The authors appear to have coined a new term “mincemeat securities”, which we like since it captures many aspects of the crisis while evoking similar risks with industrialized food production, where a small problem with one batch of meat can affect the entire supply.
We hope you had a pleasant summer and are enjoying the start of autumn.
The third quarter was very eventful, both for us as a firm and for the markets in general.
In the financial markets, the events of 2008 continued to reverberate and color all economic activity. After a precipitous drop-off in trade and consumption in the first half of the year, global economic activity began to rise from extremely low levels. Some of the more dire scenarios that had seemed possible just six months ago now look a little more remote. That said, economic activity in most developed countries continues to be far below recent levels and capacity. Unemployment continues to rise in the US and in many parts of Europe. In addition, the commercial real-estate market is suffering, many retailers are struggling to meet sales forecasts, and concerns remain about the holiday shopping season. Federal incentives have supported automobile and home sales, but we view these as temporary measures and not long-term solutions. We believe that unemployment, deleveraging and high savings rates will continue to keep growth rates at very moderate levels for some time to come. American consumers and industry remain cautious, and most participants have accepted that this recovery will be protracted and slow.
The summer also saw very large moves to the upside in both bond and stock markets, particularly in the high risk segments. Along with increased risk-taking, interest rates for intermediate and long-term treasuries have risen from panic lows, with the 10 year yield moving from 2.06% on December 30th to 3.29% today. Meanwhile, the Federal Reserve remains committed to keeping short-term rates at very low levels and the 2 year rate remains under 1%. We continue to believe the Fed will refrain from any material tightening until the end of 2010 as inflation is not a concern at the moment. However, we may see a swift rise in intermediate and long-term rates with any tightening, and have begun to position bond portfolios to take advantage of reinvestment opportunities when that happens.
We remain skeptical of the rally currently underway in global stock markets, and would like to see evidence of a sustained organic recovery (as opposed to one supported by stimulus spending) before we commit any additional capital to risk assets. From past experience, banking crises tend to cast a shadow on markets for a number of years, and we do not believe this episode will be different.
Meanwhile, on the local level, we used the summer to finalize our transition to the independent advisor model and launch a discretionary investment strategy called “Global Macro 10” which we have been discussing for some time (September was the first complete month of performance for this portfolio). Late this month Subir also learned that he had been awarded the Certified Financial Planner™ (CFP®) designation (Louis plans to follow Subir’s lead and will begin working towards his own CFP designation).
We look forward to speaking with you soon and wish you the best over the coming months.
Todd Woody writes in the New York Times on the obstacles solar energy plants in the Southwest face in securing necessary water rights. Certain solar technologies, particularly solar thermal can require large amounts of water to produce and cool steam. Coal, natural gas and nuclear plants require much larger amounts of water per unit of energy produced (though not all of it is consumed), but they can be located near large bodies of water, with the nuclear or fossil fuel being transported to the plant. Utility scale solar power plants in contrast, must be located in areas that receive a lot of sunlight, have high temperatures and by definition are arid. This makes the water sourcing problem much more acute for solar, particularly solar thermal. The American Southwest has had a history of battles over water rights, and the alternative energy industry is only the latest entrant in a long running dispute between cities, farmers, miners and environmentalists in a fast-growing area which has historically been a desert. The US Department of Energy produced a report for congress in 2006 on the interdependency of water and energy production including a discussion of various technologies to improve water-use efficiency in power plants. Wind turbines do not require water.
We believe free and fair trade are not only integral to economic growth, but also essential for a sustained global recovery. Barriers to trade reduce efficiency, inhibit growth, and hurt consumers. We are sympathetic to the argument that countries with weak legal protection for individuals can exploit resources and workers in an irresponsible fashion, but we feel in many cases the benefits from trade can outweigh these concerns and often spur the creation of better institutions and laws. We are also particularly wary of trade barriers being erected at the present time because this is exactly the type of action that exacerbated the economic impact of the crash of ’29, and led to the Great Depression. We’re not there yet, but there are some worrying signs of increasing protectionism. Within this context, we would like to highlight, an article in the Economist about the new US tariff on tires made in China, a report in the New York Times on the union which pushed for this tariff, and Arthur Laffer’s op-ed in the Wall Street Journal on tariffs and the depression, and George Will’s Op-Ed in the Washington Post on the tires tariff.