Some time ago we stumbled upon Crestmont Research – you can find their website here.  They use the memorable metaphor “sailing vs. rowing” to illustrate the changing investment methods needed to weather different markets. 

When valuations are attractive (like in the good old days and unlike today) investors can sail.  Cheap assets revert to the mean, so the brisk winds of mean reversion blow abaft the beam and propel the good ship USS Retirement Fund forward.  The last period of sailing weather began in 1982, with P/E ratios of 7 and ended in 2000 with P/E ratios of 42.  This chart from Crestmont illustrates the annualized returns during that period.  2000 saw an abrupt end to sailing weather. 

Which leads us to rowing.  When valuations are at or above fair value, we have to work to achieve positive returns.  We spy attractive relative valuations in high quality US stocks, so we row in that direction and add a few more points of exposure to our portfolio.  If their valuations become less attractive, but emerging market stocks begin to look cheap, we row away from US high quality and towards emerging.  Buy and hold does not work in this environment.  We must actively rebalance our portfolios to lock in gains and take advantage of sell-offs to buy (at least temporarily) cheap assets.  The same Crestmont chart illustrates our current rowing weather, which began in 2000 with P/E ratios of 42 and continues through 2009 with P/E ratios of 17. 

Rowing takes effort, and at times the effort may not seem to payoff.  We may spend a fair amount of time making little headway, grabbing gains a few points at a time.  But these market conditions call for rowing.  With the proper tactical changes to asset allocation we can stick close to our long-term return objectives and wait for valuations to improve.  And with time and patience, we’ll once again catch the trade winds and fill our sails.

The Bank Credit Analyst has been TCI’s “go to” economist since Hector was a pup.  The BCA’s most widely known contribution to the lexicon of economics has been the term “Debt Supercycle.”  The Debt Supercycle describes the build up in indebtedness that has been occurring since the end of World War II.

Prior to the introduction of automatic stabilizers such as unemployment insurance and government sponsored deposit insurance, economic upturns typically ended in credit crises that fully unwound leverage that had built up during the expansion.  Not so ex-post stabilizers.

Because government policies have been so successful during the past 65 years in moderating economic downturns, the level of leverage has never completely unwound during a series of shallow post-war recessions.  Consequently, our domestic indebtedness has built upon the debts of the past until we have reached an unsustainable level.  Policy makers are desperately trying to restart the cycle one more time, primarily through the government taking on debt that the private sector cannot or will not.

Whether or not the policies are successful, the Debt Supercycle must turn at some point.  A long period of increasing indebtedness will be followed by a turbulent period of deleveraging.  While beneficial in the long-term, deleveraging will prove a drag on economic growth for at least the short-term.

John Hussman’s latest offering can be found here.  He manages the Hussman Strategic Growth Fund (HSGFX), one of two long/short equity funds that we own in our portfolios.  Dr. Hussman is not excited by much of the positive economic news that we have heard this year.  He feels that government largesse has created a false sense that we have entered a self-sustaining recovery.

Hussman cites a list of indicators – he calls them “Aunt Minnies” – that taken as a whole accurately identify oncoming recessions.  The indicators are:   1. Widening credit spreads.  2.  Moderate or flat yield curve.  3.  Falling stock prices.   4.  Moderating ISM and employment growth.  Hussman believes that the four criteria are very close to being met and that the confluence will point towards a double dip recession.

Dr. Hussman is a long/short equity manager, a breed that we have found to be less optimistic than the average investor.  In the words of Yeats, “He had an abiding sense of tragedy, which sustained him through temporary periods of joy.”  With that being said, Hussman is an interesting and insightful writer and thinker.  His opinions are worth noting.

I just finished reading The Big Short by Michael Lewis.   The book discusses Wall Street’s role in the subprime mortgage scandal from 2005 to 2008.  It is a huge understatement to say that this book casts a very unfavorable light on Wall Street ‘professionals’.   Greed and hubris are everywhere from rating agencies to investment bankers to insurance companies.  The key motivation was to keep the subprime mortgage game going so all of these people could line their pockets.   The fact that home prices had not fallen nationwide since the 1930’s was all the experts needed to know.

Almost universally the players were not the victims.  Many walked away rich or worse yet, are still very gainfully employed.   My ‘favorite’ story is that of a Morgan Stanley trader, Howard Huber, who was “smart enough to be cynical about the market but not smart enough to know how cynical he needed to be”. Howard managed to lose $9 billion dollars for Morgan Stanley.   He was allowed to resign in 2007 having to somehow exist on his previous earnings including a $25 million bonus from the previous year.   

The real losers in this story are taxpaying Americans who funded the bailout as well as paying for the huge government stimulus expenses necessary to try and avoid further economic calamity. 

We held our annual Spring Conference on May 5^th.  The conference serves as an opportunity for us to recap the prior year’s performance, check-in on year-to-date performance and to express our outlook for the rest of the year.  Our tone was decidedly gloomy.  For many of the reasons we have touched on in this blog, we view lower than normal economic growth during this recovery as the most likely outcome.  Also, valuations across most asset classes appear to be rich.  Consequently, our allocations are more conservative than normal.

As of the close of the markets on May 5, our balanced model portfolio had returned 1.66% year to date net of fees.  The two benchmarks we measure ourselves against – the Wall Street Index and Morningstar’s US Open-end Moderate Allocation – had returned 2.98% and 2.95% respectively.  Part of the challenge of being value investors (as we are) is the inevitability that you will spend a fair amount of time trailing your benchmarks.  Valuations pull persistently but gently on asset prices.  Other factors, such as momentum driven by panic or euphoria can temporarily (but for perhaps quite a long time) move prices well below or beyond fair value.  And so, after having out-performed on a relative basis for the last several years, we found ourselves on May 5 reiterating our views on value and mean reversion to explain our conservative stance and our willingness to let the market party without us.

So it was with exquisite timing that on May 6 the Great 2010 Flash Trader Sell-off sent the DJIA plunging 1000 points intraday.  The S&P 500 lost 8.2% for the month; our balanced model returned -3.82% net of fees versus the Wall Street Index at -4.81% and the US OE Moderate Allocation at -5.36%.  We have almost caught the benchmarks year-to-date, with our balanced model (net of fees) down 0.94% versus a -0.01% for the Wall Street Index and -0.55% for the US OE Moderate Allocation.

The funds that helped us to limit downside risk during the month were Hussman Strategic Growth (a long/short equity fund) with a return of 4.09% and PIMCO All Asset All Authority (a global allocation fund) with a return of 0.09%.  Both funds are included in our Opportunistic Sector which for May returned -0.13%.  By way of comparison, our Stable Sector returned -0.09% MTD and our Equity Sector returned -8.83%.  (Remember that the Equity Sector includes a fair allocation to foreign stocks that struggled in May even more than US stocks.)

Because of the poor valuations of most stocks and bonds, for the most part of this year and a good part of last we have been underweight Equity and Stable and overweight Opportunistic.  We have no opinion as to what the market will do, particularly in the short run.  We have recently re-balanced our portfolios to decrease exposure to US mid/small stocks, REIT’s and US bonds as these asset classes are the most over-valued.  We have added to our US high quality stocks and emerging stocks as they are the most relatively under-valued.  Overall, our allocations remain conservative and will continue to do so until such point that valuations improve and investors can expect to be paid for taking risk.

Last Friday we spent 45 minutes talking to Michael Orkin, the lead manager of the Caldwell & Orkin Market Opportunity Fund. The fund is a long/short stock fund with seemingly random but often unfavorable results over short time periods and 800% annual turnover.  So what is there to love?

This fund is a perfect example of a fund that is purchased for its role in a portfolio.   This fund has been there when it was most needed.  Take a look at last 4 bear markets:

Since the fund began on August 24, 1992 it has provided an average annual return of 9.21% versus 8.22% for the S&P 500 Index.  In sum the fund plays a strong defensive role (like insurance) in a portfolio without sacrificing long term results.   The fund can be tough to live with in good markets.   It is no fun to pay insurance premiums when insurance seems unnecessary.

So what did Michael say?  First, the turnover is mostly a result of risk controls placed on short positions.  Remember unlike long positions, short positions grow larger as they go against you, so risk control is vital.   Second, Michael believes the market faces many economic headwinds and is still in a secular bear market that began in 2000.   Third, Michael believes that current corporate accounting standards leave plenty of room for accounting irregularities that often creat shorting opportunities. 

As of April 30^th the fund was 47% long and 12% short or 35% net long.  The rest is mostly cash equivalents.  He told us that since then the fund has become even more defensive moving to only 15% net long.   Things happen fast in the world of Caldwell & Orkin. 

Over at the Economist’s website, the blogger Buttonwood has a fascinating post comparing Greece’s debt problems with those of our worst offending states, namely New Jersey, New York, California, Massachusetts and (heaven help us) Illinois.  While the five states owe the ugly aggregate sum of $200 billion, Greece alone owes $428 billion.  The comparison is even more shocking when you consider the fact that the five states have an aggregate economic output of $4.45 trillion while Greece’s is $331 billion.  Hence the reason the EU member nations, the IMF and the global markets have been so concerned about the enormity of the Greek debt crisis.

Buttonwood’s blog is well worth following.  You can read his post here.

Jeremy Grantham’s quarterly letter is a must read.   It is posted in the resources section of the TCI website under commentary.  Read it here.   What follows are the highlights:

Conservative investors earn almost nothing on their bank deposits in order to restore the financial health of banks and bankers.  This policy begs us to speculate.

The obvious cost of the bailout is unprecedented deterioration in the Federal balance sheet.

The concept of moral hazard has changed.  It used to be a vague expression of intent: “If anything goes wrong, I will help you if I can.”  It seems to have been transmuted into a cast-iron commitment.

The economy if limping back into action, but faces some tough headwinds that Jeremy collectively calls “seven lean years.”

Overpricing of markets is only a mild downward pull.  Its virtue is that it never quits. Eventually it wears the market back to fair value.

The economy has three possible outcomes, none of them particularly good.

U.S. large quality companies are still a little cheap, having been left behind in the rally.

I recommend you read the whole piece to ‘enjoy’ Jeremy’s caustic view of current financial affairs.

We are just back from a trip to California to meet with several different managers, including PIMCo.  Regular readers will recall that we listen closely to PIMCo, particularly about matters affecting bond markets.  We make our investment decisions based primarily upon asset valuations, but we believe it is important to identify macroeconomic trends.  

To wit: inflation.  We are concerned that the Fed’s policy of quantitative easing (Fed-speak for printing money) and anticipated political pressure to delay removing monetary stimulus from the economy will give rise to inflationary pressures.  As Milton Friedman once famously said, “Inflation is always and everywhere a monetary phenomenon.”  While inflation is a distinct possibility in the long-run, according to the folks at PIMCo, deflation is a much more likely short-term risk.  High unemployment, a slow economic recovery and slack in aggregate demand will exert downward pressure on prices.  In fact, we have seen core inflation decline from 2% last year to 1% now.  With short-term interest rates near zero and a swollen Fed balance sheet, policymakers have little room to maneuver to fight deflation. 

PIMCo also identifies the ongoing deleveraging cycle as an important macroeconomic trend.  Not only does this relate to the effects on consumption brought about by tighter credit markets, it also reminds us of the staggering amount of debt still on the balance sheets of households and governments alike.  The PIMCo folks are quite concerned about the Greek debt crisis (see “Beware of Greeks Bearing Debt” below.)  The European Union faces some challenging times ahead, a period of years rather than months. 

At TCI, our portfolios remain conservatively positioned.  The year-long bull market has moved most asset classes from under-valued to over-valued.  Overlay a macroeconomic outlook of slower-than-normal-growth and you can see how we have arrived at our current position.

The recovery in residential real estate has been somewhere between painstakingly slow and non-existent.    So why have real estate investment trusts (REITs) recovered so quickly since the market bottom in March of 2009?   Last week Chip McKinley, portfolio manager of the Cohen & Steers Global Real Estate, came by to provide an answer.    As always the answer is money.   Investors were certain that commercial real estate loans would be a victim of the credit collapse. They were—but not to the point of extinction. Chip told us that at the bottom AAA 10-year commercial mortgage-backed securities yielded 14% more than 10-year treasury securities.  Not much money was available even at that rate.  Now money is available at a spread slightly below the historical norm of  3.30%.   In addition, commercial real estate prices were down 38% last March.   Speculators expected a massive fire sale as highly-leveraged private real estate holders were forced to sell.  Instead, commercial real estate prices have recovered by 14% since then.

 One lesson is that REITs are liquid investments that quickly reflect the emotions of the market.  REITs lost about 65% between October of 2007 and March of 2009.  The 100% recovery of REITs since then leaves them still down 25%.  Another lesson is that Main Street has suffered far more than Wall Street since the “Great Recession” began.   Big banks are back in business and making loans.  Small banks are still trying to stay in business.