July 2013

…………..Thoughts and Comments


The Logic of the Markets

So unless you live in a hole or do not have access to the internet, a television, or a newspaper, you know that the markets have gone crazy in the past few weeks.

Three weeks ago, the Fed announced that they would start considering the possibility of maybe slowly starting to reduce Q3 of $85 billion in monthly fixed income purchases. The suggestion was that if the economy continued to show strength they might start reducing the purchases by the end of this year and finish with it completely by the middle of 2014. This, however, requires that the Fed see stronger economic numbers, including lower unemployment and higher inflation. And even with that, they expected to keep fed fund rates at the current 0% until at least 2015.

On this announcement, the S&P 500 dropped 4.8% in a week. The ten-year treasury, which was at 1.81% yield in May, had steadily climbed up to 2.12% by mid-June. The same week the stock market dropped, bond prices dropped even harder, losing 22% and as of this writing currently yielding 2.67%. Gold, which has been under pressure all year, but particularly in the second quarter, plunged 12.5% the same week, making for a 25% loss in gold for the quarter.

A little confused why everything went down together? Let me explain: Gold went down because there is no inflation and if the Fed cuts all the spending there never will be any inflation and thus the 25% drop. Bonds dropped because now that the Fed isn’t going to be buying all the bonds with the dollars they print, then interest rates will rise. And stocks dropped 6% because the economy is getting stronger. No wait, stocks dropped because the Fed was going to stop printing money and the economy won’t be strong because interest rates rose. Oh wait, if the economy doesn’t get stronger then they will keep printing money. But wait, then inflation is an issue….

Okay, so maybe the reason isn’t all that evident. This is largely because the markets have, since the Fed starting manipulating them after the 2008 calamity, been influenced by abnormal stimuli. The real reason for the high correlation is due to the enormous leverage in the system (more so than in 2008) combined with the fact that the markets are currently the playground for traders rather than investors. And at the first sign of a change, the traders all ran for the exits at the same time – just like they always do. And that is why absolutely everything fell at the same time.

This is not new – we have been discussing this for well on a year now. What is important to understand is the risks – a word the markets and most investors seem to have forgotten – associated with the current securities marketplace.

Alfred E. Neuman, Investor

This is Alfred’s type of market. For those of you don’t remember Mad Magazine (first published in 1952), he was the weird looking guy that had that dumb smile with the caption: “What, me worry?”

He has since grown up and is loaded up with Mr. Bernanke’s cheap money.

Given the cheap money, Alfred is leveraged up big time. He has driven up prices without worrying about valuations, about cheap money being printed by virtually all governments in the world, or about addressing many of the banking/securities issues that 2008 laid bare. He is very short-term-focused and momentum-driven, and he believes he is the one investor who will get out just before all of the other Alfreds make a mad rush for the exit.

The Risks at Hand

None of this information is new and most recognize that the risks exist. Many believe these risk are already discounted by the markets. However, discounting the concern about risk (because everyone recognizes it exists) is not that same as discounting prices to adjust for the risk, which is exactly the markets proved last month.

When, sooner or later, something happens to reverse the course of the markets—whether it is a cyclical economic slowdown or a black swan event—the markets will suddenly remember the existing “built in” risks and add them to the new concern, increasing the total pain. Risk hasn’t been discounted into prices, only into risk tolerance.

Investing, Fundamentally Speaking

Most stocks today appear to be very fully valued (which is the nice way of saying “too expensive on a risk-adjusted basis”). P/Es are very high – between 18 and 22 – margins are dropping, cost of capital has risen, and the growth in revenue and earnings are slowing.

In the past month and a half, we have taken some profits off the table. For example, we have reduced our positions in Balchem, Stepan and Wabtec – all of which were up in excess of 30%. We also sold our positions in utilities and reduced our positions in natural gas and will wait for more attractive entry points before adding to them again.

In all cases, we felt that pricing was based on the absolutely perfect scenario, which means under normal circumstances, the risks at this point are greater than the associated reward.

This doesn’t mean we were just wholesale selling stocks and running from the market. In fact, during the last few weeks, as the markets gave us opportunities, we added to our Abbvie, Pitney Bowes, and Japan holdings.

We are close to adding to our gold holdings, having dramatically reduced them earlier in the year. August through February is the peak demand period for gold in many countries such as India, trades are shorting gold in record numbers, and Asia has continued to be large buyers throughout the sell-off in gold. On top of all of this, gold mining companies are now selling at prices from ten years ago, and in a number of cases are selling way too cheaply in our opinion. Several have almost no debt, are growing (all of which is being paid for from internally generated cash flow), and are profitable, even at $1200/oz.  We should see the stocks push down again and that is when we will step in.

Finally, we have added a little to our longer maturities in the bond market (10 years with our average portfolio duration of still under two years). Part of the purchases we have hedged, and part we have not.

Our reasoning is as follows: Mr. Bernanke has made it eminently clear that, before he reduces the cheap money, the economy will have to be much stronger than it is. In addition, neither the White House nor Congress wants a tight monetary policy, as we could have a recession and that is not good in an upcoming election year. We expect Yellen will be the next Fed chair, and she makes Bernanke looks like a hawk. So we expect easy money for some time.

Furthermore, company earning reports are about to start again, and unless we see very different reports from the past several quarters, we do not see anything that indicates a dramatically stronger economy.

All of this suggests that interest rates will go lower from here – somewhere in the 2.10% -2.25% range from the current 2.67%.

The Bottom Line…

Volatile markets have made us a little more active: both to take advantage of opportunities that show up quickly with very little notice and to protect profits from unexpected surprises.

We continue to believe that portfolios should be diversified by asset class, even though this has reduced the overall returns to date. Risks are simply too high to make an all-in bet on the markets at this time.

Protecting your capital will ensure you have it to invest for the next real bull market, one free to operate from the manipulations of government printing presses around the world.


Alan E. Rosenfield, Managing Director

July 2013


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