October 2013

……………Thoughts and Comments

Political Theatre

What do you get if you put a bunch of Congressmen into a room?  A really big air conditioning bill.  Why is there always a crowd around a group of politicians?  They are mistaken for a comedy club act.

Unfortunately, this is not what we mean by political theatre – although I wish it were.  You do not have to worry; we are not becoming theatre critics or political analysts, although it is very hard not to be a political satirist these days.  No, our discussion about political theatre refers to the seemingly never-ending drama that unfolds on Capital Hill (or should that be Heel?) and at the White House.  Currently everyone is in a ruckus about the debt ceiling and the budget.  The media is hysterical (it is the only thing that sells papers any more), lamenting over the catastrophe about to swallow the world.  The only problem is, the drama always turns out the same.  At the last second Congress will come up with a deal that 1) does not address the current overspending by the government; 2) does allow them to keep spending by raising the debt ceiling; and 3) both parties will paint the other as demon spawn.

On the other side of the political page, we have the Fed who has decided to continue to print money in the form of Quantitative Easing to the tune of $85 billion a month.  It will not surprise us if the planned tapering of the QE program does not start at all this year, pushing off the finish of the program by at least an additional six months if not even longer.  Quantitative Easing (versions I-IV) was an emergency measure; yet while the emergency no longer seems to exist, the policy still does.  The Fed continues to act as if the economy is in the same liquidity crisis we were in in 2008 and economic disaster we were in in 2009.  Do they know something or has what was an emergency tactic been made into a permanent Fed policy tool?  Given that the economic numbers have been slowly (very slowly) getting better, it would seem (as we have often seen in the past 100 years as of this December) that the Fed is likely behind the curve and is still looking in the rearview mirror.

Thus, while the country needs serious entitlement and tax reform, it is highly unlikely that Congress will address these issues any time soon.  This leaves our economy in a fiscal policy vacuum, and with the Fed the only policy wonk in the room.  But the Fed only has monetary policy tools with which they can work.  When your only tool is a hammer, every problem begins to look like a nail.

This is of concern to investors because it means that the Fed is likely to keep an accommodative monetary policy for a prolonged time period, leading to numerous long term issues including growing debt levels, distorted asset prices, and continued and growing wealth disparity in the country.  Thus the issues in Washington are not only disconcerting on their own, but the impact on investors is potentially disastrous.  Without leadership – real leadership – our country will find itself faced with another financial crisis before too long.

Investor Decisions

This then leads us to the obvious question of how to invest hard-earned savings?

1)    Fixed Income

Sooner or later, rates are going to rise.  Currently, the yield curve looks like this:  3month T-Bill: 0.04%; 2yr Treasury: 0.66%;  and the 10yr Treasury: 2.63%.

Inflation, according to the CPI is growing at 1.5% through August.  Ignoring the fact that the CPI is highly inaccurate and significantly lower than what it actually costs someone to live in the U.S., it still means that you have to own 7 year treasuries in order to get a positive yield (inflation adjusted) – a whopping 0.49% return!

When the Fed finally allows rates to float freely, interest will rise and the value of current fixed income securities will drop in value to adjust for the rising interest rate demanded by investors.  In fact, as a small note, the reason that the Fed will hold all of their purchases until maturity is not only because they are afraid of moving the markets, but because they would take huge losses if they did otherwise.

Michael Lewitt, author of “The Credit Strategist,” notes two areas of additional concern.  First, liquidity in the fixed income markets has been dropping.  From the repo market to the corporate bond market, volumes have been dropping ever since 2008.  While not surprising, any market turmoil means spreads will widen and prices will be more volatile.

Second, some 66% of corporate credit written in August was free of most covenants – typically a sign of lending during late stages of an economic cycle.  Again, in the case of market turmoil, these credits probably will become very weak.

Thus, either short term – which means you earn next to nothing – or floating rate securities (as long as they adjust relatively frequently) are the best place to be.  In either case, high quality will be imperative; the 3% – 4% one earns on low quality debt will not insulate investors from losses.

2)    Equities

The stock market seems the most likely choice on the face of it. The economy is slowly getting better, so that certainly is a plus.  But at the same time, we are finding many of the problems that culminated in 2008 seem to be reappearing or were never addressed in the first place.

The too-cozy relationship between Wall Street and Federal government is closer than ever.  Synthetics and derivatives have never gone away, and in fact are being issued just like before the crisis.  “Too big to fail” have become even too bigger to fail.

Leverage in the stock markets is higher than back in 2007-2008 and stocks are being led by speculative issues with ridiculous multiples – such as Tesla, Netflix, anything Internet related – which cannot be supported fundamentally.

As we noted last month, revenue and earnings growth are slowing and yet multiples are at highs.  Analysts justify the multiples with the argument that multiples based on next year’s earnings – but of course this assumes that those estimates are not too high to begin with.  Given that we are five years into the “recovery” and most companies are showing signs of slowing growth, that seems a little questionable.

Meanwhile, the stock markets in Europe, Asia and the emerging markets are lower than in the U.S. and there is little growth coming from any of these areas.  What growth there is primarily is due to their own money-printing efforts and exports.  But as we have said many times, exporting your way to growth only works if someone else is importing.

3)    Commodities

With everyone printing money, gold should rise as a protection against loss of purchasing power.  But even in the past two weeks, as the U.S. dollar has dropped against many currencies, gold has dropped as well.

Oil prices have been trading in a range for four years, moving between current highs and prices some $10/barrel lower, as growing instability in the Middle East has been offset by the tepid growth of most economies in the past twelve months.

Historically, most other commodities are going to be driven by economic demand: copper and lumber by housing, silver by electronics and the dollar, etc.   With weak worldwide demand, significant price jumps would seem unlikely.

However, in the past ten years, commodities have been the haven of investment banks turning commodities into another trading center.  Thus few of the commodities trade based on supply and demand, as the supply is often manipulated by these traders.  A number of banks are now being investigated (or already have settled charges) on these issues, which is good in the long run, but until they are removed from the marketplace, prices continue to be distorted.

The lack of an obvious asset class leads us to believe that one must stay very diversified.  Certainly, there are individual situations that are attractive, however, there is little to argue  for heavily overweighting any asset class.

For those that would argue that being 100% in stocks works best over time, we would agree – as long as the time frame is at least fifteen to twenty years.  However, many investors do not have that long of a time horizon.

For example, in the past six years, the S&P 500 has appreciated a total of 12%.  If you change the time frame by two months, the S&P 500 is up only 6%!  The same is true of the bond markets.  Over the past six years, the bond markets are up 8%.  But change that by just a few months and the bond markets were up 24%!  Such small changes in time frames result is massive changes in return denotes the precariousness of large asset class positions during the increasing volatility markets.

The Bottom Line…

We continue to believe that there are individual companies and securities that offer attractive opportunities.  Yet, to be heavily invested in any asset class is problematic, offering a great deal of risk along with the reward.  Thus we will continue to stay diversified, even though it limits our upside for the time being.  Protecting capital now will ensure the ability to play later when opportunities are more attractive; those who get too greedy will find they have no capital left with which to participate.

Alan E. Rosenfield                                                                                                                               Managing Director


October 2013


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