The counterpoint to Fingers of Instability is Glimmers of Hope (see here for an explanation of the thinking behinds Fingers of Instability and Glimmers of Hope), which looks at some of the things that could go right in the economy and drive markets higher.
- Private Sector to drive GDP growth
While Our Man believes that the underlying problem in the US (and other places) is primarily a solvency issue, the Government and the Fed believes that through increased fiscal spending and liquidity (i.e. QE1, QE-lite and QE2) they can help provide an escape valve. In essence, QE and fiscal stimulus have supplied liquidity to the market to help boost GDP and asset prices. This has provided support for the private sector, allowing it time to repair its balance sheet and rebuild confidence in the economy. The underlying hope is that with confidence rebounding and balance sheets in better shape, the private sector will be able to take over the leadership in driving GDP growth and balance sheets can be further repaired as a function of this growth. The Q4 survey data showed the first hints of truly positive data points, and this was supplemented by the Q4-10 GDP data which saw Real Final Sales leaping to 7%+ annualized from the 1-2% run-rate since the recession ended. (Tim Duy has other morcels of good news from the recent Q4-10 GDP data)
- QE2 & the Wealth Effect
The other aim of Quantitative Easing has been to help US households rebuild their balance sheets & net worth, primarily through rising equity prices and the attempt to curtail the fall in house prices. The additional hope is that a rising market will further help build confidence in the economy by boosting investors’ “animal spirits”. Should this prove successful, there’s the possibility of the strong market performance (since QE2 rumours abounded during late-Q3) turning into a melt up.
- Falling Unemployment (and Rising Incomes)
It should go without saying that the best way for US households to repair the balance sheets and increase consumption is for them to be employed in jobs whose salaries are increasing! With regards to the first part, Weekly Unemployment Claims still remain elevated by historical levels, but they have certainly declined from their peak. This, coupled with hiring starting to edge up as the private sector gains confidence in the economy’s stability, has seen the economy start to produce net hiring over the last 6months. While the numbers have been small, they have helped chip slowly chip away at the unemployment numbers. While the second part of the equation has been quieter, Our Man think it’s fair to surmise real incomes are more likely to rise in a falling unemployment market than a rising one!
- China & an Asian soft landing
In much of a similar vein to last year’s Glimmers, perhaps Our Man remains just plain ole wrong on China. Maybe they genuinely have built a better mousetrap in terms of this whole running an economy thing! And if they haven’t, well they’ve shown a willingness and ability to throw money at problems whenever they arise. While this may lead to longer-term imbalances and further misallocation of resources, it could certainly help 2011’s markets.
- Valuation
Like the prior note, it’s another repeat from 2010’s list. Our Man continues to mutter that it’s an expensive market (and using longer-term measures it is) but if one only looks at short-term horizons (or uses current year P/E, or mutations of it….such as P/E based on Operating Earnings, or projected forward P/E, etc) then the market can look cheap.
- Constructive Government behaviour (in the US and Europe)
Stranger things have happened! In the US, with a Democratic President looking to run for re-election in 2012 and the Republican’s having taken over Congress there is incentive for both parties to ensure the economy doesn’t suffer a reversal in the next year or two. Who knows, perhaps they might even find their way to co-operating to do something constructive on Medicare/Medicaid and Social Security over the coming year or so. In Europe, with Greece and Ireland having to be bailed out by their European partners, and Portugal seemingly next on the list, perhaps recent reports of a move towards investors having to take haircuts on their troubled bonds (i.e. reducing the debt burden, for those countries in trouble by making investors take a loss on their bonds) is the first step towards sorting out their sovereign debt problems.
Monday, January 31
Monday, January 17
NCAV 2011-1
The first NCAV update of the year, proved to have no major impact on the Absolute Value bucket portfolio (for information on this bucket, and how it works, read here).
Three new names (NINE and PCC) were found by the screen but were removed by my qualitative overlay;
- PCC and SVLF: the screen used total assets (rather than current assets) thereby invalidating its calculation of NCAV.
- NINE: the financial statements used were stale (over 6months old) and hence NINE was qualitatively removed.
A number of existing names (BXG, LAB, LTON, NED, TWMC, and XIN) reappeared on the screen. As such, the final date that these names must be sold by has been extended (here are the rules when NCAV names are sold).
Finally, a short update on QXM who were subject to a take-over offer from their majority shareholder, Qiao Xing Universal Resources (XING), back in September. The offer was of $0.80 in cash and 1.9 shares in XING for each of share in QXM, which is potentially worth $5.95 (XING closed at $2.71 on Friday) or about 20% higher than QXM’s closing price. In early January, a special committee of QXM’s directors has authorized that the offer be put to minority shareholders. As such with QXM trading at a discount to the bid-value, and since Our Man doesn’t want to hold any XING shares, the position will be sold either on/around 1st April 2011 (when it will have spent 366 days since last appearing in the NCAV screen) or earlier, should the deal with QXM be approved and close (so that Our Man does not receive any XING shares).
Three new names (NINE and PCC) were found by the screen but were removed by my qualitative overlay;
- PCC and SVLF: the screen used total assets (rather than current assets) thereby invalidating its calculation of NCAV.
- NINE: the financial statements used were stale (over 6months old) and hence NINE was qualitatively removed.
A number of existing names (BXG, LAB, LTON, NED, TWMC, and XIN) reappeared on the screen. As such, the final date that these names must be sold by has been extended (here are the rules when NCAV names are sold).
Finally, a short update on QXM who were subject to a take-over offer from their majority shareholder, Qiao Xing Universal Resources (XING), back in September. The offer was of $0.80 in cash and 1.9 shares in XING for each of share in QXM, which is potentially worth $5.95 (XING closed at $2.71 on Friday) or about 20% higher than QXM’s closing price. In early January, a special committee of QXM’s directors has authorized that the offer be put to minority shareholders. As such with QXM trading at a discount to the bid-value, and since Our Man doesn’t want to hold any XING shares, the position will be sold either on/around 1st April 2011 (when it will have spent 366 days since last appearing in the NCAV screen) or earlier, should the deal with QXM be approved and close (so that Our Man does not receive any XING shares).
Sunday, January 9
2011: Fingers of Instability
This is Our Man’s way of (exceptionally broadly, see here for an explanation of the thinking behind Fingers of Instability & Glimmers of Hope) applying the concepts of Bak-Tang-Wisenfeld’s sandpile model to how he thinks about investing
- Fraudclosure & the Housing Market
Residential construction has been an important driver in post-WW2 recoveries. Unfortunately, there have been recent signs of a double dip in house prices and the underlying problem of too much supply/too many homes on the market has not been solved. One of the ancillary factors that has been in the background is the “fraudclosure” scandal. While the long-term impacts are unclear, what is clear is that there is greater doubt surrounding the ownership of homes (both foreclosed and not) in the US, which adds yet more uncertainty to the housing market. In all probability there’s unlikely to be any Federal moratorium on foreclosures, though a State-level moratorium (like we saw in the 30’s) is eminently possible. An interesting, but less talked about issue, remains that most of the Mortgage-Backed Securities vehicles (to whom the mortgages were sold) were enacted under NYS Law, where the dealer has to deliver to the mortgage notes to the trustee. If the trustee doesn’t have notes, then the contract isn’t alive and is potentially uncollateralized which I’m certain will lead to all manner of legal arguments.
- Property Taxes, and State & Local Government Finances
The unwritten story of foreclosures is the impact on property taxes, which will hamper state and local governments. This is just another problem for cash-strapped states and local governments with a number of analysts predicting potential defaults in 2011 and the municipal bond market reacting negatively. What does seem likely is that we’ll see some belt-tightening at the state level.
- European debt problems
During 2010 we saw bailouts for Greece and Ireland, what does 2011 hold for Portugal, Spain and Italy? The Europeans have largely been resistant to burden-sharing (i.e. making bondholders take a haircut), instead preferring bailouts of troubled members, as this would force European banks to take losses and potentially raise fears concerning their stability. It will be worth watching to see if there's any impact from the Irish election in March, where the opposition currently lead by double digits and are threatening to press for debt reduction.
-The make-up of the Fed and Politics
Ron Paul, author of “End the Fed”, is now the chairman of the sub-committee charged with overseeing the Fed which should prove for closer Congressional scrutiny and livelier hearings. However, a more important change is in the voting make-up of the Federal Reserve; 2 of the new voting Federal Reserve Bank presidents (Charles Plosser, Philly Fed, and Richard Fisher, Dallas Fed) oppose QE and a third (Narayana Kocherlakota, Minneapolis Fed), is skeptical that it will work. They replace three of the “doves” (Rosengren (Boston Fed), Pianalto (Cleveland Fed) and Bullard (St. Louis Fed), which may not make QE3 as inevitable as it currently seems.
-Inflation (in China)
Our Man has talked about inflation in China before, in large part because it presents great difficulties for the economic planners there. The two biggest ways that the Chinese have been trying to control it is through raising rates and controlling credit expansion (directly, or indirectly via the banks’ reserve ratios). However, both of these have the potential impact of slowing down their economy growth which has been a driver of Global growth (and especially commodity prices) and is expected to grow at 10% (ad infinitum!). Furthermore, given the possibility of a credit-driven bubble in Chinese property are the Chinese about to discover (like their Western peers) that it’s not easy to engineer a soft-landing from a credit boom?
- Global Trade, Protectionism & Emerging Asian Economies
For those who are historically minded, the steady decline of Global Trade and the rise of Protectionism, was one of the noticeable features of the 1930's depression in the US. With many seeing Quantitative Easing (QE) as an attempt to weaken the dollar, others accusing China of currency manipulation and most countries still hoping to drive GDP gains through increases in exports, it is little surprise that rhetoric surrounding trade wars continues to increase. Let’s hope we don’t see an equivalent of the Kindleberger spiral for 2010’s!
- Valuation
Though market participants always seem to manage to call the market ‘cheap’, from Our Man’s perspective the market does not appear cheap based on long-term measures. Both the Shiller CAPE ratio (currently 22x vs. a historical average of 16.5x), and the Tobin’s Q (Q3-end 1.05x vs. a historical average of 0.70x) suggest that markets are over-valued. While these long-term measures have not helped investors time the markets, they have served as good long-term guides to valuation and are worth noting.
- Fraudclosure & the Housing Market
Residential construction has been an important driver in post-WW2 recoveries. Unfortunately, there have been recent signs of a double dip in house prices and the underlying problem of too much supply/too many homes on the market has not been solved. One of the ancillary factors that has been in the background is the “fraudclosure” scandal. While the long-term impacts are unclear, what is clear is that there is greater doubt surrounding the ownership of homes (both foreclosed and not) in the US, which adds yet more uncertainty to the housing market. In all probability there’s unlikely to be any Federal moratorium on foreclosures, though a State-level moratorium (like we saw in the 30’s) is eminently possible. An interesting, but less talked about issue, remains that most of the Mortgage-Backed Securities vehicles (to whom the mortgages were sold) were enacted under NYS Law, where the dealer has to deliver to the mortgage notes to the trustee. If the trustee doesn’t have notes, then the contract isn’t alive and is potentially uncollateralized which I’m certain will lead to all manner of legal arguments.
- Property Taxes, and State & Local Government Finances
The unwritten story of foreclosures is the impact on property taxes, which will hamper state and local governments. This is just another problem for cash-strapped states and local governments with a number of analysts predicting potential defaults in 2011 and the municipal bond market reacting negatively. What does seem likely is that we’ll see some belt-tightening at the state level.
- European debt problems
During 2010 we saw bailouts for Greece and Ireland, what does 2011 hold for Portugal, Spain and Italy? The Europeans have largely been resistant to burden-sharing (i.e. making bondholders take a haircut), instead preferring bailouts of troubled members, as this would force European banks to take losses and potentially raise fears concerning their stability. It will be worth watching to see if there's any impact from the Irish election in March, where the opposition currently lead by double digits and are threatening to press for debt reduction.
-The make-up of the Fed and Politics
Ron Paul, author of “End the Fed”, is now the chairman of the sub-committee charged with overseeing the Fed which should prove for closer Congressional scrutiny and livelier hearings. However, a more important change is in the voting make-up of the Federal Reserve; 2 of the new voting Federal Reserve Bank presidents (Charles Plosser, Philly Fed, and Richard Fisher, Dallas Fed) oppose QE and a third (Narayana Kocherlakota, Minneapolis Fed), is skeptical that it will work. They replace three of the “doves” (Rosengren (Boston Fed), Pianalto (Cleveland Fed) and Bullard (St. Louis Fed), which may not make QE3 as inevitable as it currently seems.
-Inflation (in China)
Our Man has talked about inflation in China before, in large part because it presents great difficulties for the economic planners there. The two biggest ways that the Chinese have been trying to control it is through raising rates and controlling credit expansion (directly, or indirectly via the banks’ reserve ratios). However, both of these have the potential impact of slowing down their economy growth which has been a driver of Global growth (and especially commodity prices) and is expected to grow at 10% (ad infinitum!). Furthermore, given the possibility of a credit-driven bubble in Chinese property are the Chinese about to discover (like their Western peers) that it’s not easy to engineer a soft-landing from a credit boom?
- Global Trade, Protectionism & Emerging Asian Economies
For those who are historically minded, the steady decline of Global Trade and the rise of Protectionism, was one of the noticeable features of the 1930's depression in the US. With many seeing Quantitative Easing (QE) as an attempt to weaken the dollar, others accusing China of currency manipulation and most countries still hoping to drive GDP gains through increases in exports, it is little surprise that rhetoric surrounding trade wars continues to increase. Let’s hope we don’t see an equivalent of the Kindleberger spiral for 2010’s!
- Valuation
Though market participants always seem to manage to call the market ‘cheap’, from Our Man’s perspective the market does not appear cheap based on long-term measures. Both the Shiller CAPE ratio (currently 22x vs. a historical average of 16.5x), and the Tobin’s Q (Q3-end 1.05x vs. a historical average of 0.70x) suggest that markets are over-valued. While these long-term measures have not helped investors time the markets, they have served as good long-term guides to valuation and are worth noting.
Monday, January 3
December Review
Performance Review
The portfolio’s behaviour and performance in December tended to be broadly reminiscent of recent months, especially October. The result, a fall of 180bips in December left the 2010 performance at a disappointing +5.04%.
The theme of recent months, weak Treasury bond performance as hopes for economic growth increased, continued throughout December. The Long Treasury Bonds (-166bps) and Long Bond Funds (-26bps) contributed substantially all of the portfolio’s losses during December. While their combined sizable negative contribution over the last 4 months of the year hampered the portfolio, it should not be forgotten that they were the largest contributors to performance (c500bps combined) throughout the year.
With December proving to be another strong month for equities, it is little surprise that the main positive contribution came from the various Equity buckets. Value Idea Equities (+28bps), NCAV Equities (+35bps) and Other Equities (+2bps) all largely moved with the markets. Against this, the Hedges/Put Options bucket (-34bps) suffered from both the rise of the equity markets and the continued fall in volatility. For the year, the NCAV bucket (+45bps) contributed well and largely outperformed the market from its inception during the latter half of the first quarter. The other main equity buckets (Value Idea Equities, Other Equities and Hedge/Put Options) were largely a wash during the year, with the negative performance of the Hedges/Put Options cancelling out positive performance from the other buckets. I was early in exploiting my China thesis and that bucket (-35-40bps) was a negative contributor. The position in Gold, which was sold far too early, also proved to be a small negative contributor.
Finally, the recently introduced Currencies bucket (-19bps) gave back part of its gains during the month as the Euro strengthened following approval of a bailout package for Ireland.
Portfolio
41.3% - Long Treasury Bonds (TLT and the Aug-29 Bond)
14.6% - Long Bond Funds (HSTRX, and VBIIX)
8.1% - Value Idea Equities (THRX, and DRWI)
4.6% - NCAV Equities
3.1% - Other Equities (NWS, CMTL and SOAP)
-0.0% (delta-adjusted) - China-Related Thesis (<1bp premium in FCX put)
-1.3% (delta-adjusted) - Hedges/Put Options (43bps premium in S&P Dec-11 puts and 1bps premium in a GS Jan-11 put)
6.0% (leverage-adjusted) – Currencies (EUO)
25.0% - Cash
The portfolio’s behaviour and performance in December tended to be broadly reminiscent of recent months, especially October. The result, a fall of 180bips in December left the 2010 performance at a disappointing +5.04%.
The theme of recent months, weak Treasury bond performance as hopes for economic growth increased, continued throughout December. The Long Treasury Bonds (-166bps) and Long Bond Funds (-26bps) contributed substantially all of the portfolio’s losses during December. While their combined sizable negative contribution over the last 4 months of the year hampered the portfolio, it should not be forgotten that they were the largest contributors to performance (c500bps combined) throughout the year.
With December proving to be another strong month for equities, it is little surprise that the main positive contribution came from the various Equity buckets. Value Idea Equities (+28bps), NCAV Equities (+35bps) and Other Equities (+2bps) all largely moved with the markets. Against this, the Hedges/Put Options bucket (-34bps) suffered from both the rise of the equity markets and the continued fall in volatility. For the year, the NCAV bucket (+45bps) contributed well and largely outperformed the market from its inception during the latter half of the first quarter. The other main equity buckets (Value Idea Equities, Other Equities and Hedge/Put Options) were largely a wash during the year, with the negative performance of the Hedges/Put Options cancelling out positive performance from the other buckets. I was early in exploiting my China thesis and that bucket (-35-40bps) was a negative contributor. The position in Gold, which was sold far too early, also proved to be a small negative contributor.
Finally, the recently introduced Currencies bucket (-19bps) gave back part of its gains during the month as the Euro strengthened following approval of a bailout package for Ireland.
Portfolio
41.3% - Long Treasury Bonds (TLT and the Aug-29 Bond)
14.6% - Long Bond Funds (HSTRX, and VBIIX)
8.1% - Value Idea Equities (THRX, and DRWI)
4.6% - NCAV Equities
3.1% - Other Equities (NWS, CMTL and SOAP)
-0.0% (delta-adjusted) - China-Related Thesis (<1bp premium in FCX put)
-1.3% (delta-adjusted) - Hedges/Put Options (43bps premium in S&P Dec-11 puts and 1bps premium in a GS Jan-11 put)
6.0% (leverage-adjusted) – Currencies (EUO)
25.0% - Cash
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