After a flat first half, there’s not a vast amount to analyze with regards to the portfolio’s performance. As such, this year’s half-term ponderings will focus on some (half-formed?) thoughts that have been germinating in my mind.
- More QE – everywhere?
While the summer has largely been very quiet, the one thing that stands out is the increased likelihood of more quantitative easing or stimulus across the globe. We’ve had the continual hints of QE3 from various Fed doves, and the market remembers Bernanke’s 2010 words at Jackson Hole that signaled QE2 while it waits for him to speak at the same venue on Friday (my guess is he’ll talk the market up, but we won’t see QE3 enacted till December’s Fed meeting). More surprising was ECB President Mario Draghi’s July promise to “do whatever it takes” and claims that this action “will be enough”. This being Europe, it goes without saying that “whatever it takes” depends on what country you’re from and the political dance matters as much as the promises; we wait to see what the reality of Draghi’s promise is and whether it’s enough. Finally, there’s China where the data continues to come in weak, which has led to hopes of another 2009-style round of investment spending and stimulus.
Frankly, the fact we’re now discussing yet another round of QE should be sign to the Fed that they’re pushing on a string and that the previous rounds have failed at stimulating any sustainable growth. However, I’m sure they feel the need to do something and the world of the counter-factual (“imagine how much worse it would be without QE1/2/Operation Twist/etc”) that they inhabit no doubt provides reason enough to try more unorthodox policy in the hope something works. It’s no surprise that I’m skeptical about there being any medium-term benefits (despite the long-term costs). However, with global QE/stimulus seemingly coming and the portfolio not particularly well positioned for it, Our Man’s added a little Gold as a 6-12month ‘trade’.
- Has the Fed succeeded, at least on one psychological level, by turning everything into a yield asset?
While there’s much debate over the whether QE1/2/Lite, Operation Twist, et al have succeeded in generating any sustainable economic growth, they have succeeded in getting investors to focus on yields. This is evident across markets, from the obvious places such performance of Investment Grade bonds (LQD: +9% YTD) and High Yield (JNK: +7.5%) to the keen focus on dividend yield stocks and on potential rental yields in the housing market. By persuading investors to reach for yield, and kindling their animal spirits the Fed’s moves can be seen, so far, as a success by helping to drive a range of asset prices higher and endowing people with the wealth effect.
The problem, of course, is that by encouraging investors to “reach for yield” the Fed is also trying to persuade them to focus on return on capital rather than return of capital, and thus take more risk. What do I mean by this? Let’s take the simple examples: much has been written about how “cheap” stocks are, either due to their earnings yield (inverse of P/E) or their dividend yield. As these yields compare very favourably to the low yield on a 10-year Treasury, the argument goes that one should own stocks. After all, a 10-year Treasury yields a mere 1.6%, why wouldn’t you want to own the S&P 500, which has a 2.1% Dividend Yield, instead. The answer of course lies in the risk you’re taking to earn those yields, or more simply – bond math matters. In bond-world, a major risk metric is duration which simply tells you the weighted average of the time that the cash-flows from an asset are received. For a 10-year Treasury bond this figure is between 7-8years, for the S&P based on the dividend yield it is 30-40years, hence in the world of bond-math you’re taking 4-5x the risk to own the S&P. Suddenly, that extra 50bps/year of extra yield doesn’t quite look as attractive…
- Earnings: But what about the margins?
Our Man has long been surprised at the resilience of corporate profit margins, which have hovered around historic highs for the l2mos and whose strong bounce-back from 2008/9 has driven Earnings-growth and been an important contributor to the rally in stocks. Interestingly, we’re now starting to see Earnings-growth falter for the first time post-2008, with YOY Earnings growth turning negative in Q2-2012.
This fall has also started to impact analyst projections for the upcoming quarters, which have steadily fallen throughout the year.
Given the falling Earnings, and with margins at historic highs, it means that the market is relying on either multiple expansion or the quick reversion of this trend to help it go higher. That should sound a note of caution to investors.
- Ideas: what’s Our Man looking at?
As is traditional a little note/insight, albeit brief this time, into some of the new things that Our Man is pondering and spending his free time looking at.
a). Europe: There are signs, like this Global Shiller/CAPE analysis by Mebane Faber, that Europe is approaching the boundary being potentially very cheap. While a number of European countries certainly look cheap comparative to other OECD nations, Our Man is keen on looking at them versus their own history before declaring them absolutely cheap and looking to invest. Given Our Man is limited to US-listed positions, any future positions will largely be ETFs or potentially some ADRs.
b). Possible Puts/Shorts: Generally, Our Man can only short using puts and predominantly has to use ETFs to get his exposure. That said, I’m looking at few things that might be interesting. The fall into two main buckets; (i) Stocks which have benefited as investors chased yield and may offer opportunity if the dividend isn’t as secure as it seems on the surface (areas of interest include REITs and some Consumer Staples/Telecoms), (ii) stocks where the drivers of growth are misunderstood or where the forward-looking expectations are particularly unrealistic (the two names, in particular, that have drawn Our Man’s interest are Lulu Lemon and Tesla, although Apple is, or rather one-day could be, potentially particularly fascinating)
