The past 2 months have been frustrating. Market up, market down, often sending contradictory messages and moving the opposite of what would be expected from news releases. So while it has still been a good year, I am tired of giving back gains in a market that changes dramatically each day.
As of now, I have positioned my IRA as follows:
~75% Cash
~8% Corporate Bonds (Ford and NOVA Chemicals)
~17% Large dividend companies and consumer non-discretionary.
Yes, a very bearish position that is trying to avoid volatility.
I exited my positions in financials, short treasuries and precious metals. On-going turmoil in Europe and a strengthening US dollar has not helped my portfolio. With little action from either the European Central Bank and the Federal Reserve, I have found myself on the wrong side of market movements.
So I turn my attention to 2012 and whether there are any longer-term "investable" trends or if volatility will make only the most talented trader wealthy. At this point my 6-12 month outlook is quite bearish and I have decided to "stop banging my head against the wall" in this volatile market, which feels much better.
Happy Holidays to everyone and May the Markets be Fortunate for You.
Wednesday, December 14, 2011
Thursday, December 1, 2011
Whipsaw November
In November I violated my first rule of investing, which is "To make money, don't lose money."
For the month my IRA declined 4.1%. The main reason for the loss was that I positioned the portfolio for a brightening outlook driven by monetary stimulus and short-term fixes in Europe. I expected the yield curve to steepen, the dollar to decline, and US economic data to remain passable. Well the increasing monetary stimulus may have started yesterday, the last day of the month, but was too little too late to allow my portfolio to recover. Part way through the month I "cried uncle" and retreated to about a 60% cash position, allowing for a more peaceful night of sleep but also removing the opportunity to fully participate in upside. Yesterday I did move back into financials and shorted longer-term treasuries based on the coordinated actions of the central banks. However, my cash position remains close to 30%, highlighting my uncertain outlook about the direction of the market in the short-term.
Over the next month I expect a "Santa Claus" rally based on increased central bank activity, a large amount of cash on the sidelines, and possibly some short-term fixes in Europe. Of course, I was too optimistic about European politics last month, thus a more conservative portfolio this time.
For the trailing year my IRA has increased 19.9%, outpacing the S&P 500 annual increase of 5.6%. The top fund increased 42.6% over the past year, which was Vanguard Extended Duration Treasury Index Instl. Of the over 16,000 funds the 20th best performing fund produced a one-year increase of 19.8%, based on Morningstar. The average performance of funds over the past year was an increase of 2.1%. Obviously the average fund has underperformed the market, suggesting fund managers may try to play catch-up in December if the markets start to rally.
For the month my IRA declined 4.1%. The main reason for the loss was that I positioned the portfolio for a brightening outlook driven by monetary stimulus and short-term fixes in Europe. I expected the yield curve to steepen, the dollar to decline, and US economic data to remain passable. Well the increasing monetary stimulus may have started yesterday, the last day of the month, but was too little too late to allow my portfolio to recover. Part way through the month I "cried uncle" and retreated to about a 60% cash position, allowing for a more peaceful night of sleep but also removing the opportunity to fully participate in upside. Yesterday I did move back into financials and shorted longer-term treasuries based on the coordinated actions of the central banks. However, my cash position remains close to 30%, highlighting my uncertain outlook about the direction of the market in the short-term.
Over the next month I expect a "Santa Claus" rally based on increased central bank activity, a large amount of cash on the sidelines, and possibly some short-term fixes in Europe. Of course, I was too optimistic about European politics last month, thus a more conservative portfolio this time.
For the trailing year my IRA has increased 19.9%, outpacing the S&P 500 annual increase of 5.6%. The top fund increased 42.6% over the past year, which was Vanguard Extended Duration Treasury Index Instl. Of the over 16,000 funds the 20th best performing fund produced a one-year increase of 19.8%, based on Morningstar. The average performance of funds over the past year was an increase of 2.1%. Obviously the average fund has underperformed the market, suggesting fund managers may try to play catch-up in December if the markets start to rally.
Friday, November 18, 2011
Stuck in the Middle
Sold my positions in financial and industrial companies this morning. This including Morgan Stanley (ticker MS), Goldman Sachs (GS), Citigroup (C), Prudential (PRU), Brookfield Asset Management (BAM), General Electric (GE), and Eaton Corp (ETN). Also sold my positions in Base Industrial Metals (BDD), Inverse Long Treasuries (TBT), Computer Associates (CA), Ferrellgas (FGP), and Huntsman (HUN).
This leaves me over 50% in cash and positions in precious metals (Gold, Palladium and Silver), and larger high quality companies like DOW Chemical (DOW) and General Electric (GE).
I find myself stuck in the middle on the future direction of the market, and thus uncomfortable being fully invested. The rising yields for European sovereign debt are highlighting, in my view, that credit markets are beginning to breakdown. This could result in a significant deflationary event, especially if Germany remains opposed to the European Central Bank intervention. On the other hand, if the ECB does actually step in and begin printing more money to offset the growing liquidity crisis, accompanied by actions by the Federal Reserve, we likely continue down the path I outlined in my previous post of a couple months of rising equity and commodity prices followed by a violent re-balancing of the market. Germany has a bad history with inflation that makes them anti-inflationary and they seem determined not to pick up the tab for everyone else. Fair enough, but it means the end game may be closer than I have been anticipating.
The bottom line is that the markets are increasingly moving towards a re-balancing of valuations to reflect the unsustainable debt levels in the world and my positions were increasingly relying on a "Hail Mary" from the central banks. As a wise boss once told me, "once you start hoping for something to happen you're screwed."
This leaves me over 50% in cash and positions in precious metals (Gold, Palladium and Silver), and larger high quality companies like DOW Chemical (DOW) and General Electric (GE).
I find myself stuck in the middle on the future direction of the market, and thus uncomfortable being fully invested. The rising yields for European sovereign debt are highlighting, in my view, that credit markets are beginning to breakdown. This could result in a significant deflationary event, especially if Germany remains opposed to the European Central Bank intervention. On the other hand, if the ECB does actually step in and begin printing more money to offset the growing liquidity crisis, accompanied by actions by the Federal Reserve, we likely continue down the path I outlined in my previous post of a couple months of rising equity and commodity prices followed by a violent re-balancing of the market. Germany has a bad history with inflation that makes them anti-inflationary and they seem determined not to pick up the tab for everyone else. Fair enough, but it means the end game may be closer than I have been anticipating.
The bottom line is that the markets are increasingly moving towards a re-balancing of valuations to reflect the unsustainable debt levels in the world and my positions were increasingly relying on a "Hail Mary" from the central banks. As a wise boss once told me, "once you start hoping for something to happen you're screwed."
Saturday, November 5, 2011
Easy Money Now, Hard Times Later
Following up on the last post, "Freight Trained," I wanted to highlight an article in Barron's that outlines quite well the expansionary monetary policies by most large central banks in the world. I agree with many of the concerns outlined in the article and believe these monetary policies, coupled with the fiscal austerity in many countries, lead to the following in 2012:
(1) Rising commodity prices into the first half of 2012, driving up prices for gas and food,
(2) Higher equity valuations into the first half of 2012 as liquidity inflates the stock markets,
(3) Rising interest rates on longer-term bonds due to inflation concerns and rising stock valuations,
(4) Declining wages as companies control headcounts to offset higher material prices, and
(5) Rising CPI by mid-2012 as companies pass along higher costs to customers,
All this leads to a potentially violent reset of the markets in the middle of 2012, in my view, in-line with my expectations under my Sagflation thesis of slow-to-negative growth combined with more volatile prices. During this phase of Sagflation there may be rising fear that we are entering a period of Stagflation, or high inflation, high unemployment and slow economic growth. I suspect this potential period of Stagflation may precede a period of negative growth and deflation in 2013 and 2014. While worrisome, I also believe the years 2013 and 2014 enable the political and economic re-structuring required to set-up for healthy growth in 2015 and beyond.
Returning to 2012, the potentially violent reset during the middle of the year may occur due to:
(1) Consumer spending falling due to a squeeze between rising food/gas prices and declining incomes,
(2) Debt stifling growth in European countries and with US consumers,
(3) Social unrest stemming from economic hardship in Europe and the US (Occupy movement),
(4) Additional austerity measures legislated in the US and enacted in Europe to reduce debt, and
(5) Diminishing impact, or even reversal, of expansionary monetary policies that appear to hurt growth.
These are my opinions and I lay them out in order to refer back to them in the future in order to track how my perception of the future evolves as unexpected events occur.
With all this in mind, I may exit a few positions that do not benefit from the anticipated rise in commodity prices and steepening of the yield curve. My portfolio currently includes the following:
(1) Rising commodity prices into the first half of 2012, driving up prices for gas and food,
(2) Higher equity valuations into the first half of 2012 as liquidity inflates the stock markets,
(3) Rising interest rates on longer-term bonds due to inflation concerns and rising stock valuations,
(4) Declining wages as companies control headcounts to offset higher material prices, and
(5) Rising CPI by mid-2012 as companies pass along higher costs to customers,
All this leads to a potentially violent reset of the markets in the middle of 2012, in my view, in-line with my expectations under my Sagflation thesis of slow-to-negative growth combined with more volatile prices. During this phase of Sagflation there may be rising fear that we are entering a period of Stagflation, or high inflation, high unemployment and slow economic growth. I suspect this potential period of Stagflation may precede a period of negative growth and deflation in 2013 and 2014. While worrisome, I also believe the years 2013 and 2014 enable the political and economic re-structuring required to set-up for healthy growth in 2015 and beyond.
Returning to 2012, the potentially violent reset during the middle of the year may occur due to:
(1) Consumer spending falling due to a squeeze between rising food/gas prices and declining incomes,
(2) Debt stifling growth in European countries and with US consumers,
(3) Social unrest stemming from economic hardship in Europe and the US (Occupy movement),
(4) Additional austerity measures legislated in the US and enacted in Europe to reduce debt, and
(5) Diminishing impact, or even reversal, of expansionary monetary policies that appear to hurt growth.
These are my opinions and I lay them out in order to refer back to them in the future in order to track how my perception of the future evolves as unexpected events occur.
With all this in mind, I may exit a few positions that do not benefit from the anticipated rise in commodity prices and steepening of the yield curve. My portfolio currently includes the following:
| Weight | Name | Ticker |
|---|---|---|
| ~16% | Proshares Ultrashort 20+ Yr Treasury | TBT |
| ~11% | SPDR Gold Trust | GLD |
| ~4% | Base Metals Double Long | BDD |
| ~4% | Rowan | RDC |
| ~4% | Boardwalk Pipeline | BWP |
| ~4% | Eaton Corp. | ETN |
| ~4% | DOW Chemical | DOW |
| ~4% | Huntsman | HUN |
| ~4% | Prudential Financial | PRU |
| ~4% | Brookfield Asset Mgmt | BAM |
| ~4% | General Electric | GE |
| ~4% | Vale SA | VALE |
| ~3% | iShares Silver Trust | SLV |
| ~3% | Tyson | TSN |
| ~3% | Goldman Sachs | GS |
| ~3% | Ferrell Gas Partners | FGP |
| ~2% | ETFS Physical Palladium Shares | PALL |
| ~2% | Citigroup Inc. | C |
| ~2% | Morgan Stanley | MS |
| ~2% | Pepsico | PEP |
| ~1% | Teva Pharmaceutical Industries | TEVA |
| ~1% | Computer Associates | CA |
Thursday, November 3, 2011
Twelve Month Outlook - Investors May Get "Freight Trained"
Freight Trained - (Rodeo Term) Being run over by an animal that is traveling at top speed.
Investment Conclusion
I believe the equity markets and commodity prices perform reasonably well, albeit volatile, through much of the fourth quarter due to the recent monetary stimulus injected into the world economy. I also believe the significant sovereign debt outstanding results in each round of monetary stimulus having a diminished impact, reducing its impact in both duration and strength. Therefore, I believe there is a risk that investors move back into the market over the next few months chasing the monetary-driven valuation increases, only to become exposed to a significant correction in 2012 once the monetary stimulus diminishes. To put it more colorfully, investors potentially get run-over when a perceived bull run turns on them.
More specifically, I believe the equity and commodity markets peak at some point in the next 2-3 months and then begin to reverse. Without additional significant monetary stimulus in the first half of 2012 I expect the equity and commodity markets to move sideways to down during the first two quarters. Around mid-year I expect a violent correction in the markets due to one or more of the following causes: (1) decelerating growth associated with austerity, (2) accelerating inflation associated with monetary policies, and/or (3) major sovereign debt defaults associated with excessive debt levels. After this correction I expect equity markets to continue downward for an extended period of time before bottoming with the S&P 500 around 700, consistent with my previous views within my Sagflation thesis.
The following are four points supporting my argument that inflationary pressures move the markets over the next few months:
(1) ECB Switches to Monetary Stimulus
The European Central Bank, ECB, cut rates to 25 bps to 1.25% in a "surprise" move. The takeaway, in my mind, is that the ECB is prepared to aggressively stimulate the European economy through rate cuts over the next few months to offset an economy that is slowing due to the debt crisis. This moves likely drives commodity prices higher and possibly stocks higher due to more liquidity in the world financial markets. The change of course also likely weakens the Euro, although the US dollar also likely continues to weaken relative to a basket of foreign currencies due to the Fed's low interest rates and monetary stimulus.
(2) Europe Appeases Markets in Short-term
My takeaways from the European Greek debt agreement were: (1) Over $1 trillion may be injected into the market, adding inflationary pressures, (2) market activity was perverted, setting an ominous precedent, (3) maybe contagion has been avoided stemming from Greece but what about Italy and other countries, and (4) a short term solution was created that may or may not accomplish its goals, if implemented at all. In short, the agreement pushes these issues into 2012 and likely amplifies their negative impact next year.
(3) The Federal Reserve Remains Expansionary
While the Federal Reserve did not announce any additional quantitative easing programs, it did say it "is prepared to employ its tools to promote a stronger economic recovery." I believe this wording positions the Fed for further quantitative easing. The Federal Reserve also expects to maintain the low interest rates. While the Fed obviously doesn't want to jump into action at the whim of the markets, it appears more focused on driving growth in the economy. My takeaway is that the outlook from the Fed's position is inflationary since they appear to be shifting to more worry about growth than inflationary.
(4) Japan Focused on Healthy Exports
Japan's central bank is focused on weakening the Yen to aid its export-driven economy. The central bank has agreed that the future purchases of financial assets may be warranted, setting the possibility of a sort of quantitative easing in Japan, adding liquidity and inflationary pressures to the world markets. This implies that each of the three major world currencies are implementing an expansionary monetary policy, increasing the likelihood of inflation building in hard assets, like gold, copper and other commodities. It also likely pushes stock valuations higher, until inflation pressures accelerate above 3-4% in the larger developed economies of the world.
My current positions I expect to let run until one of the following occurs: (1) the stock price approaches its 52-week high, which for many of my holding represents over 50% upside; (2) the S&P 500 climbs over 1,375; (5) worries about a sovereign nation defaulting begin to dominate the market; (4) inflation concerns begin to dominate market movements in the US; (5) the yield on the 30-year treasury tips above 4.5%; or (6) 1Q of 2012. Once one of these criteria are reached I plan to begin executing my exit strategy. I suspect the market may move up aggressively through much of the fourth quarter as portfolio managers who are under-performing their benchmarks attempt to make-up the difference, but the last week may prove a much more volatile quarter.
Monday, October 31, 2011
October Performance
For October the balance increased 1.1%. It was a wild ride as the markets gyrated pretty violently throughout the month. While I underperformed the S&P 500, which increased about 11% during the month, I am happy that the balance ended up for the month after beginning the month largely in treasuries and ending the month in stocks on a day the S&P 500 declined 2.5%. Treasury prices declined significantly during the month as the yield on the 30-year treasury rose about 30 basis points.
I look forward to comments by both the Federal Reserve and the European Central Bank this week. In both cases I expect at least talk of additional monetary stimulus since the economic outlook remains cloudy. Should the markets begin to anticipate additional stimulus I expect the dollar to decline, yields to rise, and stocks to lift. These types of movement should drive performance going forward.
I look forward to comments by both the Federal Reserve and the European Central Bank this week. In both cases I expect at least talk of additional monetary stimulus since the economic outlook remains cloudy. Should the markets begin to anticipate additional stimulus I expect the dollar to decline, yields to rise, and stocks to lift. These types of movement should drive performance going forward.
Friday, October 28, 2011
Sold Unitil Corp. Postion
With inflationary pressures dominating in my Sagflation theme, I have sold my position in the utility Unitil (Ticker UTL). I bought a ~4% position in May 2011 and realized a return of about 10%, including dividends. The main reason for selling the position is my belief that utilities under perform the market in the near-term as inflation likely builds up with monetary stimulus increases.
Wednesday, October 26, 2011
Bought Base Metals as Sagflation Likely Swings Prices Higher
As I continue to round out my portfolio I purchased a ~5% position in Powershares Base Metals Double Long ETN, which is invested in aluminum, copper and zinc futures. This brings my exposure to commodities up to about 20% of my portfolio, with a ~10% position in gold, ~3% position in silver, and ~2% in palladium. My outlook is bullish for these metals, driven by settling of worries about European debt, increasingly expansionary monetary policies with possible new programs announced by the Fed, and stimulus spending in China to re-accelerate growth. This outlook implies rising inflationary pressures within commodities, in general, stabilizing short-term world economic performance, and growth in demand for base metals from China.
Tying my current outlook to a longer-term Sagflation view, I believe we are simply buying time before deflationary forces overwhelm the economy. Sovereign debt in Europe and the US is increasingly hampering economic growth and reducing our ability to pursue Keynesian-like stimulant spending, in my opinion. I simply do not see an easy road out of the corner in which we have painted ourselves. Inflationary pressures within emerging markets are increasingly hindering monetary policies, which likely only worsen as we move forward, in my view, due to monetary policies. Europe is creating a short-term solution to a long-term problem, in my view. In essence, appeasing the markets and the voting populations. The US is also focused on short-term solutions to long-term structural problems, in my view. China has the financial flexibility to act aggressively but I fear time may run out on them at some point soon, as bank loans turn sour.
Sagflation is slow-to-negative real economic growth combined with volatile prices. For a while the prices likely swing up, in my opinion, but keep in my mind that bureaucrats are pushing it higher and higher, not fundamentals.
Tying my current outlook to a longer-term Sagflation view, I believe we are simply buying time before deflationary forces overwhelm the economy. Sovereign debt in Europe and the US is increasingly hampering economic growth and reducing our ability to pursue Keynesian-like stimulant spending, in my opinion. I simply do not see an easy road out of the corner in which we have painted ourselves. Inflationary pressures within emerging markets are increasingly hindering monetary policies, which likely only worsen as we move forward, in my view, due to monetary policies. Europe is creating a short-term solution to a long-term problem, in my view. In essence, appeasing the markets and the voting populations. The US is also focused on short-term solutions to long-term structural problems, in my view. China has the financial flexibility to act aggressively but I fear time may run out on them at some point soon, as bank loans turn sour.
Sagflation is slow-to-negative real economic growth combined with volatile prices. For a while the prices likely swing up, in my opinion, but keep in my mind that bureaucrats are pushing it higher and higher, not fundamentals.
Tuesday, October 25, 2011
Bought Citigroup on Expectations of European Financial Appeasement
Updating a few trades completed recently.
Today I opened a 2% position in Citigroup (Ticker C) as I expand my exposure to financial companies during the market pullback this morning. My Sagflation thesis has turned inflationary and so I continue to increase exposure to companies that likely benefit from a steepening yield curve. Citigroup's stock was down to start the day largely due to concerns about a solution in Europe. While admitting Europe is a risk to financial markets, I also believe that this week or next Europe arrives at some sort of financial appeasement that satiates the markets for the next couple quarters. I don't expect a solution but instead just enough to make the markets move their myopic focus from Europe. With a forward year PE in the mid-single digits I believe I have some cushion on the downside.
Citigroup Inc. (Ticker: C)
Citigroup Inc. is a global diversified financial services
holding company. Citigroup businesses provide consumers, corporations,
governments and institutions with a range of financial products and
services. As of December 31, 2010, the Company had approximately 200
million customer accounts and did business in more than 160 countries
and jurisdictions.
Kimberly Clark Corp. (Ticker KMB)
Also, yesterday I exited my position in Kimberly Clark (Ticker KMB), booking about a 4% return for holding it about a half year. I exited KMB due to worries that rising prices on commodities may pressure margins going forward. The fact that management lowered revenue growth expectations for 2011 only reinforced my decision to exit the position. My take on the lowered revenue guidance is that competitive pressure is growing from generic brands with lower prices, a concern longer-term.
Today I opened a 2% position in Citigroup (Ticker C) as I expand my exposure to financial companies during the market pullback this morning. My Sagflation thesis has turned inflationary and so I continue to increase exposure to companies that likely benefit from a steepening yield curve. Citigroup's stock was down to start the day largely due to concerns about a solution in Europe. While admitting Europe is a risk to financial markets, I also believe that this week or next Europe arrives at some sort of financial appeasement that satiates the markets for the next couple quarters. I don't expect a solution but instead just enough to make the markets move their myopic focus from Europe. With a forward year PE in the mid-single digits I believe I have some cushion on the downside.
Citigroup Inc. (Ticker: C)
| Price Purchased | $30.97 | Mkt Cap | $90.8 Billion |
| 52-Wk Low | $21.40 | Beta | 2.55 |
| CY+1 PE | 6.8x | Rating (# of) | Overweight (29) |
Kimberly Clark Corp. (Ticker KMB)
Also, yesterday I exited my position in Kimberly Clark (Ticker KMB), booking about a 4% return for holding it about a half year. I exited KMB due to worries that rising prices on commodities may pressure margins going forward. The fact that management lowered revenue growth expectations for 2011 only reinforced my decision to exit the position. My take on the lowered revenue guidance is that competitive pressure is growing from generic brands with lower prices, a concern longer-term.
Monday, October 24, 2011
Re-Positioned Portfolio For Next Phase of Sagflation
Given my belief that the outlook in my Sagflation theme has now shifted more inflationary, I have established positions that benefit from a steepening yield curve, commodity price increases, and manufacturers that either benefit from higher commodity prices or are able to pass along rising commodity prices.
From a volatility standpoint, I have favored quality larger cap names with a higher beta to benefit from a rising equity market. I believe these names have fallen out of favor over the past few months due to the volatility in the market and uncertain outlook. I have also favored stocks near their 52-week lows with a forward PE in the low teens or single digits to provide some cushion on the downside. Finally, I have favored stocks with bullish analyst opinions to help filter out companies with poor management and unattractive prospects.
Focusing on the next six months, I have established the following positions:
Rowan Companies, Inc. (Ticker: RDC)
Rowan Companies, Inc. is a provider of international and domestic contract drilling services. Rowan also owns and operates a manufacturing division that produces equipment for the drilling, mining and timber industries. The Company operates in three segments: Drilling Services, Drilling Products and Systems, and Mining, Forestry and Steel Products.
Eaton Corporation (Ticker: ETN)
Eaton Corporation is a diversified power management company. It
is engaged in the manufacturing of electrical components and systems for
power quality, distribution and control; hydraulics components, systems
and services for industrial and mobile equipment; aerospace fuel,
hydraulics and pneumatic systems for commercial and military use, and
truck and automotive drivetrain and powertrain systems for performance,
fuel economy and safety.
The Dow Chemical Company (Ticker: DOW)
The Dow Chemical Company is a diversified manufacturer and
supplier of products used primarily as raw materials in the manufacture
of customer products and services worldwide. It operates in eight
segments. Dow provides services to a range of industries, including
appliance, automotive, agricultural, building and construction, chemical
processing, electronics, furniture, house wares, oil and gas,
packaging, paints, coatings and adhesives, personal care pharmaceutical
processed foods pulp and paper textile.
Huntsman Corporation (Ticker: HUN)
Huntsman Corporation is a manufacturer of differentiated organic chemical products and of inorganic chemical products. The Company’s products consists of a range of chemicals and formulations,
which it markets globally to a group of consumer and industrial
customers. It operates through five segments: Polyurethanes, Performance
Products, Advanced Materials, Textile Effects and Pigments.
The Goldman Sachs Group, Inc. (Ticker: GS)
The Goldman Sachs Group, Inc. is a bank holding and a
financial holding company. Goldman Sachs is a global investment banking,
securities and investment management company providing a range of
financial services to a client base that includes corporations,
financial institutions, governments and high-net-worth individuals.
Morgan Stanley (Ticker: MS)
Morgan Stanley is a global financial services firm that, through its
subsidiaries and affiliates, provides its products and services to a
group of clients and customers, including corporations, governments,
financial institutions and individuals. The Company is a financial
holding company. The Company is a global financial services firm. The
Company operates in three segments: Institutional Securities, Global
Wealth Management Group and Asset Management.
Prudential Financial, Inc. (Ticker: PRU)
Prudential Financial, Inc. is a financial services company. It has
operations in the United States, Asia, Europe and Latin America. Through
its subsidiaries, it offers an array of financial products and
services, including life insurance, annuities, retirement-related
services, mutual funds, investment management and real estate services.
It offers these products and services to individual and institutional
customers through third-party distribution networks.
Brookfield Asset Management Inc. (Ticker: BAM)
Brookfield Asset Management Inc. is a global asset management company
focused on property, power and infrastructure assets. The Company
operates and manages assets in the areas, such as Renewable Power
Generation, which include power generating operations, along with a
small number of co-generation and wind energy facilities; Commercial
Properties, in which the Company owns and operates commercial office and
retail properties on behalf of selves and its co-investors;
Infrastructure, in which the Company’s infrastructure activities are
concentrated in the utilities, transport and energy and timber sectors;
Development activities include residential operations, properties held
for development and opportunity investment funds; Private Equity and
Finance business includes restructuring, real estate financing and
bridge lending in the property, power and infrastructure areas.
General Electric Company (Ticker: GE)
General Electric Company is a diversified technology and financial
services corporation. The products and services of the Company range
from aircraft engines, power generation, water processing, and household
appliances to medical imaging, business and consumer financing and
industrial products. It serves customers in more than 100 countries.
Effective January 28, 2011, it held a 49% interest in a media entity
that includes the NBC Universal businesses. Its segments include Energy
Infrastructure, Technology Infrastructure, NBC Universal, GE Capital and
Home & Business Solutions.
Vale SA (Ticker: VALE)
Vale SA is a Brazil-based metals and mining company. The
Company's product portfolio includes nickel, iron ore and iron ore
pellets, manganese ore, ferroalloys, aluminum, fertilizers, copper and
coal among others. Vale is engaged in the mineral exploration in 24
countries around the globe. In addition, the Company operates logistics
systems in Brazil, including railroads, maritime terminals and ports,
which are integrated with its mining operations and it has a maritime
freight portfolio to transport iron ore.
From a volatility standpoint, I have favored quality larger cap names with a higher beta to benefit from a rising equity market. I believe these names have fallen out of favor over the past few months due to the volatility in the market and uncertain outlook. I have also favored stocks near their 52-week lows with a forward PE in the low teens or single digits to provide some cushion on the downside. Finally, I have favored stocks with bullish analyst opinions to help filter out companies with poor management and unattractive prospects.
Focusing on the next six months, I have established the following positions:
| Weight | Name | Ticker |
|---|---|---|
| ~20% | Proshares Ultrashort 20+ Yr Treasury | TBT |
| ~2% | ETFS Physical Palladium Shares | PALL |
| ~10% | SPDR Gold Trust | GLD |
| ~3% | iShares Silver Trust | SLV |
| ~4% | Eaton Corp. | ETN |
| ~4% | Rowan | RDC |
| ~4% | DOW Chemical | DOW |
| ~4% | Huntsman | HUN |
| ~2% | Goldman Sachs | GS |
| ~2% | Morgan Stanley | MS |
| ~4% | Prudential Financial | PRU |
| ~4% | Brookfield Asset Mgmt | BAM |
| ~4% | General Electric | GE |
| ~4% | Vale SA | VALE |
Rowan Companies, Inc. (Ticker: RDC)
| Price Purchased | $34.14 | Mkt Cap | $4.4 Billion |
| 52-Wk Low | $28.13 | Beta | 1.65 |
| CY+1 PE | 8.8x | Rating (# of) | Overweight (33) |
Rowan Companies, Inc. is a provider of international and domestic contract drilling services. Rowan also owns and operates a manufacturing division that produces equipment for the drilling, mining and timber industries. The Company operates in three segments: Drilling Services, Drilling Products and Systems, and Mining, Forestry and Steel Products.
Eaton Corporation (Ticker: ETN)
| Price Purchased | $41.67 | Mkt Cap | $14.2 Billion |
| 52-Wk Low | $33.09 | Beta | 1.44 |
| CY+1 PE | 9.6x | Rating (# of) | Overweight (22) |
The Dow Chemical Company (Ticker: DOW)
| Price Purchased | $27.50 | Mkt Cap | $32.6 Billion |
| 52-Wk Low | $20.61 | Beta | 2.32 |
| CY+1 PE | 8.9x | Rating (# of) | Overweight (19) |
Huntsman Corporation (Ticker: HUN)
| Price Purchased | $10.64 | Mkt Cap | $2.6 Billion |
| 52-Wk Low | $8.13 | Beta | 2.23 |
| CY+1 PE | 5.4x | Rating (# of) | Overweight (9) |
The Goldman Sachs Group, Inc. (Ticker: GS)
| Price Purchased | $102.81 | Mkt Cap | $52.3 Billion |
| 52-Wk Low | $84.27 | Beta | 1.40 |
| CY+1 PE | 7.6x | Rating (# of) | Overweight (29) |
Morgan Stanley (Ticker: MS)
| Price Purchased | $17.18 | Mkt Cap | $33.0 Billion |
| 52-Wk Low | $11.58 | Beta | 1.42 |
| CY+1 PE | 8.5x | Rating (# of) | Overweight (28) |
Prudential Financial, Inc. (Ticker: PRU)
| Price Purchased | $53.66 | Mkt Cap | $29.0 Billion |
| 52-Wk Low | $42.45 | Beta | 2.38 |
| CY+1 PE | 7.1x | Rating (# of) | Overweight (23) |
Brookfield Asset Management Inc. (Ticker: BAM)
| Price Purchased | $28.39 | Mkt Cap | $17.8 Billion |
| 52-Wk Low | $24.42 | Beta | 1.54 |
| CY+1 PE | 24.9x | Rating (# of) | Buy (10) |
General Electric Company (Ticker: GE)
| Price Purchased | $16.47 | Mkt Cap | $176.3 Billion |
| 52-Wk Low | $14.02 | Beta | 1.61 |
| CY+1 PE | 10.5x | Rating (# of) | Overweight (18) |
Vale SA (Ticker: VALE)
| Price Purchased | $23.44 | Mkt Cap | $123.5 Billion |
| 52-Wk Low | $21.14 | Beta | 1.64 |
| CY+1 PE | 4.5x | Rating (# of) | Overweight (25) |
Saturday, October 22, 2011
Entering New Phase of Sagflation
Based on recent news articles in Barron's and in the Journal, it appears as though monetary policy in both the US and Europe may be increasingly relied on to counter an economic slowdown. Around the world there has been a recent shift to expansionary monetary policies with loosening in Britain, Brazil, and possibly China. This shift in monetary policies was the main reason I recently sold my large position in 30-year treasuries since there is a greater risk of inflation, in my view.
However, fiscal policies have remained firmly focused on austerity, as shown by cuts in Greece, Portugal, Italy, and with some success in Britain. It would appear as though austerity remains the driving theme in the US with the deficit reduction super committee efforts. If the committee cannot reach a compromise then cuts are automatically enacted.
Under my Sagflation theme I argue that there are fundamental deflationary forces in the economy due to excessive debt and the deflating of previous asset bubbles. Expansionist monetary policies are acting against these fundamental forces. The result is slow to negative economic growth with larger price swings as monetary policies expand and then retreat.
I continue to believe economic growth likely remains slow to negative due to the austerity measures, stagnant house prices, declining income, high unemployment, burdensome consumer debt, and increasingly misallocated investments in an economy where money is cheap. The shift in monetary policies suggests that prices are likely to swing upward in the form of inflation over the next one to two years.
In the short-term, defined as the next 2-6 months, I believe the headline inflation of CPI may not show much increase, and may actually decline somewhat due to the recent slide in commodity prices trickling up to the consumer. Should the widely watched CPI remain tame over the next few months it is likely a positive for stocks as investors assume inflation is under control and stocks benefit from growing liquidity. As I reminder, I view the CPI as more of a 3-9 month lagging inflation gauge right now due to pricing pressure coming up through companies' cost structures from higher commodity prices. If the CPI was rising because demand was out-stripping supply, then I believe it would be a more current measurement. Other than stocks I believe rising bottom-up inflation pressures likely drives price movements in debt, commodity and currency markets.
While the European debt crisis is a black cloud over the markets, I believe the European leaders likely pursue financial appeasement, giving the financial markets just enough reform, bail-out, and stimulus to appease them in the short-term but not fix the longer-term problem. Political realities and economic challenges would tend to push the European leaders in this direction, in my view.
This short term outlook suggests over-weighting high beta stocks and precious metals, in my view. It also suggests the US dollar declines and yields on the 10 and 30 year treasury rise significantly, in my opinion.
Longer-term, however, these trends are setting us up for a period beginning at some point in 2012 that combines higher unemployment, slow growth, and high inflation, in my opinion. Emerging economies rich in natural resources that have historically tilted toward inflation, like Brazil, potentially move closer to the dangers of hyper-inflation. As we move through 2012 I believe rising commodity prices likely again force manufacturers and retailers to constrict labor in an effort to protect margins, eventually raising prices that pushes the CPI higher. US consumers are likely increasingly squeezed between falling income and rising prices. In addition, austerity plans implemented late in 2011 likely begin to have an effect in 2012. This is a potentially explosive combination both financially and socially, as explained in The Economist.
Once we move into 2012 I believe investors should become conservative as inflation worries mount, debt issues remain, and any short-term financial appeasements made in 2011 prove ineffective. At this point I believe we may reach the end game in which fiscal stimulus is neutered by high sovereign debt levels and monetary stimulus is neutered by high inflation. If volatility in 2011 was trying for investors, swings in 2012 may prove fatal.
However, fiscal policies have remained firmly focused on austerity, as shown by cuts in Greece, Portugal, Italy, and with some success in Britain. It would appear as though austerity remains the driving theme in the US with the deficit reduction super committee efforts. If the committee cannot reach a compromise then cuts are automatically enacted.
Under my Sagflation theme I argue that there are fundamental deflationary forces in the economy due to excessive debt and the deflating of previous asset bubbles. Expansionist monetary policies are acting against these fundamental forces. The result is slow to negative economic growth with larger price swings as monetary policies expand and then retreat.
I continue to believe economic growth likely remains slow to negative due to the austerity measures, stagnant house prices, declining income, high unemployment, burdensome consumer debt, and increasingly misallocated investments in an economy where money is cheap. The shift in monetary policies suggests that prices are likely to swing upward in the form of inflation over the next one to two years.
In the short-term, defined as the next 2-6 months, I believe the headline inflation of CPI may not show much increase, and may actually decline somewhat due to the recent slide in commodity prices trickling up to the consumer. Should the widely watched CPI remain tame over the next few months it is likely a positive for stocks as investors assume inflation is under control and stocks benefit from growing liquidity. As I reminder, I view the CPI as more of a 3-9 month lagging inflation gauge right now due to pricing pressure coming up through companies' cost structures from higher commodity prices. If the CPI was rising because demand was out-stripping supply, then I believe it would be a more current measurement. Other than stocks I believe rising bottom-up inflation pressures likely drives price movements in debt, commodity and currency markets.
While the European debt crisis is a black cloud over the markets, I believe the European leaders likely pursue financial appeasement, giving the financial markets just enough reform, bail-out, and stimulus to appease them in the short-term but not fix the longer-term problem. Political realities and economic challenges would tend to push the European leaders in this direction, in my view.
This short term outlook suggests over-weighting high beta stocks and precious metals, in my view. It also suggests the US dollar declines and yields on the 10 and 30 year treasury rise significantly, in my opinion.
Longer-term, however, these trends are setting us up for a period beginning at some point in 2012 that combines higher unemployment, slow growth, and high inflation, in my opinion. Emerging economies rich in natural resources that have historically tilted toward inflation, like Brazil, potentially move closer to the dangers of hyper-inflation. As we move through 2012 I believe rising commodity prices likely again force manufacturers and retailers to constrict labor in an effort to protect margins, eventually raising prices that pushes the CPI higher. US consumers are likely increasingly squeezed between falling income and rising prices. In addition, austerity plans implemented late in 2011 likely begin to have an effect in 2012. This is a potentially explosive combination both financially and socially, as explained in The Economist.
Once we move into 2012 I believe investors should become conservative as inflation worries mount, debt issues remain, and any short-term financial appeasements made in 2011 prove ineffective. At this point I believe we may reach the end game in which fiscal stimulus is neutered by high sovereign debt levels and monetary stimulus is neutered by high inflation. If volatility in 2011 was trying for investors, swings in 2012 may prove fatal.
Tuesday, October 18, 2011
Exited 30-Year Treasury Position
Today I sold all of my position in 30-year treasuries. The main reason for selling is a growing concern that central banks may increase their efforts to stimulate the world economy. Last week illustrated what likely happens to yields on treasuries if central bankers become more active. Longer-term yields increased, dropping prices.
I continue to believe that if left alone, yields on the 30-year treasury could dip to 2.5%. However, if the ECB or the Fed announce a major effort involving the printing of money under another QE program to stimulate growth the yield on the 30-year could easily move back above 4%, in my opinion. I believe the risk is simply too great over the next few weeks of a major move downward in treasury prices.
While I gave back a little of my profit this quarter on the position, I closed out the position up in excess of 25% from when I purchased the bonds in April and May.
My plan is to watch what happens with treasuries over the next few weeks and potentially re-enter a position in longer term bonds or invest in the ETF TBT, which moves inversely to treasury prices.
I continue to believe that if left alone, yields on the 30-year treasury could dip to 2.5%. However, if the ECB or the Fed announce a major effort involving the printing of money under another QE program to stimulate growth the yield on the 30-year could easily move back above 4%, in my opinion. I believe the risk is simply too great over the next few weeks of a major move downward in treasury prices.
While I gave back a little of my profit this quarter on the position, I closed out the position up in excess of 25% from when I purchased the bonds in April and May.
My plan is to watch what happens with treasuries over the next few weeks and potentially re-enter a position in longer term bonds or invest in the ETF TBT, which moves inversely to treasury prices.
PEP: A Restructuring Story within the Declining Commodity Prices Theme
A couple weeks ago I laid out the theme of falling commodity prices within my Sagflation thesis, ultimately buying shares in Tyson Foods (Ticker TSN). In this post I continue with the deflationary theme but add in a restructuring story. One of my favorite signals when looking at a stock is a re-structuring or re-focusing of a strong brand. I call this the "Bain Capital" method since Bain Capital has a proven track record of buying distressed brand names and turning them around for a profit.
Pepsico, Inc. (Ticker PEP) has been popping up on my radar because of a re-emphasis on developing the popularity and identity of their brands, as opposed to just pushing volume. For about three years management has been focusing on improving productivity and re-investing savings back into R&D, brand-building and market-specific initiatives. During this time period of restructuring the returns of the business can appear worse than expected due to investment spending and uncertainty about the pay-off. However, as the investments begin to produce returns in the form of higher sales and improved margins, the stock can produce above average returns. For this reason, today I established a 2% position in PEP.
I have been considering Pepsico for its potential margin improvement due to my belief that commodity prices may continue to fall due to deflationary pressures. In the third quarter the gross margin declined 300 basis points annually, largely due to rising commodity prices. Sugar is a significant cost, as well as aluminum, corn, wheat, and gas. Due to a reduced supply of sugar from both Brazil and Australia, sugar prices have remained fairly high despite a pullback in other commodities. Since sugar prices have not declined significantly I have held back from Pepsico. That said, I expect more supply to come on the market as we roll through 2012 as growers are attracted by the higher prices in 2011. Management actively hedges commodity prices and the recent volatility may provide them with an opportunity to lock-in lower prices in 2012 relative to 2011, in my view. With all that considered, I decided Pepsico could benefit from falling commodities given its more stable sales characteristics and significant exposure to snack foods, which use corn and wheat. Wheat and corn prices have declined recently.
A risk to sales is that large retailers like Wal*Mart and Costco are able negotiate lower prices should the cost structure of Pepsico, and their competitors, decline due to falling commodity prices. Obviously these two retailers have significant leverage due to their size and from talking to a friend who has called on Costco, I know they can drive hard for price concessions. If Pepsico can increase volume of their products through their marketing campaigns, the company should have greater negotiating power when working with retailers. In addition, by improving productivity the company should be able to produce higher returns as the business lowers fixed costs and increases turnover. Improving returns should translate into an outperforming stock. That said, Coca-Cola has also worked on productivity improvements to lower its cost structure and has expanded vertically through its acquisition of the North American operations of bottler Coca Cola Enterprises last year.
Returning to the re-structuring plans, management began investing in its brands about 3 1/2 years ago when it focused on Gatorade. Management then moved to Tropicana, Pepsi Max, Sierra Mist, and Mountain Dew, each showing improvement. Now management is focused on Pepsi, a potential bigger bang for the buck after the cola fell to third place in the US in 2010 behind Coke and Diet Coke. Higher spending on marketing, funded by cost improvements, should enable Pepsi sales to improve going forward. In addition to the turnaround of established markets, the emerging markets remain a significant growth opportunity for the company to expand consumption with snack revenue growth of 31% in China and 26% in India this past quarter.
Last week they reported strong results after implementing price increases to offset rising commodity prices. An encouraging signal was that volume changes were within management expectations despite the price increase. Also encouraging was a reiteration of high single digit earning growth for 2011, despite less anticipated benefit from currency, implying the actual business is improving slightly better than expectations. Compare these results with a consensus EPS growth estimate of 6% in 2012 and I believe there is upside to forward year estimates should commodity prices fall or Pepsi sales improve.
The consensus analyst opinion is overweight for the stock. PEP trades at 13x the consensus 2012 EPS estimates. The dividend yield is an attractive 3.3%, higher than Coco-Cola's (Ticker KO) of 2.7%. PEP is trading close to its 52-week low.
Pepsico, Inc. (Ticker PEP) has been popping up on my radar because of a re-emphasis on developing the popularity and identity of their brands, as opposed to just pushing volume. For about three years management has been focusing on improving productivity and re-investing savings back into R&D, brand-building and market-specific initiatives. During this time period of restructuring the returns of the business can appear worse than expected due to investment spending and uncertainty about the pay-off. However, as the investments begin to produce returns in the form of higher sales and improved margins, the stock can produce above average returns. For this reason, today I established a 2% position in PEP.
I have been considering Pepsico for its potential margin improvement due to my belief that commodity prices may continue to fall due to deflationary pressures. In the third quarter the gross margin declined 300 basis points annually, largely due to rising commodity prices. Sugar is a significant cost, as well as aluminum, corn, wheat, and gas. Due to a reduced supply of sugar from both Brazil and Australia, sugar prices have remained fairly high despite a pullback in other commodities. Since sugar prices have not declined significantly I have held back from Pepsico. That said, I expect more supply to come on the market as we roll through 2012 as growers are attracted by the higher prices in 2011. Management actively hedges commodity prices and the recent volatility may provide them with an opportunity to lock-in lower prices in 2012 relative to 2011, in my view. With all that considered, I decided Pepsico could benefit from falling commodities given its more stable sales characteristics and significant exposure to snack foods, which use corn and wheat. Wheat and corn prices have declined recently.
A risk to sales is that large retailers like Wal*Mart and Costco are able negotiate lower prices should the cost structure of Pepsico, and their competitors, decline due to falling commodity prices. Obviously these two retailers have significant leverage due to their size and from talking to a friend who has called on Costco, I know they can drive hard for price concessions. If Pepsico can increase volume of their products through their marketing campaigns, the company should have greater negotiating power when working with retailers. In addition, by improving productivity the company should be able to produce higher returns as the business lowers fixed costs and increases turnover. Improving returns should translate into an outperforming stock. That said, Coca-Cola has also worked on productivity improvements to lower its cost structure and has expanded vertically through its acquisition of the North American operations of bottler Coca Cola Enterprises last year.
Returning to the re-structuring plans, management began investing in its brands about 3 1/2 years ago when it focused on Gatorade. Management then moved to Tropicana, Pepsi Max, Sierra Mist, and Mountain Dew, each showing improvement. Now management is focused on Pepsi, a potential bigger bang for the buck after the cola fell to third place in the US in 2010 behind Coke and Diet Coke. Higher spending on marketing, funded by cost improvements, should enable Pepsi sales to improve going forward. In addition to the turnaround of established markets, the emerging markets remain a significant growth opportunity for the company to expand consumption with snack revenue growth of 31% in China and 26% in India this past quarter.
Last week they reported strong results after implementing price increases to offset rising commodity prices. An encouraging signal was that volume changes were within management expectations despite the price increase. Also encouraging was a reiteration of high single digit earning growth for 2011, despite less anticipated benefit from currency, implying the actual business is improving slightly better than expectations. Compare these results with a consensus EPS growth estimate of 6% in 2012 and I believe there is upside to forward year estimates should commodity prices fall or Pepsi sales improve.
The consensus analyst opinion is overweight for the stock. PEP trades at 13x the consensus 2012 EPS estimates. The dividend yield is an attractive 3.3%, higher than Coco-Cola's (Ticker KO) of 2.7%. PEP is trading close to its 52-week low.
Thursday, October 13, 2011
The Battle Against Deflation Rises Again
In April I argued that deflationary pressures would likely drive market movements for the rest of the year. One of the points I made was the following:
"Unless the Fed continuously 'raises the ante' by increasing the level of stimulus, I believe the Fed's actions likely cannot offset the fundamental deflationary forces in the economy. Additionally, foreign governments have actively raised rates and reserve requirements in efforts to slow down inflationary pressures in their countries. These efforts likely start putting a brake on world economic growth"
- Stock Ideas to Money, April 26 2011
With the Federal Reserve considering becoming more active, foreign central banks increasingly stepping in, and the yield on the ten year and thirty year bonds rising; I return to this thought and ask whether fundamental deflationary forces likely subside. To start, I have summarized an analysis of price volatility in the following table.
The key points to pull out, in my view, are:
(1) The longer-term fundamental trends of declining wages and government austerity remain deflationary. Until either fiscal policies become more expansionary or market imbalances are allowed to correct themselves, I believe these fundamental deflationary pressures remain two of the more dominant forces in the economy.
(2) The more volatile segments of commodity, financial and currency have recently swung towards deflationary pressures after providing inflationary pressure for a couple years. These are the sectors affected most immediately by monetary policy in the current low interest rate environment, in my view. The turn-around during the past week in many of these markets, with equity and commodity markets up and the dollar down, likely is due in some part to recent articles suggesting another round of QE is coming. The primary reason for improvements in these markets, in my view, was increasing signs of progress towards the European bailout. In short, activist government policies but no real change in the underlying problems.
(3) The one segment that shows obvious signs of inflationary pressure is goods and services. However, an important distinction needs to be made about this indicator. The CPI is relatively high right now because businesses have been trying to pass along rising costs to customers, in my view. I do not believe it is high at the moment due to excessive demand relative to supply. This point is illustrated by the relatively weak shipments ahead of the Christmas season.
The conclusion is that my Sagflation theme remains in play. I believe fundamental deflationary pressures remain in place but if governments around the world keep announcing new fiscal and monetary stimulants I likely need to exit my 30-year treasury position.
"Unless the Fed continuously 'raises the ante' by increasing the level of stimulus, I believe the Fed's actions likely cannot offset the fundamental deflationary forces in the economy. Additionally, foreign governments have actively raised rates and reserve requirements in efforts to slow down inflationary pressures in their countries. These efforts likely start putting a brake on world economic growth"
- Stock Ideas to Money, April 26 2011
With the Federal Reserve considering becoming more active, foreign central banks increasingly stepping in, and the yield on the ten year and thirty year bonds rising; I return to this thought and ask whether fundamental deflationary forces likely subside. To start, I have summarized an analysis of price volatility in the following table.
| Segment | Direction | Argument |
|---|---|---|
| Commodity | Deflationary | Commodity prices have been falling for the last few months, applying deflationary pressure in the cost structure of the world economy. |
| Wages | Deflationary | Wages have declined 10% since December 2007, due primarily to the significant number of unemployed in the country. |
| Financial Assets | Deflationary | With the S&P 500 down significantly from its highs, financial assets have generally declined over the past few months, reducing the wealth of many in the country. |
| Tangible Assets | Stable | Housing prices remain well off their highs from a few years ago, but appear more stable than in the past. However, banks appear more aggressive in acting against owners who have missed a payment, which could push prices lower if the banks choose to try to expedite the foreclosure process and sell the property. |
| Currency | Mixed | The US Dollar index has strengthened recently due largely to weakness outside the US. That said, the strength of the dollar has begun to weaken again. If the dollar continues to slide, inflationary pressure may return to the U.S. economy. |
| Fiat | Deflationary | Governments remain fairly committed to austerity measures as countries in Europe attempt to reduce debt levels and the right-wing in the US continues to favor a balanced budget. Reduced spending is likely a deflationary force in the economy. |
| Goods & Services | Inflationary | The CPI-U increased almost 4% annually in August, a lagging indicator, in my opinion, of inflationary pressure from higher commodity prices earlier in the year. Weak consumer demand suggests this segment could turn deflationary once cost pressures subside. |
The key points to pull out, in my view, are:
(1) The longer-term fundamental trends of declining wages and government austerity remain deflationary. Until either fiscal policies become more expansionary or market imbalances are allowed to correct themselves, I believe these fundamental deflationary pressures remain two of the more dominant forces in the economy.
(2) The more volatile segments of commodity, financial and currency have recently swung towards deflationary pressures after providing inflationary pressure for a couple years. These are the sectors affected most immediately by monetary policy in the current low interest rate environment, in my view. The turn-around during the past week in many of these markets, with equity and commodity markets up and the dollar down, likely is due in some part to recent articles suggesting another round of QE is coming. The primary reason for improvements in these markets, in my view, was increasing signs of progress towards the European bailout. In short, activist government policies but no real change in the underlying problems.
(3) The one segment that shows obvious signs of inflationary pressure is goods and services. However, an important distinction needs to be made about this indicator. The CPI is relatively high right now because businesses have been trying to pass along rising costs to customers, in my view. I do not believe it is high at the moment due to excessive demand relative to supply. This point is illustrated by the relatively weak shipments ahead of the Christmas season.
The conclusion is that my Sagflation theme remains in play. I believe fundamental deflationary pressures remain in place but if governments around the world keep announcing new fiscal and monetary stimulants I likely need to exit my 30-year treasury position.
Tuesday, October 4, 2011
Revisiting the S&P 500 Falling Below 700 Call
On June 1, 2011 I wrote that the S&P 500 may drop below 700. In the article I wrote the following based on my Sagflation theme:
"I believe the stock markets are in for a significant retrenchment based on the deflationary trends of weakening home prices, slowing hiring in a weak employment environment, likely restrictions on fiscal spending, consideration of tightening monetary policy, commodity prices that appear to have peaked, and lack of pricing power by retailers as consumers struggle with debt."
- Stock Ideas to Money, June 1, 2011
In the article I also said that I believed the yield on the 10-year treasury may drop to 2% and the yield on the 30-year treasury may drop to 2.5%, suggesting "the place to make money is in treasury bonds as prices rally as investors flood to the safe haven." Since the yield on the 10-year is now below 2% and the yield on the 30-year treasury is around 2.7%, I felt it appropriate to re-visit the article.
One thing I had not anticipated when I wrote the article was the Federal Reserve's Operation Twist. While long-term yields were likely on their way to current levels, in my view, the Fed's announcement likely hastened the move. This week the Fed actually began buying longer duration treasury bonds, likely the primary reason for the fall in 30-year yields yesterday. So I continue to believe yields on the 30-year treasury move down to 2.5%, at which point I plan to further evaluate the position.
Turning to the S&P 500, the index has a long way to fall before dropping below 700. Two points that I have made in the past, but are worth reiterating: (1) the bottom in the stock market most likely does not coincide with the nadir of yields, and (2) on an inflation and cyclically adjusted basis, the valuation of S&P 500 remains above the historical median of 15.8x and well above historical lows in the single digits, which have occurred during extraordinary times. A single-digit PE, as defined by Robert Shiller, would translate to the S&P 500 below 600.
Source: Robert Shiller, Yale Department of Economics
If 2008/09 is any guide, we can look forward to the following steps:
(1) Capitulation in the markets, defined as record, or near record, volume combined with intraday price swings in excess of 5%. This occurred on October 10, 2008.
(2) Bottoming of the 10-year and 30-year yields. This occurred on December 18, 2008.
(3) Actual stock market bottom, which occurred on March 9, 2009.
Going back to the 30-year treasury yield, if the yield drops below 2.5% before an obvious capitulation day in the equity markets, I may hold the position a little longer.
"I believe the stock markets are in for a significant retrenchment based on the deflationary trends of weakening home prices, slowing hiring in a weak employment environment, likely restrictions on fiscal spending, consideration of tightening monetary policy, commodity prices that appear to have peaked, and lack of pricing power by retailers as consumers struggle with debt."
- Stock Ideas to Money, June 1, 2011
In the article I also said that I believed the yield on the 10-year treasury may drop to 2% and the yield on the 30-year treasury may drop to 2.5%, suggesting "the place to make money is in treasury bonds as prices rally as investors flood to the safe haven." Since the yield on the 10-year is now below 2% and the yield on the 30-year treasury is around 2.7%, I felt it appropriate to re-visit the article.
One thing I had not anticipated when I wrote the article was the Federal Reserve's Operation Twist. While long-term yields were likely on their way to current levels, in my view, the Fed's announcement likely hastened the move. This week the Fed actually began buying longer duration treasury bonds, likely the primary reason for the fall in 30-year yields yesterday. So I continue to believe yields on the 30-year treasury move down to 2.5%, at which point I plan to further evaluate the position.
Turning to the S&P 500, the index has a long way to fall before dropping below 700. Two points that I have made in the past, but are worth reiterating: (1) the bottom in the stock market most likely does not coincide with the nadir of yields, and (2) on an inflation and cyclically adjusted basis, the valuation of S&P 500 remains above the historical median of 15.8x and well above historical lows in the single digits, which have occurred during extraordinary times. A single-digit PE, as defined by Robert Shiller, would translate to the S&P 500 below 600.
S&P 500 PE Ratio
If 2008/09 is any guide, we can look forward to the following steps:
(1) Capitulation in the markets, defined as record, or near record, volume combined with intraday price swings in excess of 5%. This occurred on October 10, 2008.
(2) Bottoming of the 10-year and 30-year yields. This occurred on December 18, 2008.
(3) Actual stock market bottom, which occurred on March 9, 2009.
Going back to the 30-year treasury yield, if the yield drops below 2.5% before an obvious capitulation day in the equity markets, I may hold the position a little longer.
Monday, October 3, 2011
Stock Ideas During Falling Commodity Prices
The idea is to invest in companies that should benefit from falling commodity prices but not get hurt by slowing economic activity. Ideally, the company would also have strong brands or other competitive advantages that allow for stable prices of their products. This should enable margin expansion, and thus EPS growth above the average.
From the top down, I'm looking for companies with stable, almost annuity-like, revenue during economic cycles combined with a large percentage of expenses from materials. An example in my portfolio is Kimberly-Clark (ticker KMB), a consumer staple company that sells products like Kleenex and has significant costs associated with wood due to its paper-based products.
Of course, this idea assumes commodity prices continue to fall. Based on my Sagflation theme of slow-to-negative growth combined with volatile prices, in which I believe the current direction of prices is moving towards deflation, commodities should continue to decline. Significant government intervention in the form of fiscal and monetary stimulus could change this outlook.
In this article I review my investment in Kimberly Clark (ticker KMB), analyze a few companies with similar margin improvement potential due to falling commodity prices, and conclude with a decision to make 2-4% investment in Tyson Foods, ticker TSN.
First, a look at some commodity prices and their change this year:
Source: CNNMoney (http://money.cnn.com/data/commodities/)
The charts above illustrate that the largest price drops over the past year have occurred in copper. Over the past six months there has also been a significant drop in oil and cotton prices with more moderate pullbacks in corn and wheat. Not included in the charts is lumber, which has also seen a modest pull back in prices over the past couple months. Cattle prices have actually rallied strongly over the past. While I expect commodity prices, in general, to continue their decline as deflationary pressures strengthen, for the purposes of the current analysis I shall focus on oil, copper and agricultural products, excluding livestock.
Kimberly-Clark (Ticker: KMB) Cost of Products Analysis
Source: SEC Filings
In 2010 cost of products sold accounted for about 67% of revenue, highlighting the importance of raw material costs in the actual products and used during the manufacturing process. The primary raw materials in the company's products are recovered paper, synthetics, kraft pulp, cellulose pulp and recycled fiber. Natural gas, electricity, and petroleum-based products are key costs during the manufacturing process. Therefore pulp prices and oil prices can have a material impact on financials.
As seen in the charts above, oil prices have declined about 22% since the May peak. The Forestweb North American Pulp Index has dropped over 9% since the June peak. The gross margin for KMB dropped more than 400 basis points from 33.8% in 2Q10 to 29.6% in 2Q11, largely due to higher raw material costs, much of which the company does not hedge. Should oil and pulp prices continue to decline I expect to see the margins improve for the business, enabling above average EPS growth.
Looking over some other key metrics: annual dividend yield is a healthy 4%, the dividend increased 6% this year, TD/ EBITDA is a comfortable 1.5x, PE on '12 EPS is an okay 13.5x, and last month the consensus recommendation moved up to Overweight from Hold because one analyst upgraded. Five analysts have a Buy, ten have a Hold recommendation, and one Sell. I believe the stock is reasonably valued and the dividend yield combined with stable revenue should attract buyers in a weak market.
Sysco Corporation (Ticker: SYY) Cost of Sales Analysis
Sysco is a food distributor with significant fuel and food costs. Because of this position, I decided to look at the margin potential. For the purposes of this analysis, in which I am looking for potential margin expansion due to falling commodity prices, the key disclosure in the company's filing is the following, "we make a significant portion of our sales at prices that are based on the cost of products we sell plus a percentage markup." As a result, falling commodity prices are likely passed along to the customer in the form of lower prices, instead of retained by the company for margin improvement purposes.
Campbell Soup Company (Ticker: CPB) Cost of Products Sold Analysis
Campbell Soup is a food company whose significant costs include agriculture commodities like tomato paste. Therefore I looked at it as a candidate for margin improvements. The key disclosure in their SEC filings is the following, "The company also enters into commodity futures and options contracts to reduce the volatility of price fluctuations of diesel fuel, wheat, natural gas, soybean oil, aluminum, sugar, cocoa, and corn, which impact the cost of raw materials." Therefore there is likely not the upside to margins as commodity prices fall.
Cracker Barrel (Ticker: CBRL) Cost of Goods Sold Analysis
Cracker Barrel is a family-dining restaurant plus retail chain that are typically located next to highways. While not immune to economic slowdowns, their relative low average check, locations near highways, and established brand name can provide healthy revenue trends when gas prices fall, encouraging more people to drive. Thus the company is fairly unique in that falling gas prices can actually drive revenue. The concern is that the company's niche is largely in the lower-to-middle class income segment, which may be hurt proportionally more during an economic slowdown.
Source: SEC Filings
Gross profit was 68% in the fiscal fourth quarter (FYE July), down 170 basis points from the previous year. The primary cause of the higher cost of goods sold was a 2.9% increase in food commodity prices for the fiscal year. Looks promising so far. Dairy, including eggs, accounted for 13% of food purchasing expense in fiscal 2011. Beef, poultry, and pork each accounted for 11% of food purchasing expense. Together, these four segments accounted for 46% of food costs. The company raised menu prices 2% last year to offset the rising costs but the traffic declined about 2%, which may be due to the higher menu prices, weak economic environment, and also higher gas prices.
The key issue, in my mind, concerns the following disclosure about the fiscal 2012 outlook, "we presently expect the rate of commodity inflation to approximately double in 2012 as compared to 2011. We expect to offset the effects of food commodity inflation through a combination of menu price increases, supply contracts and other cost reduction initiatives." On the one hand, expectations are already set for higher commodity prices, providing room for upside should food prices actually fall. The problem is that beef prices are rising due to the droughts around Texas. On the chicken side you would think poultry prices would decline with lower corn prices. However, producers have been getting squeezed due to higher corn prices and thus have cut back production, suggesting poultry prices may remain firmer. Pork belly prices have declined about 5% since peaking in May, so this segment may offer some upside.
My conclusion is that food prices impacting Cracker Barrel may not go down as much, offering less upside to margins. Couple this with the uncertain impact of a weaker economy and I have decided to put this idea on the shelf.
Tyson Foods (Ticker: TSN) Cost of Sales Analysis
Tyson Foods, Inc. is a meat protein and food production company. It produces, distributes and markets chicken, beef, pork, prepared foods and related allied products. Its operations are conducted in four segments: Chicken, Beef, Pork and Prepared Foods. The largest revenue segment is beef, followed closely by chicken, which together account for almost three-quarters of revenue. Revenue is typically fairly stable during economic cycles, although can fluctuate due to prices for beef, chicken and pork.
Source: SEC Filings
After looking at Cracker Barrel, and trends in poultry prices, I found the chart below interesting. Basically, it summarizes the ratio between broiler prices (chicken) versus feed. The higher the ratio the better the margins for a chicken producer. The chart's labels are horrible, but basically the time line is from 2007 to the end of September 2011. I love this chart because it illustrates an unsustainable state in the market. Chicken producers are actively cutting back production because their margins are under pressure, suggesting broiler prices should remain at least stable in a weak economy. Additionally, I believe with corn and wheat prices declining the feed prices should decline, enabling the ratio to recover back above 1.0x.
Source: The Market Oracle blog. http://www.marketoracle.co.uk/Article30748.html
Because of the rising feed costs associated with corn and wheat prices, Tyson saw its gross margin decline 370 basis points in the quarter ended July 2. The company does actively enter into derivative and longer-term contracts in order to manage the volatility of prices like corn, live cattle, lean hogs, and natural gas. Thus how well they manage these positions likely impacts the margin potential, in my view.
A couple additional key metrics: The PE on C2011 is an attractive 8.5x. The consensus recommendation is Overweight, which has been stable for the past quarter. The company has met or exceeded EPS estimates each quarter during the past two years. The consensus EPS estimate for the September quarter is $0.31, a drop of over 50% from the previous year. Dividends have been stable over the past two years and the current annual dividend yield is about 1%. The company's debt has been upgraded twice by both Moody's and S&P over the past two years. TD-to- TTM EBITDA is just over a healthy 1x and the company plans to repurchase debt outstanding with cash on-hand. As of July 2, the company was authorized to repurchase over 18 million shares.
In conclusion, I plan to establish a 2-4% position in Tyson Foods based on what I believe is an outlook of stable protein commodity prices and falling feed costs, offering upside potential to estimates through margin improvements. In addition, I believe the valuation builds in a cushion for higher expected feed costs and worries about a demand slowdown.
From the top down, I'm looking for companies with stable, almost annuity-like, revenue during economic cycles combined with a large percentage of expenses from materials. An example in my portfolio is Kimberly-Clark (ticker KMB), a consumer staple company that sells products like Kleenex and has significant costs associated with wood due to its paper-based products.
Of course, this idea assumes commodity prices continue to fall. Based on my Sagflation theme of slow-to-negative growth combined with volatile prices, in which I believe the current direction of prices is moving towards deflation, commodities should continue to decline. Significant government intervention in the form of fiscal and monetary stimulus could change this outlook.
In this article I review my investment in Kimberly Clark (ticker KMB), analyze a few companies with similar margin improvement potential due to falling commodity prices, and conclude with a decision to make 2-4% investment in Tyson Foods, ticker TSN.
First, a look at some commodity prices and their change this year:
Oil (Light Crude)
 |
Copper
 |
Corn
 |
Wheat
 |
Cotton
 |
Live Cattle
 |
The charts above illustrate that the largest price drops over the past year have occurred in copper. Over the past six months there has also been a significant drop in oil and cotton prices with more moderate pullbacks in corn and wheat. Not included in the charts is lumber, which has also seen a modest pull back in prices over the past couple months. Cattle prices have actually rallied strongly over the past. While I expect commodity prices, in general, to continue their decline as deflationary pressures strengthen, for the purposes of the current analysis I shall focus on oil, copper and agricultural products, excluding livestock.
Kimberly-Clark (Ticker: KMB) Cost of Products Analysis
| 2Q11 | Y/Y | |
|---|---|---|
| Revenue ($mm) | $5,259 | + 8.3% |
| Gross Margin | 29.6% | - 4.2% |
| Op. Margin | 11.9% | - 2.7% |
| Dil. Op. EPS | $1.18 | - 1.7% |
Source: SEC Filings
In 2010 cost of products sold accounted for about 67% of revenue, highlighting the importance of raw material costs in the actual products and used during the manufacturing process. The primary raw materials in the company's products are recovered paper, synthetics, kraft pulp, cellulose pulp and recycled fiber. Natural gas, electricity, and petroleum-based products are key costs during the manufacturing process. Therefore pulp prices and oil prices can have a material impact on financials.
As seen in the charts above, oil prices have declined about 22% since the May peak. The Forestweb North American Pulp Index has dropped over 9% since the June peak. The gross margin for KMB dropped more than 400 basis points from 33.8% in 2Q10 to 29.6% in 2Q11, largely due to higher raw material costs, much of which the company does not hedge. Should oil and pulp prices continue to decline I expect to see the margins improve for the business, enabling above average EPS growth.
Looking over some other key metrics: annual dividend yield is a healthy 4%, the dividend increased 6% this year, TD/ EBITDA is a comfortable 1.5x, PE on '12 EPS is an okay 13.5x, and last month the consensus recommendation moved up to Overweight from Hold because one analyst upgraded. Five analysts have a Buy, ten have a Hold recommendation, and one Sell. I believe the stock is reasonably valued and the dividend yield combined with stable revenue should attract buyers in a weak market.
Sysco Corporation (Ticker: SYY) Cost of Sales Analysis
Sysco is a food distributor with significant fuel and food costs. Because of this position, I decided to look at the margin potential. For the purposes of this analysis, in which I am looking for potential margin expansion due to falling commodity prices, the key disclosure in the company's filing is the following, "we make a significant portion of our sales at prices that are based on the cost of products we sell plus a percentage markup." As a result, falling commodity prices are likely passed along to the customer in the form of lower prices, instead of retained by the company for margin improvement purposes.
Campbell Soup Company (Ticker: CPB) Cost of Products Sold Analysis
Campbell Soup is a food company whose significant costs include agriculture commodities like tomato paste. Therefore I looked at it as a candidate for margin improvements. The key disclosure in their SEC filings is the following, "The company also enters into commodity futures and options contracts to reduce the volatility of price fluctuations of diesel fuel, wheat, natural gas, soybean oil, aluminum, sugar, cocoa, and corn, which impact the cost of raw materials." Therefore there is likely not the upside to margins as commodity prices fall.
Cracker Barrel (Ticker: CBRL) Cost of Goods Sold Analysis
Cracker Barrel is a family-dining restaurant plus retail chain that are typically located next to highways. While not immune to economic slowdowns, their relative low average check, locations near highways, and established brand name can provide healthy revenue trends when gas prices fall, encouraging more people to drive. Thus the company is fairly unique in that falling gas prices can actually drive revenue. The concern is that the company's niche is largely in the lower-to-middle class income segment, which may be hurt proportionally more during an economic slowdown.
| F4Q11 | Y/Y | |
|---|---|---|
| Revenue ($mm) | $613 | 0% |
| Gross Margin | 68.4% | - 1.7% |
| Op. Margin | 6.2% | - 1.2% |
| Dil. Op. EPS | $0.25 | + 14% |
Source: SEC Filings
Gross profit was 68% in the fiscal fourth quarter (FYE July), down 170 basis points from the previous year. The primary cause of the higher cost of goods sold was a 2.9% increase in food commodity prices for the fiscal year. Looks promising so far. Dairy, including eggs, accounted for 13% of food purchasing expense in fiscal 2011. Beef, poultry, and pork each accounted for 11% of food purchasing expense. Together, these four segments accounted for 46% of food costs. The company raised menu prices 2% last year to offset the rising costs but the traffic declined about 2%, which may be due to the higher menu prices, weak economic environment, and also higher gas prices.
The key issue, in my mind, concerns the following disclosure about the fiscal 2012 outlook, "we presently expect the rate of commodity inflation to approximately double in 2012 as compared to 2011. We expect to offset the effects of food commodity inflation through a combination of menu price increases, supply contracts and other cost reduction initiatives." On the one hand, expectations are already set for higher commodity prices, providing room for upside should food prices actually fall. The problem is that beef prices are rising due to the droughts around Texas. On the chicken side you would think poultry prices would decline with lower corn prices. However, producers have been getting squeezed due to higher corn prices and thus have cut back production, suggesting poultry prices may remain firmer. Pork belly prices have declined about 5% since peaking in May, so this segment may offer some upside.
My conclusion is that food prices impacting Cracker Barrel may not go down as much, offering less upside to margins. Couple this with the uncertain impact of a weaker economy and I have decided to put this idea on the shelf.
Tyson Foods (Ticker: TSN) Cost of Sales Analysis
Tyson Foods, Inc. is a meat protein and food production company. It produces, distributes and markets chicken, beef, pork, prepared foods and related allied products. Its operations are conducted in four segments: Chicken, Beef, Pork and Prepared Foods. The largest revenue segment is beef, followed closely by chicken, which together account for almost three-quarters of revenue. Revenue is typically fairly stable during economic cycles, although can fluctuate due to prices for beef, chicken and pork.
| F3Q11 | Y/Y | |
|---|---|---|
| Revenue ($mm) | $8,247 | 11% |
| Gross Margin | 6.4% | - 3.7% |
| Op. Margin | 3.8% | - 3.0% |
| Dil. Op. EPS | $0.46 | - 31% |
After looking at Cracker Barrel, and trends in poultry prices, I found the chart below interesting. Basically, it summarizes the ratio between broiler prices (chicken) versus feed. The higher the ratio the better the margins for a chicken producer. The chart's labels are horrible, but basically the time line is from 2007 to the end of September 2011. I love this chart because it illustrates an unsustainable state in the market. Chicken producers are actively cutting back production because their margins are under pressure, suggesting broiler prices should remain at least stable in a weak economy. Additionally, I believe with corn and wheat prices declining the feed prices should decline, enabling the ratio to recover back above 1.0x.
Because of the rising feed costs associated with corn and wheat prices, Tyson saw its gross margin decline 370 basis points in the quarter ended July 2. The company does actively enter into derivative and longer-term contracts in order to manage the volatility of prices like corn, live cattle, lean hogs, and natural gas. Thus how well they manage these positions likely impacts the margin potential, in my view.
A couple additional key metrics: The PE on C2011 is an attractive 8.5x. The consensus recommendation is Overweight, which has been stable for the past quarter. The company has met or exceeded EPS estimates each quarter during the past two years. The consensus EPS estimate for the September quarter is $0.31, a drop of over 50% from the previous year. Dividends have been stable over the past two years and the current annual dividend yield is about 1%. The company's debt has been upgraded twice by both Moody's and S&P over the past two years. TD-to- TTM EBITDA is just over a healthy 1x and the company plans to repurchase debt outstanding with cash on-hand. As of July 2, the company was authorized to repurchase over 18 million shares.
In conclusion, I plan to establish a 2-4% position in Tyson Foods based on what I believe is an outlook of stable protein commodity prices and falling feed costs, offering upside potential to estimates through margin improvements. In addition, I believe the valuation builds in a cushion for higher expected feed costs and worries about a demand slowdown.
Saturday, October 1, 2011
Third Quarter Review - Up 18%
| Position | % of IRA | Q Performance |
|---|---|---|
| 30-Yr Treasury | ~65% | up ~29% |
| KMB | ~5% | up ~7% |
| BWP | ~4% | down ~12% |
| UTL | ~3% | down ~2% |
| FGP | ~3% | down ~12% |
| CA | ~1% | down ~15% |
| TEVA | ~1% | down ~23% |
| Cash | ~18% | N/A |
My defensive strategy worked quite well during the quarter as I significantly under-weighted equity and significantly over-weighted government debt with a long duration. My equity positions were focused in the more defensive sectors of consumer staples, US-based natural resources, utilities, healthcare, and stable customer-based technology.
Overall performance in the quarter was an increase of 18%. For the quarter, all but my two smallest positions outperformed the S&P 500, which was down about 14%.
The treasury position also paid out a coupon in excess of 2%, on top of the approximately 29% bump in principle, increasing my cash position. I also received dividends during the quarter, raising my cash balance.
I did close two positions during the quarter on August 3, CALM at $33.88 for a 6% gain in the quarter and TNH at $150.93 for a 10% gain in the quarter. I did not open any new positions during the quarter.
Thursday, September 29, 2011
Stagnation vs. Sagflation
Goldman Sachs recently argued that the world economy may be entering a period of Stagnation. “During these episodes, GDP per capita growth hovers below 1 percent and
is less volatile than usual. They are also characterized by low
inflation, rising and sticky unemployment, stagnant home prices, and
lower stock returns,” wrote Jose Ursua, an economist at Goldman Sachs.
Goldman Sachs appears to have described the current environment and applied a name to it, although they have not adequately explained the volatile commodity, debt, and equity prices. My problem with the argument is that the remedy appears very similar to what we've been trying for the past few decades. “Whether these countries manage to avoid a ‘Great Stagnation’ by a pick-up in the recovery is likely to depend on policy being able to restore confidence and putting in place reforms that can decisively jolt growth,” Goldman Sachs argues. I am assuming a "jolt" means stimulus in the form of lower taxes or more spending.
In my opinion, Goldman Sachs misses the underlying problem, which is structural in nature. Decades of activist fiscal and monetary policy to avoid economic slowdowns have produced a perverted economic environment. Inefficiencies have built up into bubbles and then burst, resulting is massive losses of investment and political structures set up to avoid further losses. An economy cannot allocate resources to capital destroying endeavors indefinitely, either due to the siren call of bubbles or politically protected segments. Eventually, the economic activity slows as investors and businesses earn diminishing returns on their investments.
The US economy needs to go through a period of healing, in my opinion, which could prove painful for many. I believe confidence is restored by allowing poor investment decisions to fail, enabling the failure to be understood, and clearing the environment for healthy investments to take their place. The problem is that people are increasingly looking to the government to "fix it." I find it highly ironic that the capital markets, which tend to advocate less government intervention, are breathlessly anticipating a bailout in Europe and further Fed actions. For over 30 years we have been lowering taxes, legislating Keynesian stimulus spending, and providing ever more accommodating monetary policy. Asking for more government intervention is like a drug addict asking for another hit, it feels good initially but only leads to more pain.
Under my Sagflation theme I argue that fundamental deflationary pressures in the economy likely cause slow to negative growth. These deflationary pressures largely stem from the excessive debt to be serviced by governments and consumers. As a result of the debt burden there are deflationary pressures through government austerity measures, falling house prices, weak wages due to high unemployment, falling commodity prices, stronger dollar as other regions weaken, and eventually lower prices for goods and services as costs subside, competition intensifies, and technology advancements improve quality.
Offsetting the deflationary pressures, under my Sagflation theme, are overly active monetary and fiscal policies attempting to avoid deflation. These aggressive policies are more arbitrary, mostly temporary, and reactionary. By aggressively trying to stimulate the economy through tax decreases, spending increases, and monetary jolts, these policies result in more volatile prices (not less) as the economy swings from inflationary pressures back to deflationary pressures. Until the government addresses structural inefficiencies and markets clear the poor investment decisions over the past few decades, I believe we are stuck in an environment of low-to-negative growth and volatile prices.
What the US government should do, in my opinion, is focus on structural changes that enable efficient markets to operate. Reform the tax code, streamline regulations, and as much as possible remove the money from politics. The money flowing around DC creates conflicts of interest and encourages inefficient legal structures that favor one entity over another, to the detriment of society as a whole. The current argument between "no new taxes" and spending to stimulate the economy misses the real problem, in my opinion. I am not opposed to higher tax rates on the wealthy to fund longer-term stimulus spending. This is because tax rates on the wealthy are low by historical standards and the wealthy have generally benefited from the economic inefficiencies to a greater degree. Additionally, performing a thorough "reorganization" of the government that improves efficiency is likely overdue.
Goldman Sach's "Great Stagnation" is closer to identifying the problem, in my opinion, than "Stagflation," but is still off the mark. In my view, "Sagflation" explains the issues better and offers greater insight to make proper investment decisions.
In a deflationary period, which I believe we have been turning towards for much of 2011, I believe long-term treasuries tend to outperform, which the strong performance in my position in 30-year treasuries has supported. As inflation expectations decline the real interest rate improves on longer-term treasuries. In addition, in a deflationary world the economic landscape can look scary, in my view. Under these circumstances investors are looking for safe havens, of which treasuries rank near the top, in my view. For these reasons I have maintained my 30-year treasury position.
Goldman Sachs appears to have described the current environment and applied a name to it, although they have not adequately explained the volatile commodity, debt, and equity prices. My problem with the argument is that the remedy appears very similar to what we've been trying for the past few decades. “Whether these countries manage to avoid a ‘Great Stagnation’ by a pick-up in the recovery is likely to depend on policy being able to restore confidence and putting in place reforms that can decisively jolt growth,” Goldman Sachs argues. I am assuming a "jolt" means stimulus in the form of lower taxes or more spending.
In my opinion, Goldman Sachs misses the underlying problem, which is structural in nature. Decades of activist fiscal and monetary policy to avoid economic slowdowns have produced a perverted economic environment. Inefficiencies have built up into bubbles and then burst, resulting is massive losses of investment and political structures set up to avoid further losses. An economy cannot allocate resources to capital destroying endeavors indefinitely, either due to the siren call of bubbles or politically protected segments. Eventually, the economic activity slows as investors and businesses earn diminishing returns on their investments.
The US economy needs to go through a period of healing, in my opinion, which could prove painful for many. I believe confidence is restored by allowing poor investment decisions to fail, enabling the failure to be understood, and clearing the environment for healthy investments to take their place. The problem is that people are increasingly looking to the government to "fix it." I find it highly ironic that the capital markets, which tend to advocate less government intervention, are breathlessly anticipating a bailout in Europe and further Fed actions. For over 30 years we have been lowering taxes, legislating Keynesian stimulus spending, and providing ever more accommodating monetary policy. Asking for more government intervention is like a drug addict asking for another hit, it feels good initially but only leads to more pain.
Under my Sagflation theme I argue that fundamental deflationary pressures in the economy likely cause slow to negative growth. These deflationary pressures largely stem from the excessive debt to be serviced by governments and consumers. As a result of the debt burden there are deflationary pressures through government austerity measures, falling house prices, weak wages due to high unemployment, falling commodity prices, stronger dollar as other regions weaken, and eventually lower prices for goods and services as costs subside, competition intensifies, and technology advancements improve quality.
Offsetting the deflationary pressures, under my Sagflation theme, are overly active monetary and fiscal policies attempting to avoid deflation. These aggressive policies are more arbitrary, mostly temporary, and reactionary. By aggressively trying to stimulate the economy through tax decreases, spending increases, and monetary jolts, these policies result in more volatile prices (not less) as the economy swings from inflationary pressures back to deflationary pressures. Until the government addresses structural inefficiencies and markets clear the poor investment decisions over the past few decades, I believe we are stuck in an environment of low-to-negative growth and volatile prices.
What the US government should do, in my opinion, is focus on structural changes that enable efficient markets to operate. Reform the tax code, streamline regulations, and as much as possible remove the money from politics. The money flowing around DC creates conflicts of interest and encourages inefficient legal structures that favor one entity over another, to the detriment of society as a whole. The current argument between "no new taxes" and spending to stimulate the economy misses the real problem, in my opinion. I am not opposed to higher tax rates on the wealthy to fund longer-term stimulus spending. This is because tax rates on the wealthy are low by historical standards and the wealthy have generally benefited from the economic inefficiencies to a greater degree. Additionally, performing a thorough "reorganization" of the government that improves efficiency is likely overdue.
Goldman Sach's "Great Stagnation" is closer to identifying the problem, in my opinion, than "Stagflation," but is still off the mark. In my view, "Sagflation" explains the issues better and offers greater insight to make proper investment decisions.
In a deflationary period, which I believe we have been turning towards for much of 2011, I believe long-term treasuries tend to outperform, which the strong performance in my position in 30-year treasuries has supported. As inflation expectations decline the real interest rate improves on longer-term treasuries. In addition, in a deflationary world the economic landscape can look scary, in my view. Under these circumstances investors are looking for safe havens, of which treasuries rank near the top, in my view. For these reasons I have maintained my 30-year treasury position.
Tuesday, September 27, 2011
European Banks, China Investors and US Consumers
This post is written with the yield on the 30-year treasury floating back up above 3%. This yield is significant because it is a sharp bounce off of the recent low, it suggests the markets anticipate an improving economy largely due to a bail-out in Europe, and it calls into question the level to which the Federal Reserve would like push down long-term yields. In this post I focus on economic stresses caused by volatile markets, arriving at the conclusion that I should hold, for now, the treasury position based on my belief that today's rally is a "dead cat" bounce that ultimately turns back down. That said, it is becoming more difficult to separate volatility from longer-term moves and I have noted that treasury yields can bottom before equity markets.
In my last post on 30-year treasuries, I mentioned that I believe it may take until June 2012 for the full impact of the recent market volatility to completely impact equities. There are a few signs emerging of real world stress on economic activity.
According the WSJ, the rise of perceived risk in European banks has made it more difficult for them to issue new debt. The banks have only issued $34 billion of senior unsecured debt this quarter, on track to being the lowest issuance in any quarter in over a decade. The timing, as is usually the case during a crisis, stinks because of an estimated $1 trillion of debt coming due next year. There is still time for the banks to issue enough debt to meet the required financing of maturing debts. But, the issue is becoming more pressing and the banks potentially have to accept higher rates, placing further pressure on their business.
Adding to the potential hit is the increasing likelihood of new capital requirements for banks, as international regulators push to require banks to hold extra capital. This change would require US banks, collectively, to raise an extra $200 billion in common equity. At a time when most US banks stocks are depressed, this requirement could prove costly.
In Asia it is worth noting that China is actually actively attempting to raise the value of its currency. The effort is a result of rising inflation in the country. A stronger yuan helps hold down inflation since imports become less expensive, albeit at the expense of exports and potentially the economy. The key takeaway, in my view, is that investor money has been leaving China as growth opportunities lessen and perceived risk increases. I am not the only one noticing a familiar trend that portends a significant bear market in equities.
Finally, add in the depressed state of US consumer confidence, which was below expectations, and the potential for problems for equity markets over the next few quarters are magnified.
In my last post on 30-year treasuries, I mentioned that I believe it may take until June 2012 for the full impact of the recent market volatility to completely impact equities. There are a few signs emerging of real world stress on economic activity.
According the WSJ, the rise of perceived risk in European banks has made it more difficult for them to issue new debt. The banks have only issued $34 billion of senior unsecured debt this quarter, on track to being the lowest issuance in any quarter in over a decade. The timing, as is usually the case during a crisis, stinks because of an estimated $1 trillion of debt coming due next year. There is still time for the banks to issue enough debt to meet the required financing of maturing debts. But, the issue is becoming more pressing and the banks potentially have to accept higher rates, placing further pressure on their business.
Adding to the potential hit is the increasing likelihood of new capital requirements for banks, as international regulators push to require banks to hold extra capital. This change would require US banks, collectively, to raise an extra $200 billion in common equity. At a time when most US banks stocks are depressed, this requirement could prove costly.
In Asia it is worth noting that China is actually actively attempting to raise the value of its currency. The effort is a result of rising inflation in the country. A stronger yuan helps hold down inflation since imports become less expensive, albeit at the expense of exports and potentially the economy. The key takeaway, in my view, is that investor money has been leaving China as growth opportunities lessen and perceived risk increases. I am not the only one noticing a familiar trend that portends a significant bear market in equities.
Finally, add in the depressed state of US consumer confidence, which was below expectations, and the potential for problems for equity markets over the next few quarters are magnified.
Sunday, September 25, 2011
Neutrinos and Other Little Things Rocking Our World
Some times the smallest of things can turn our understanding of the world upside down. For example, it was announced this week that neutrinos have consistently been measured to travel faster than the speed of light. So much for Albert Einstein and his theory of relativity that forms the bedrock of physics. More importantly, after about 30 years of "educated" thought, this means I can once again fantasize about time travel.
One would think neutrinos affected the financial world as well with a Barron's title like, "A Market in the Twilight Zone." Strategists love to quote P/E multiples during these times, arguing that valuations are irrational based on a multiple of forward earnings estimates. In the article it is noted that the forward-looking valuation of the market today is approaching the valuation of the lows in 2009.
There are two fundamental problems with an analysis based on forward earnings. The first problem is typically the historical analysis is based on either the actual earnings for the "forward" year, or uses the low point of downward revisions of forward earnings. By using the actual figures instead of the changes in estimates as time moved through the year, the point is missed that the market was significantly over-valued at the start. The second problem is that forward earnings for the present situation may not yet reflect what the forward year looks like. Of course determining where forward estimates ultimately go is one of the main jobs of analysts, and one of the hardest.
As can be seen in the chart below, which was published on Dr. Ed Yardeni's blog, forward earnings in 2009 for the SP 500 started in 2008 around $120 per share before declining to below $60 by March 2009, about the time of the market bottom. In fact, the consensus estimate for 2009 SP 500 earnings was still above $100 near the end of 2008, highlighting how quickly an outlook can change.
Source: http://blog.yardeni.com/2011/08/s-500-earnings-valuation.html
Another takeaway from Dr. Yardeni's chart is the significant growth expected to continue in both 2011 and 2012. Earnings in 2011 ans 2012 are expected to grow well in the double digits. How is this possible when real US GDP growth has remained below 4% since 2009, has slowed to 1% in 2Q11, and is forecast to slow even further?
A large portion of the difference is the revenue US companies collect outside the country. The only problem is that foreign economies are stalling. Europe could enter a full-on depression, China is slowing significantly, and commodity-driven emerging markets are showing signs of problems. Looking from the top-down, it is difficult to find the source of the anticipated growth in profits.
Assuming the 2012 world economy is as bad as 2009, an assumption not unrealistic based on the on-going debt burdens in the world, forward earnings for 2012 likely decline again to $60. This suggests the current forward P/E for the SP 500 is 19x, hardly cheap by any historical measure. To use Thomas Lee's 12x multiple from the Barron's article on $60 earnings in 2012 suggests the SP 500 bottoms around 720.
During these unusual times it is helpful to refer to data that factors out economic cycles and inflation in order to reduce the noise level. For this analysis I refer to the Shiller PE Ratio, which bases PE on the average inflation-adjusted earnings from the previous 10 years. From the chart below one can see the SP 500 remains relatively high on a PE basis at 19x. A technical analyst might become worried about the trend of declining highs and declining lows. From a fundamental perspective, it is well above the 15x it touched in 2009 and the 5x for an all-time low. Again, this analysis suggests the SP 500 could fall to around 1,000 if it simply reverts to a historical median of 15.8x, and well below 1,000 if the economic slowdown mirrors the 1930's or 1970's.
Source: http://www.multpl.com/
Little things, like the pennies companies earn per share, have a tendency to upset our belief systems.
One would think neutrinos affected the financial world as well with a Barron's title like, "A Market in the Twilight Zone." Strategists love to quote P/E multiples during these times, arguing that valuations are irrational based on a multiple of forward earnings estimates. In the article it is noted that the forward-looking valuation of the market today is approaching the valuation of the lows in 2009.
There are two fundamental problems with an analysis based on forward earnings. The first problem is typically the historical analysis is based on either the actual earnings for the "forward" year, or uses the low point of downward revisions of forward earnings. By using the actual figures instead of the changes in estimates as time moved through the year, the point is missed that the market was significantly over-valued at the start. The second problem is that forward earnings for the present situation may not yet reflect what the forward year looks like. Of course determining where forward estimates ultimately go is one of the main jobs of analysts, and one of the hardest.
As can be seen in the chart below, which was published on Dr. Ed Yardeni's blog, forward earnings in 2009 for the SP 500 started in 2008 around $120 per share before declining to below $60 by March 2009, about the time of the market bottom. In fact, the consensus estimate for 2009 SP 500 earnings was still above $100 near the end of 2008, highlighting how quickly an outlook can change.
Another takeaway from Dr. Yardeni's chart is the significant growth expected to continue in both 2011 and 2012. Earnings in 2011 ans 2012 are expected to grow well in the double digits. How is this possible when real US GDP growth has remained below 4% since 2009, has slowed to 1% in 2Q11, and is forecast to slow even further?
A large portion of the difference is the revenue US companies collect outside the country. The only problem is that foreign economies are stalling. Europe could enter a full-on depression, China is slowing significantly, and commodity-driven emerging markets are showing signs of problems. Looking from the top-down, it is difficult to find the source of the anticipated growth in profits.
Assuming the 2012 world economy is as bad as 2009, an assumption not unrealistic based on the on-going debt burdens in the world, forward earnings for 2012 likely decline again to $60. This suggests the current forward P/E for the SP 500 is 19x, hardly cheap by any historical measure. To use Thomas Lee's 12x multiple from the Barron's article on $60 earnings in 2012 suggests the SP 500 bottoms around 720.
During these unusual times it is helpful to refer to data that factors out economic cycles and inflation in order to reduce the noise level. For this analysis I refer to the Shiller PE Ratio, which bases PE on the average inflation-adjusted earnings from the previous 10 years. From the chart below one can see the SP 500 remains relatively high on a PE basis at 19x. A technical analyst might become worried about the trend of declining highs and declining lows. From a fundamental perspective, it is well above the 15x it touched in 2009 and the 5x for an all-time low. Again, this analysis suggests the SP 500 could fall to around 1,000 if it simply reverts to a historical median of 15.8x, and well below 1,000 if the economic slowdown mirrors the 1930's or 1970's.
Little things, like the pennies companies earn per share, have a tendency to upset our belief systems.
Friday, September 23, 2011
Sharpening Pencil on 30-Year Treasury Position
Sharpening my pencil to evaluate my 60+% position in 30-year treasuries. The yield has been plummeting since the Fed's announcement, falling to around 2.8%. Previously I had said I would look to sell my position at a yield below 3%.
Given the Fed's anticipated buying of 20-30 year treasuries, a growing banking crisis in Europe, slowing growth in China, and on-going political gridlock and economic concerns in the U.S.; it is difficult to point to a "proper" yield. So, based on my contrarian Sagflation thesis I believe there are strong fundamental reasons driving the price changes in the markets, I need to look at the timing of my exit strategy from a different angle. Luckily, there is a recent severe drop in 30-year yields from which to learn lessons.
On December 18, 2008 the yield on the 30-treasury closed at 2.54%. Three days earlier it was up around 3%. This event occurred almost three months before the bottom of the SP500 on March 9, 2009. By March 2009 the yield on the 30-year treasury was back above 3.5%, hurting investors who had bought the treasuries for safety reasons while equity market declined between December 2008 and March 2009. During this time there were similar fears about the banking sector and economic slowdowns around the world. From this angle, there is an argument to sell my treasury position well before an anticipated bottom in the equity markets.
One of the biggest signs of "capitulation" in the equity market is a large spike in volume. One interpretation of a capitulation is investors giving up hope of a rally combined with forced selling either to try and protect performance, redemption of money in funds, or margin calls. The day of capitulation may not coincide with the actual market bottom, but it is likely reasonably close. Through this lens we see the largest one day volume in the SP500 occurred on October 10, 2008 when volume spiked to 11.5 billion shares, characterized by wild 7% swings. This event likely coincided with investors shifting to a more cautious stance. It also preceded the bottom of the 30-year yield by about 2 months. While the markets have been volatile, the volume has not come close to 11.5 billion, instead clearing 6 billion a few times. In my view, this suggests investors are holding positions as they hope for economic conditions to turn-around. In other words, I believe we are only at the beginning, implying yields drop further and 2012 is fairly bumpy.
Looking more closely at the events around December 18, I was reminded that the Federal Reserve cut interest rates from 1% to 0-0.25% on December 17, 2008. Included in the announcement was the phrase "the outlook for economic activity has weakened further", adding that the rates would stay at their current levels for some time. This point reminds me that I should ask the question, "Will the Fed release an even more negative statement than what it did this week?" Anything is possible. There is some speculation that the Fed may print more money through QE3 should economic indicators continue to deteriorate. If the Fed made this announcement I would likely sell my treasury position and begin considering buying commodity-related investments due to increased likelihood, in my view, of rising inflation. QE3 would likely initially cause treasury yields to fall due to the added buying pressure from the Fed, but longer-term the inflationary pressures it would create would likely cause yields to rise, in my opinion.
Looking at the news around March, 2009, when the stock markets bottomed, I was reminded that generally the economic indicators were negative. Investors, already hurt from a significant slide in the markets, were expecting the worst and in full-on survival mode. Both macro indicators and micro indicators from companies were negative. Personally, I don't think we are there yet. News out of companies remains generally okay and we have not actually tipped over in Europe or Asia. Investors remain hopeful it can be avoided. In my opinion, we may not get there until June 2012 as the full ramifications of bank failures in Europe and a slowdown in emerging markets take time to be understood.
Bottom line, I plan to exit my treasury position in the next few months. I am looking for one of the following occur: (1) 30-year treasury yields fall below 2.5% (a technical support level since it represents the low in 2008), (2) a major macroeconomic shock of the size of European sovereign debt defaults and bank failures, (3) a 30+% pullback in the equity markets, or (4) a Fed announcement about printing more money under QE3.
Given the Fed's anticipated buying of 20-30 year treasuries, a growing banking crisis in Europe, slowing growth in China, and on-going political gridlock and economic concerns in the U.S.; it is difficult to point to a "proper" yield. So, based on my contrarian Sagflation thesis I believe there are strong fundamental reasons driving the price changes in the markets, I need to look at the timing of my exit strategy from a different angle. Luckily, there is a recent severe drop in 30-year yields from which to learn lessons.
On December 18, 2008 the yield on the 30-treasury closed at 2.54%. Three days earlier it was up around 3%. This event occurred almost three months before the bottom of the SP500 on March 9, 2009. By March 2009 the yield on the 30-year treasury was back above 3.5%, hurting investors who had bought the treasuries for safety reasons while equity market declined between December 2008 and March 2009. During this time there were similar fears about the banking sector and economic slowdowns around the world. From this angle, there is an argument to sell my treasury position well before an anticipated bottom in the equity markets.
One of the biggest signs of "capitulation" in the equity market is a large spike in volume. One interpretation of a capitulation is investors giving up hope of a rally combined with forced selling either to try and protect performance, redemption of money in funds, or margin calls. The day of capitulation may not coincide with the actual market bottom, but it is likely reasonably close. Through this lens we see the largest one day volume in the SP500 occurred on October 10, 2008 when volume spiked to 11.5 billion shares, characterized by wild 7% swings. This event likely coincided with investors shifting to a more cautious stance. It also preceded the bottom of the 30-year yield by about 2 months. While the markets have been volatile, the volume has not come close to 11.5 billion, instead clearing 6 billion a few times. In my view, this suggests investors are holding positions as they hope for economic conditions to turn-around. In other words, I believe we are only at the beginning, implying yields drop further and 2012 is fairly bumpy.
Looking more closely at the events around December 18, I was reminded that the Federal Reserve cut interest rates from 1% to 0-0.25% on December 17, 2008. Included in the announcement was the phrase "the outlook for economic activity has weakened further", adding that the rates would stay at their current levels for some time. This point reminds me that I should ask the question, "Will the Fed release an even more negative statement than what it did this week?" Anything is possible. There is some speculation that the Fed may print more money through QE3 should economic indicators continue to deteriorate. If the Fed made this announcement I would likely sell my treasury position and begin considering buying commodity-related investments due to increased likelihood, in my view, of rising inflation. QE3 would likely initially cause treasury yields to fall due to the added buying pressure from the Fed, but longer-term the inflationary pressures it would create would likely cause yields to rise, in my opinion.
Looking at the news around March, 2009, when the stock markets bottomed, I was reminded that generally the economic indicators were negative. Investors, already hurt from a significant slide in the markets, were expecting the worst and in full-on survival mode. Both macro indicators and micro indicators from companies were negative. Personally, I don't think we are there yet. News out of companies remains generally okay and we have not actually tipped over in Europe or Asia. Investors remain hopeful it can be avoided. In my opinion, we may not get there until June 2012 as the full ramifications of bank failures in Europe and a slowdown in emerging markets take time to be understood.
Bottom line, I plan to exit my treasury position in the next few months. I am looking for one of the following occur: (1) 30-year treasury yields fall below 2.5% (a technical support level since it represents the low in 2008), (2) a major macroeconomic shock of the size of European sovereign debt defaults and bank failures, (3) a 30+% pullback in the equity markets, or (4) a Fed announcement about printing more money under QE3.
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