December 2011 |
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“I am eagerly awaiting the day to finally arrive when our fiduciary duty compels us to worry less and invest more.” ~ J. Kyle Bass, Managing Partner, Hayman Capital Management
We know that our clients hired us to not only protect their money but to make a decent return on their money when investment opportunities present themselves. Unfortunately, over the last two years the environment has been too risky to just focus on achieving higher returns. It remains a time to worry and the reasons are many. Having lived through other challenging economic times, I know that the day will come when we will worry less and invest more. It is our mission to try to get our clients’ portfolios to that better day fully intact.
We started Front Street Investment Management to manage clients’ money differently than the average registered investment advisor or stockbroker. We promised our clients that we would take action to protect their retirement savings when we thought the economic and/or market conditions warranted such action. We lived up to that promise during the market crash in 2008 and know our actions were appreciated.
However, with the stock market up significantly from the March of 2009 low, we understand the questions and concerns as to why we have maintained a defensive strategy during this recovery. Our cautious approach has caused our clients’ portfolios to earn less than what they would have had we set them free without the protective hedges.
While the returns may have been better with a more aggressive strategy, we think that the tremendous volatility that was required to achieve them would have alarmed most of our clients. Many of them would have questioned our commitment to the promise that we made.
Today we still see numerous risks in the economy and the stock market that could cause a fast and furious market decline. Because of that, we will not now renege on our promise in an effort to try to make up for those past results.
Our overriding concern about the stock market is that it is still in the midst of a secular bear market. Investing in bear markets is challenging because of the risk of having too much exposure to stocks when the shorter-term, cyclical rallies suddenly give way to dramatic declines. We have seen this twice in the past two years.
Some of the characteristics of a secular bear market are flat-to-down long-term price trends, declining valuations, high volatility, and negative money flows. Those words accurately describe this stock market environment, especially since 2007.
Bear markets are caused by psychological or emotional factors as much as fundamental reasons. They start like a normal price correction during a bull market run but cascade into a much more severe decline when the “buy the dip” crowd is no longer enough to push the prices back to the elevated levels. Those elevated prices that seemed rational at the time are later determined to not be supported by sound economic principles. We saw this first with technology stocks in the late 1990’s and later with real estate bubble in the last decade.
The fundamental causes come when the excesses and imbalances in the economy (that are results of the long-term bull market) become evident. That usually happens with a major financial event like a sudden threat of bankruptcy of a well-known institution or the freezing up of the entire financial sector as happened in 2008 and almost again this year.
The psychological factor relates to the pervasive lack of confidence among investors, both in the abilities of others (government leaders) to find solutions to more macro economic or governmental challenges as well as in their own abilities to navigate their investments through the uncertain times. It normally results in steady outflows of money from the assets engulfed in the bear market.
According to the Investment Company Institute (ICI), investors have been taking money out of U.S. stock mutual funds fairly consistently since the summer of 2008. The amount of the net withdrawals has actually increased significantly since last June. This contributes to less liquidity in the market, which results in more volatility.
In addition to our concerns of the current state of the overall market, we have several specific worries that keep us cautious and, therefore, defensive.
First of all, contrary to what many Wall Street gurus say, the stock market is not cheap, in our opinion. They point to the “low” price/earnings (P/E) ratio of the market as proof to their claim. The problem with that analysis is that they are using historically high corporate profit margins that we don’t believe are sustainable. Competition tends to trim abnormally high margins over time in a free enterprise economy. Therefore, the current “low” P/E ratio is appropriate, in our opinion. It has been at this level for awhile despite the impressive earnings growth.
There are actually other methods for measuring the valuation of the stock market that compare the price or current market value to more normalized earnings or to the replacement value of the assets. These alternative methods show the market to be at least 20% overvalued, which gives us pause.
Secondly, Europe is rapidly sinking into a recession. The spread of austerity from the sovereign debt problems and the threat of an actual breakup of the Eurozone and an end to the euro have put the brakes on their economic recovery. In addition, many Asian countries, including China, are slowing as their trading partners demand less of what they are selling.
We think this slowdown in global demand will be a strong headwind for United States in 2012. And when this is combined with the lack of real personal income growth and continued deleveraging in the U.S., there is a strong likelihood of another recession in 2012. The recent improvement in various economic indicators does not necessarily negate that possibility. Just look back to what was happening a year ago. Our hope for a sustainable and stronger recovery in 2011 was dashed in the first half of this year, when it grew at less than 1%.
Lastly, despite the trillions of dollars for two quantitative easings by the Federal Reserve and the trillions of dollars spent for government stimulus programs, the economy has only been able to grow at about a 1.5% real rate over the past year. That is not much BANG for that many BUCKS. However, without that stimulus, the economy would have already slipped back into a recession.
The U.S. economy remains in a vulnerable state and coming into an election year it is doubtful we will see any bold programs from our political leaders to try to help increase growth and create more jobs. In fact, there seems to be more attention on trying to reduce our debt load with austerity measures of spending cuts and higher taxes. That strategy only increases recessionary risks next year.
With the approach of the New Year, we want to be hopeful and optimistic for a better economy and a sustainable bull market rally. While we think we are closer to that time, we are not there yet.
More work needs to be done to correct the current sovereign debt issues (including ours) in the global economy and a more realistic market valuation needs to reflect the current economic imbalances. When one of those two events occurs, we will be more bullish and confidently taking action to earn higher returns. Until that happens we will be keeping our promise to protect out clients’ portfolios.
