Monday, December 20, 2010

Too Conservative?

Is it possible to be too conservative in the face of all that is going on in the world right now, both economically and geopolitically? We don’t think so.

During the last year, we have patiently developed a portfolio designed to bring consistent, compounding returns over several years. We have focused on dividend yield and capital preservation, as we carefully invest our cash position. Through the first eight months of 2010, the market was extremely volatile (remember the “flash crash” in May?), while our portfolios held steady, maintaining a sizable advantage in returns. Ironically, right about the time we started seeing widespread value in the stock market, the Federal Reserve hit the panic button in the face of a softening economy, to ward off deflation. The “Bernanke Playbook”, about which we’ve previously written, is in full effect and lifting the stock market. While we benefit from this increase, our conservative strategy (which incorporates both stocks and bonds) is naturally slower to respond than the overall stock market, at least for the moment.

Get With the Program

The Fed’s current, extreme and historic quantitative easing effort (QE2) to buy newly issued, longer-term government bonds is an attempt to raise inflation expectations and lift asset prices, in particular equities (yes, they actually said that). The thinking goes like this: lower the longer-term cost of capital, making current equity valuations look attractive. By bringing investors into the equity markets, companies can access capital on better terms (e.g. the General Motors IPO). That, of course, assumes there is an abundance of viable capital projects that can return in excess of this lowered cost of equity. If so, then you get immediate job creation as capital spending increases.

The question is, when this explicit subsidy to the cost of capital is removed (through future Fed tightening), are those newly formed investments sustainable? Furthermore, the unintended consequences of inadvertently financing subpar “investments” (i.e. housing) can have dramatic consequences. An increase in equity values supports greater amounts of debt. If equity values falter, the debt becomes highly onerous.

The first round of Fed quantitative easing (QE1) in 2009 was probably effective in preventing a liquidity crisis from exacerbating an already deepening insolvency crisis. Now, with an extra $600 Billion promised over the next six months, coupled with a lenient tax policy, you can see that our country’s monetary and fiscal leaders have implemented an all out go-for-growth (go-for-broke?) strategy. While all of this might create growth, we remain skeptical that it will create sustainable value. For now the stock market has taken the bait and gone higher. However, bond yields have also gone higher, giving a confusing signal about expectations for growth, inflation, and future unfunded deficits. To what extent will the Fed tolerate such rate increases before embarking on another round of bond purchases?

That said, there are signs of stability in the economy and we are encouraged to see the productive spirit of the private sector deliver profits. Unemployment is still high and likely to grow, but new jobs are usually seen late in a recovery. The banks appear stabilized, although a persistent decline in real estate prices keeps them in capital preservation mode. Right now the stock, bond, and commodity markets appear certain that the economy will grow unabated, given the aid of massive stimulus.

What Happened to The Road Not Taken?

I shall be telling this with a sigh

Somewhere ages and ages hence:

Two roads diverged in a wood, and I--

I took the one less traveled by,

And that has made all the difference.

-Robert Frost, The Road Not Taken

Certainty in the market makes us wary. Such confidence emanates from what has become Wall Street’s Golden Rule: “Don’t Fight the Fed”. Oddly enough, for the past 12 years, the exact opposite would have been more rewarding. Perhaps that rule should be rephrased: “Get Rich or Die Trying”. That doesn’t sound quite as appealing. Needless to say, Wall Street is feeling bullish these days. We’ve seen this road before.

The list of headwinds to economic recovery is long. But that is not what primarily concerns us. Most of them are well known to investors already. We are concerned with the risk of government policies preventing the market from functioning efficiently. For example, we are encouraged by the pace of domestic private sector deleveraging (whether through default or pay down) and the concurrent increase in personal savings. Such headwinds to growth will eventually become tailwinds. Our greater concern is whether productive, market-clearing processes are interrupted by potentially false perceptions created by chronic money printing and stimulus spending. Rising asset prices without wealth creation leads to debt/payment obligations with no collateral value. Again, we’ve been down this road before.

Feeling Like a Contrarian

At least for the moment, our year-to-date equity performance trails the market, as investors have ramped up their risk-appetite. Yet, we are very confident in maintaining our conservative position. Even though we wrote about the potential for QE2 this summer, perhaps we mistakenly believed the political fallout over printing money would have short-circuited its occurrence. Or perhaps that story has yet to be told. There’s nothing like a political vacuum, created by an election season, to give the Fed free reign. Either way, since we ourselves cannot print money, we choose to stick with prudent capital management on behalf of our clients. We are moving down the road we want to take, looking for consistent, compounding returns.

We are avoiding market-timing, looking instead to “draw our own line” that wavers less than the markets. We do this by investing only where we see value and value-creation for the long-term, sometimes regardless of the level of the stock market. As frustrating as the past decade has been, that strategy has worked for us and resulted in consistently better returns than the market over time. Making predictions about future stock market values can be eternally futile. We will stick with what we know and pursue our strategy of creating wealth and preserving capital by investing in companies that consistently create value for shareholders.

Hopefully we have been able to clarify what’s going on in the economy and the markets, here at the end of 2010.

Holiday greetings to all,

Peter and Jack Falker

December 20, 2010

No comments: