From Tapering to Teetering
As has been the pattern of the past six years, the summer always brings an interesting set of challenges for the financial markets. This summer was no exception, from continued uncertainty in the financial markets soothed over by unprecedented Fed stimulus to geopolitical developments that are still unfolding. Unfortunately, the political dysfunction that has riddled the nation for the past fews years has reached a stage that will only continue to harm the economy and the country.
The positives, however, are fairly obvious: the US continues to pump $85 billion of newly printed money into the system on a monthly basis, with the stock market as the primary beneficiary. While the numbers vary week to week, the S&P500 is up around 15% year-to-date. The other bits of good news are real estate prices, which are on a remarkable recovery, a nominally growing US economy, solid corporate profits, and the recent changes in our energy dependence.
Unfortunately, each of those positives are countered by negatives: the stock market went apoplectic when Ben Bernanke suggested tapering of the stimulus, growth from the emerging markets has faltered, US overall employment levels are the same as five years ago (mid-recession), and the economic growth in the US is significantly below the long-term average needed to insulate us from negative shocks.
The employment picture is perhaps the best place to find reasons for caution. Although the unemployment figure we so often read about is significantly down from the high of ten percent, the employment picture is a bifurcated situation. In the recession, we lost nearly 10 million jobs in the span of just a few quarters. And while we have created 7 million jobs since then, our labor force has grown in those five years by roughly the same number. So in short, the labor participation rate among Americans is at a 30-year low. The following chart shows this fairly well.
The anecdotal evidence suggests the jobs we’ve created in the past five years are of far lesser value than the jobs lost. Most are at minimum wage, there is a tremendous underemployment problem, and the divisions among social classes continues to widen. These issues only make the next conundrum even more challenging.
Market behavior continues to indicate that we are in a cycle of bubble markets driven by consumption economics. The next chart shows the movement of the S&P 500 over the past 30 years, in which the market is pushed to new highs in each cycle. The driving force behind these peaks is external stimulus leading to bubble asset valuations (dotcom in the 90s, real estate in the 00s, and Fed stimulus in the 10s). In the collapse of the two prior bubbles, the damage to the financial condition of the broader society was extensive – far greater than the benefits from those bubbles.
For the current market rise to continue (as opposed to correcting by 20%-50%), we need corporate revenues to grow. Thus far, corporate profitability has backfilled the market as price-to-earnings ratios remain at or below historical averages (16x). This has been primarily achieved through layoffs and productivity increases with some revenue increase. With the internal measures largely exhausted, revenue growth is going to be front and center for the next several quarters.
This picture could work but demand needs to come from a mixture of domestic and global consumers. The global scene is dominated by Europe – still struggling to get out of a recession – and Emerging Markets. As we have seen in China and elsewhere, the massive boom in the emerging markets over the past decade has created disruptive air pockets that make predictable growth elusive. Hence, the need for the American consumer to find additional disposable income or a willingness to once again increase personal debt levels. With such a stagnant US employment situation, neither are likely soon.
It is for these reasons that we at Vodia Capital maintain a diversified asset allocation strategy for our portfolios. Relying on just equities to drive gains would subject portfolios to far too much volatility and uncertainly. While markets have shown an ability to recover in the past, these gyrations eat away at long-term returns and ultimately underperform when compared to a diversified strategy. In response, we continue to use fixed income, commodities and derivates to both stabilize portfolios from global uncertainty and generate predictable growth.
The biggest challenge to backfilling the equity asset bubble is global conflict. Domestic issues are important and bleak, but with enough time and some basic legislation, our current situation will ameliorate or the domestic economy will simply adapt. But until that happens, we do not have enough consistent economic growth to withstand a shock to the system and not enter another recession.
The global issues are less predictable, although we seem to have hit a moment of pause. Despite my wildest expectations, the situation in Syria seems to have found a multi-lateral solution with Russia participating and China consenting. While I have my doubts on the ability for the global community to truly disarm Syria’s WMD capabilities in the long-term, it is a relief to see it handled through cooperative diplomacy and through the UN.
On a separate but related front, Iran has consistently posed the greatest threat to global stability in the past few years. Compared to Syria, Iran’s pursuit of WMD’s is a real problem with real ramifications. Not to overstate the situation, but by many accounts this region was on the brink war if something was not done soon. And while I also have serious doubts as to the authenticity of Iran’s overtures, we have taken steps to open a dialogue that has been closed for decades. That is progress.
Where we do not have progress is in our own political structure. As of this writing, we have a partial shutdown of our government, with another looming prospect of defaulting on our debt in another three weeks. By some estimates, a complete shutdown of a few weeks could wipe out our economic growth for the quarter and possibly the year. And defaulting on our debt is simply a non-starter – the financial ramifications are just too vast to play with. While cooler heads will prevail, the damage to the economy through continued uncertainty has already taken a toll on lower economic growth.
Changing Energy Dynamics
The most promising development is the changing energy dynamic in the US. The past six years have seen a dramatic and unprecedented change in our energy dependence. Despite the mild economic recover, our use of oil has actually decreased by 10% from a combination of better vehicle fuel economy and alternative sources. During this same time, our oil production has doubled from technological advances. The net impact is to decrease our reliance on oil imports by half, to less than 10% of global production.
Combined with our natural gas boom, this is an incredibly positive development for the economy. Much of our economic growth over the past decades has depended on cheap energy, creating a political structure and international presence that went to extreme lengths to protect the dynamic. As net exporters or natural gas and coal, along with a far lighter dependence on the global oil market, untold resources will be freed up and could generate a new form of a “peace dividend” that we experienced post-Cold War.
The medium-term impact of our energy production and consumption is still of grave concern – from global climate change to the damage we are doing to our drinking water. The shift to alternative sources, whether they be truly green or simply move us away from oil, is of paramount importance and must continue. But the ability to shift a focus away from deeply disruptive policies to protect a bad oil dynamic is a start. Where we take it next will determine just how much of a global leader we can be in the coming decades as the forces of economics increasingly determine our actions as a country.
All the best for an enjoyable fall.
David B. Matias, CPA
What is NORMAL?
Normal is a much-overused but complex word. It can refer to societal values that reflect one group’s preferences to the exclusion of another. In a statistical sense, it refers to a baseline expectation drawn from reams of data. When you combine the two, you create statistical measures that can be used to determine behavior in certain situations, such as IQ tests. You see how this gets tricky, and fast.
Now let’s discuss the “normal” of economics. The financial markets are permeated with the statistical use of “normal” – without some idea of what “normal” looks like all of risk management and portfolio construction would fall apart. But now economists are trying to assess this current economic period as either a “new normal” or a return to the “old normal.” But what exactly does that mean?
As you will have gathered from my blog entries and market updates, I often point out where the statistical use of “normal” in the financial markets is broken. Whether it is the price movement on gold or the stock market collapse of 2008/2009, “events” have happened that simply should not have – they seem, to us, to be statistically impossible and “abnormal.” As an asset manager, it is terrifying at times that the statistical “normal” of the past 50 years is no longer valid.
Somewhere along the way, someone decided that the word “normal” will make it easier for people to understand a complex topic. We live in a world of mass media and shortened attention spans, where messages need to be simple and short or else they are ignored (think Twitter). Hence, the word “normal” has been redeployed in our current world without people stopping to think about what it really means, much as they don’t think about the incessant sound bites of recent political campaigns. Unfortunately, the word “normal” captures very little of reality, and leads to a misguided sense of safety for investors.
In the broadest sense, there is nothing normal about the economy today. We have a world population that now exceeds seven billion people and a method of supporting those lives through consumption-based wealth creation. That is not normal – it has never happened before and we don’t know if it can be sustained.
Yet here in the US, we are supported by an economic model that has been proven over decades. We have a population that grows at 187,500 people per month, and an economy that is just generating roughly that same number of jobs. We have been the center of innovation and entrepreneurship for the globe for a century, and combined with a tremendous level of investment over that period, we have an economic base that supports the wealthiest nation today.
The challenges here, however, are vast.
- Job growth is able to support the current population growth, but does not replace any of the jobs lost in 2008 and 2009. Today, we have the same relative number of jobs as the 1970s – when most households had a single wage earner. To replace those jobs, however, we need to consume at a level consistent with dual-income households.
- The economic growth necessary to build back those jobs might not be attainable – that is the core of the current economic debate. We need 4% annual growth – we’ve been lucky to see half that over the past fifteen years.
- Wealth is more concentrated now than in the past 100 years. Middle income families have been decimated by the financial turmoil (retirement and real estate assets), while the top income groups have seen their wealth explode.
- Our political structure is largely paralyzed in guiding the nation’s resources and regulations in a way that invests for the future – whether it be in education, transportation, or conservation of natural resources.
- The explosion of the digital age has created large potholes in the road to certainty. Whether it be financial calamities from computerized trading systems, social unrest, or the leaking of state secrets, these changes are redefining expectations.
With that introduction, I would like to say there is in fact good news to discuss. Last week’s dismal market performance masks one very important bit of news – the Fed believes that the economy is improving, so much so, in fact, that they might start to “taper” back on their historical stimulus program within a year or so.
Rather than treat this news with excitement, the market plunged. And it wasn’t just stocks – it was everything. (For those who wonder if this might be “normal” or part of the “new normal,” , let me point out that this 1.0 correlation broke all normal statistical expectations). It parallels the market behavior of this year – bad news is good for the markets, good news is bad for the markets.
People are saying that the US markets are up strictly because of all the stimulus. Without that stimulus, things will go back to “normal” – positive real bond yields, stock prices that follow company profits, and commodities prices that reflect demand. In other words, markets will have to reflect “normal” values for things, as opposed to the central bank inflation created by trillions in new money. That is not really a bad thing – in fact it is astoundingly good. The printing of money cannot continue without there being some serious damage to the global financial system in the form of currency devaluation and price inflation.
But like every aberration we have seen in the past five years, change is not taken well by the financial markets, even if the change in this case is a change in expectations about something that might happen a year from now.
Our role as investment managers is to determine what assets will be worth, based on their intrinsic value today and growth potential for tomorrow. To review the major asset classes and our perspective going forward:
Domestic Equities: US stocks have taken a beating, but only just so much. They were down 6% from their highs, but up 18% before the sell-off (for a net gain of 14% for the year as of right now). Whether we continue down or up from here is well beyond anyone’s control or foresight right now.
Our investment perspective on equities is essentially to stay steady – we have already kept a lower equity exposure precisely because of the inherent volatility, but do not believe that the recent volatility is reason to change that position. Instead, we are viewing this as an opportunity to increase investments in those individual equities that have the fundamental value and growth prospects to benefit from a growing US economy.
Valuations on the broad market are reasonable (S&P500 is around 15x earnings) and balance sheet structure of these companies is remarkably strong, thanks to years of cheap corporate borrowing. US companies have also shown further strength in their global customer base – as the world grows, so do the markets for many of the best US companies. If it is true that the economy is showing further signs of strength – as signaled by the Fed this week – then US companies are extremely well positioned to benefit.
The risk is a host of geo-political troubles that could trigger a global recession. There is no immediate indication that such a situation will arise imminently, but until we have see resolution in a couple of situations, we are going to maintain these equity levels as a buffer.
Foreign Equities: Here the story in remarkable contrast to the US. In short, the global stimulus from the central banks – not just the US – has propped up these markets for the past two years. Under the surface, however, the economic growth is weak. Europe has been in a recession for quite some time, Japan was on life support until recently and the emerging markets cannot support their economic growth through internal consumption.
The resulting equity performance is rough. Global markets have shown just a few percentage points of gain this year (if not a small loss right now). Emerging markets on their own are down 12% on average, with some markets taking a 25% beating.
As investment managers, we have avoided Europe almost completely but still maintain a modest exposure to the emerging markets. We’ve done this mainly through positions in US companies that sell heavily into those markets, and whose future profitability will depend on growth in those regions. We are still very positive for the growth prospects for the emerging markets and view the current swoon as a market psychology driven movement. Especially as the US slowly pulls into a higher growth mode, these regions will benefit significantly.
Domestic Fixed Income: This market has received an enormous amount of attention of late in the form of interest rate movements of historical proportions. Rates on the 10-year Treasury note have move from 1.6% to 2.6% in a matter of weeks, and the 30-year rates have gone from 2.8% to 3.6% in that period. Again – “normal” of any sort doesn’t compute.
The impact on bond prices is tremendous – market price move down as yields go up. But from the perspective of an investor holding bonds to maturity, it is good news. As long as your maturities are relatively short, you will get to reinvest your cash at higher rates down the road, once your bonds mature at par. There is no impairment of value in this situation – a fact that is often overlooked.
Commodities: Again, this market has taken a beating this year, although far less so than some of the global equities. As emerging markets are perceived as slowing down, so does the thinking for the commodities consumed by growth.
Our perspective is quite to the contrary. The slowdown in emerging markets growth is only temporary. The US is pulling out of its malaise, and population growth in developing regions will continue to fuel demand. China, for instance, is planning to urbanize 250 million people in the next decade. To put that into perspective, that is the same population of all the major cities around the world – combined.
In addition to the global demand for construction resources, we are holding a notable position in grains and agriculture. The dynamic is a simple one: populations are growing and the global middle class is consuming more meats and high value foods. Production is keeping up – but just as long as there are reliable and predictable methods. Climate change is for real, however, and creates mayhem in the production cycles through drought, flood, and changing weather patterns. As we saw last summer, with these disruptions comes significant supply constraints and rising prices.
The area that is least “normal” is metals. Gold and silver, the two metals that we use for hedging purposes have seen historic declines. The price of silver has been cut in half with all the reactivity to the central banks, gold is off a third. More disconcerting is the daily movement, which is down under every market condition – whether there is good news in the world or bad.
Seeing these risks, we exited our silver position many months ago, just at the high. We kept the gold, however, as a hedge against some of the events we have recently witnesses. But in the break from any form of “normal” that hedge has failed and the position has been a drag. Under the perspective that this is a market dislocation unrelated to the value of metals, we continue to monitor that market and the timing for when it may make sense to restore the positions to their original allocation.
In summary, it has been an unusual year. The markets went straight up for four months, creating a buzz reminiscent of the late 1990s. During that period, stocks went up at a blistering pace and there seemed to be no end in sight for the dotcom stocks. The buzz was a simple, yet persistent demand to be in the stock market. If you were not fully invested, then you were “missing out.” Unfortunately, those who did go full into the market saw a remarkable event – a -70% loss in their portfolio values.
That buzz has ended now, as we are reminded of the vast uncertainty in the equity markets. In the last month, we have begun to witness volatility across disparate asset classes, from US Treasuries to Japanese equities. During late May and early June, the Nikkei had five trading days of 3-7% losses. Then just three weeks ago, it saw a 5% gain in one day. Like the movement in gold just two months ago and again now, that volatility is well outside “normal” volatility. And it is happening in US equities, to a smaller but notable degree.
To make this point, for the months of May and June (since the Fed started to talk about “tapering”), we have had 24 days of 100+ point movements in the Dow Industrials average: thirteen times it was up, eleven times it was down. That contrasts to the first three months of the year in which there were just nine such days, only two of which were down. Volatility came back with a vengeance, and when it did losses ensued.
As reported by the financial website Seeking Alpha and others, May saw the highest equity weighting among individual investors since September 2007. As a reminder, September 2007 was the beginning of the equity decline that lasted 18 months and 50% down. In the parlance of market psychology, it is not unusual for individual investors to be the last to the party.
And this lack of “normal” is creating havoc for the institutional managers as well. Hedge funds, the massively concentrated pools of capital that supposedly can time these events, have done no better. With gains of roughly 2.7% for the year, they haven’t solved this problem – no one is immune.
Our view is that we are seeing the shift to an investment environment based in old-fashioned fundamentals as the US economy pulls forward and artificial drivers fade out. It could take years, but ultimately that is a good thing. In the process, there will be uncertainty and wild volatility.
In the end, there is nothing normal about these markets – old or new. We are going through changes on historic scales, and as we continue to remind folks, we are all sorting through the events and the data to find the best places to invest assets for the future.
All the best for an enjoyable summer.
David B. Matias, CPA
Apple Earnings Release
It is impressive how the market can fixate on a single stock. Apple has been that focus for a few years now – on the way up and on the way down. And while I rarely focus on a single company given the diverse nature of our investment strategy, Apple is as much a mainstream news event as American Idol.
Last night Apple released their earnings from the past quarter (their Q2), and gave some guidance for the next quarter. While there has been a tremendous focus on Apple’s “lost mojo,” they actually did extraordinarily well – selling 37.4 million iPhones in the quarter – a small gain over the same quarter last year.
That fact is huge. Despite the bad press, the cratering stock price, and the onslaught of competition from Samsung, HTC and others, people still want Apple products in record numbers. The distorted market perception ignores the global diversification that Apple accomplished last year. Now two-thirds of their revenue comes from abroad, attributable to the fact that they expanded into over 100 new phone markets in 2012. To emphasize the appeal of their products, iPad sales increased by 65% over the same period. Not a small feat – and one done extremely well.
To give you a little context, iPhone and iPad sales combined to roughly 57 million units for the three-month quarter. That translates to roughly 26,000 sold every hour of every day, or 440 units per minute. Given an average selling price of $612 for the iPhone and $449 for the iPad, that is stunning demand for a premium product.
The downside is that Apple will not have any new phones, pads or game-changing products for at least another four months – an eternity in the minds of stock traders. But in my opinion, that is fine. What Apple has done thus far in logistics and supply-chain in unprecedented. To wait and build that supply-chain for the next wave of products over the following year is perfectly acceptable for a long-term view of maintaining the world’s most valuable brand.
Consistent with this philosophy, and solidifying the slow-growth nature of such a large market footprint, Apple is radically changing their balance sheet structure to be more friendly to value-based investors. It is well overdue – this should have been done last year and created a wicked backlash from investors – but the changes are good ones. First, they boosted the dividend to a 3% yield. Second, they increased their stock buyback by $50 billion, reducing the stock float by 15%. And third, they will bring debt onto the balance sheet for the first time in decades. All of these changes have the net result of increasing the value per share, flowing cash to stockholders, and lowering the stock volatility in the long term. In short, they will now be a value stock.
Unfortunately, Tim Cook and Apple’s culture took many missteps before getting to this point, and the stock has suffered mightily. Some of those missteps were addressed last night. Next is execution on the business strategy and the ability to create new and exciting products – and that again is where time will tell.
David B. Matias, CPA
Last week was another one of those moments in the market which reminds us that we are in troubled times. Taking a completely agnostic, statistical perspective on last Monday’s events in the gold market, we again had an event that demonstrates the unstable foundation of the market. In this case, gold dropped by 5.8% on Friday, April 12 and then 7.7% on the following Monday, for a combined two-day drop of 13.5%.
For perspective, using the prior 1,000 days of trading data as a baseline, gold typically moves around 0.5% per day. A 2% move is big (once every couple of weeks). 3% is rare (three times a year). A bigger move than 3% is statistically remote. A two-day move of 13.5%, under these conditions, has a probability of one-in-a-trillion or roughly once every four billion years. So maybe my assumptions are wrong (that market returns are normally distributed), but then you would have to discredit an entire generation of financial theory and models.
So where does this leave us? In the span of two days, gold prices (and a host of other commodities) moved in a way that is not supposed to happen unless we are facing the most dire of global circumstances. In effect, something snapped in commodities. There are a host of explanations as to why (Cyprus might sell all their gold, Goldman Sachs starting bad rumors, North Korea did it, Paulson did it…. and so on), but the result is rather simple. We are in an investing world in which market mechanics are evolving into a dynamic that is both unpredictable and challenging to comprehend.
[To emphasize the volatility problem, yesterday someone hacked the AP twitter account and sent out a false report of an attack on the White House. The Dow dropped 140 points in a few seconds, then recovered. Someone made a small fortune on their put options.]
My suspicion regarding gold is that the Exchange Traded Funds (ETFs) which hold a large percentage of the World’s gold supply are causing distortions in the market and led to the market dislocation. It is a rather nuanced explanation based on the way that ETFs are created, but the theory also helps to explain the Flash Crash of 2011. Whatever the answer is, since 2008 we have been in a new world of investing and markets. Gold is supposed to be a safe haven, stable asset with limited volatility. While it still may be safe in the long term, it is now subject to the same randomness as the rest of the market.
I will later elaborate about other such events during the past three weeks, but the conclusions are the same. Under the veneer of a bull market in US stocks, there remains tremendous unpredictability and dislocations continue to manifest.
As an investment manager, we have mitigated these risks through our asset allocation strategy and the manner in which we use specific securities. And in all likelihood, the dislocation in gold is temporary. But time will tell, as always.
David B. Matias, CPA
I would like to take a moment to acknowledge yesterday’s events, both on a local level and with a broader perspective.
First of all, to the best of our knowledge everyone within the Vodia community is safe and sound. We thank all of you who reached out to us in the past day – while it is a tremendous shock to all of us here it is deeply reassuring to be touched by so many.
So often it comes down to timing. In our professional world timing can be everything. In this situation, timing was again all the difference. As a local who grew up here, I have stood on that spot a hundred times. Yesterday, I was not at that spot. Others were, and their lives are changed forever.
I can explain time in a rational sense using all sorts of paradigms and equations, but I have none to explain yesterday. Instead, it is a reminder that we also have to honor the spiritual aspects of life and what a moment can be.
There is no good explanation for what happened yesterday. This is our world today, a reality we all live with. But we also have the choice to embrace the aspects of humanity that push us all to a better place. That place is inside each of us, and ultimately forms how we each deal with yesterday.
Here at Vodia we send our wishes and thoughts to the victims of yesterday’s tragedy.
It is nice to see the winter finally start to come to a close, with daylight savings restored this morning, the foot of new snow in my front yard notwithstanding. Less pleasant that the onset of spring is the reaction to Friday’s unemployment figures. I fear that we are seeing a repeat of the market myopia that so widely devastated portfolios in the last financial crisis.
By all means, the report on Friday – a gain of 236,000 jobs for the month of February – is a welcome sign. Construction spending and hiring continue to increase at a vigorous pace, and the medical industry leads the hiring trend. But the figures still reflect a troubled situation.
The unemployment rate reflects only those who are looking for jobs; another 130,000 people chose to leave the workforce, hastening the decline in the unemployment rate. And an equally important measure is the long-term unemployed, which increased to 4.8 million people, or 40% of those reported as unemployed. Furthermore, the gains in February are tempered by a downward revision of 38,000 fewer jobs in January, which was already a weak month.
We need 150,000 new jobs a month to maintain stable employment given population growth – a level we have yet to maintain during this recovery. During the financial crisis, we lost over 7 million jobs, which we have not begun to restore, factoring in population growth since then. Certainly the momentum is in the right direction, but it has been five years since the recession began, and we are only beginning the process of restoring lost jobs and incomes.
When we factor in mediocre economic growth of around 2%, the impact of the sequester cuts, and the consumption-dampening effects of higher gas prices combined with a payroll tax increase, we can see that we are still skating on extremely thin ice in the short-term.
Yet, the stock market has reached an all-time high.
The disconnect is a result of the Fed’s $85 billion monthly monetization program. By “printing” money in such vast quantities at a sustained rate, they are able to inflate the various markets beyond values that reflect the true economic risks. Yes, companies are profitable and cash is abundant on their balance sheets, but the prospects for strong continued growth are dubious at best. We need some impressive magic to make it all work in a way to support these values. Anything short of magic will be another collapse.
As with every other asset bubble human emotion reigns – with a healthy dose of marketing. The financial media loves to fixate on stock prices and stock highs. You cannot walk 50 feet in today’s cities without seeing some headline, quote or other reminder of the stock market and the related hype. With the strong propensity for people to forget past events and fixate on the immediate market news, the bubble has plenty of fuel to grow to dangerous proportions.
How we proceed from here is with caution. What we need to remember is that volatility will remain, and until we fix the more pressing issues these market highs are not likely to persist. As a reminder, our investment strategy reflects these risks through a broad asset allocation that enables growth from stocks as well as several other asset classes. The success of this long term approach will fluctuate with market distortions, but it is a steady perspective that favors stable growth over extreme highs and lows.
David B. Matias, CPA
I am going to make a bold statement here: I declare 2012 the least interesting year since 2006 – at least from a markets perspective. The stock market went up. The bond market went up. Commodities went up, a little. And more importantly, there were no market calamities. We have had a financial disaster every year since 2006: the sub-prime collapse in 2007, the banking collapse in 2008, the market collapse in 2009, the flash crash and Greek collapse in 2010, a political collapse in the United States and Greek collapse (again) in 2011. This year was actually pretty calm: markets generated rather steady gains, and we didn’t reach the brink of collapse. The only exception was the Fiscal Cliff political drama in the last weeks of 2012, and we won’t know how that plays out for a while longer.
A relatively sleepy year notwithstanding, I don’t believe that we are out of the woods yet. In fact, I’m still holding onto some concerns and worries that have affected our decision-making and strengthened our belief that Vodia’s commitment to stable, conservative investment strategies that manage risk effectively is what’s most needed as we make our way in an uncertain future. America, along with other developed economies in the world, is going through one of the deepest set of challenges we have faced as a nation. How we fare, and how the next generation thrives, is dependent on what we all do now.
Market Performance and Apple
The year’s equity market performance was remarkably steady. The market went up for the first three quarters of the year, despite some volatility in the spring. The fourth quarter was a lot bumpier. With a decline of several percent in Q4, the largest companies in the market indices led these declines.
The Q4 decline settled in immediately following the election in early November. With Obama’s re-election, it was clear that capital gains tax rates would rise. With this certainty, there was a large impetus for institutions and folks to realize their larger long-term gains, namely in stocks that have done exceedingly well in the past year such as Apple, Intel, and also Merck.
I want to focus on Apple for a few moments, not only because it has become a permanent fixture in the media, but also because it has been a longterm holding at Vodia. The tax selling is not the only reason for Apple’s decline, but it was a large part of it initially. With Apple being the largest company in the stock market at the time, it represented a significant part of the market’s daily movement. In fact, institutional portfolios are saturated with Apple and have no further room to allocate to the stock. Hence, any type of short-term aberration, whether it be tax selling or a slow down in growth, has the propensity for a dramatic movement in Apple’s market value. But that was not the entire picture.
Over the past twelve years, Apple created several new markets around portable devices and the software-based ecosystem to support those devices. The devices (iPod, iPhone, iPad or MacBook), the services (iTunes, Apps Store, iCloud or the support services to these offerings), and their operating software (OSX and iOS) all work together in an intuitive and seamless manner. And let me emphasize the intuitive user experience aspect here – whether it is my father or a toddler, nearly everyone can use Apple products. This level of ubiquitous access to technology is unprecedented, and the ramifications for everything from corporate productivity to education are enormous.
This unprecedented accessibility has been reflected in the company’s financial performance. Apple generates over $50 billion in operating cash flow each year – after all expenses are paid (for comparison, this is the equal to HP, Microsoft and Google’s operating cash flow combined). And they continue to grow at impressive rates. This past quarter saw revenue grow at 18% over the prior quarter, with the realization that they could not make enough of their hot products to meet demand. Put simply, they sold nearly everything they could make.
But there are glitches in the story. The cost of making the products has gone up. As a result, Apple profit this past quarter was roughly the same as a year ago, even though sales were up. They are also facing significant competition for the iPhone as knock-off and competitive products have matured. And of course, with the passing of Steve Jobs, we don’t know what markets Apple will reinvent next; one possibility is television, and Tim Cook’s drive to redesign the entire experience.
Although these threats exist, they don’t change the overall picture of Apple’s position in the markets – they are still growing extensively and globally. We have managed the Apple position accordingly, moving from an overweight risky equity at the beginning of the year to a neutral/underweight in the fall. The market decline, however, has placed Apple’s value far out of line with the fundamentals, and with near hysteria surrounding their recent decline we are again viewing them as a potential overweight.
Getting back to the equity markets, Apple’s impact was felt far and wide. Noting that Apple was still up 33% for the year, the S&P 500 with Apple in the index was up 16% for the year, while the Dow Industrials, which does not include Apple, was up by only 10.2%. That is a fairly wide disparity, and one worth tracking. Alternatively, the international markets performed even better, with the MS EAFE developed markets index up 17%. With far less volatility than we have seen in the past five years, it was a decent showing all around.
My overall assessment of equities remains cautious. I still hear the chatter from equity managers to “just stay the course” with the stock market. If you have twenty years to invest and wait, that has usually been a safe and wise way to go. But the pursuant returns (9% per annum for the past twenty years) do not justify the ridiculous volatility from a repeated cycle of price bubble and collapse. And the reality is that few investors have the ability to wait another twenty years. If markets collapse again, waiting to see what happens could prove to be a devastating experiment.
What might happen in the next few years is not so clear. Equity performance depends on the ability for companies to grow profits, speculative bubbles aside. Profit growth in a broad sense can only occur with a growing economy. Our economic growth used to be around 4% per annum – a healthy and vigorous pace for a developed nation. But that was back in the 1960s and 70s. Today the pace has dropped to 2% or less when we are not in a recession. It used to take six months to recover lost jobs after a recession; we now are sixty months past the last recession and there is no jobs restoration horizon in sight.
Our economy is still strong – the largest for any single nation in the world. But it is not strong enough to sustain repeated blows: the financial crisis, sub-prime real estate disintegration, financial market dislocations, or political infighting and potentially devastating partisan divisiveness. Each and every one of these has happened in the past five years, and the debt- ceiling debate is still getting postponed. It won’t take too much to cause another recession, or further job loss.
I am optimistic that we will be able to continue growth, but it will have to come with change. Overall, we are witnessing the change from an industrial economy to a digital one. This has generated a level of income and wealth inequality that hasn’t existed since the end of the 19th century. And with changing geopolitical dynamics, we have become a nation driven by fear: not only do we see terrorism as a threat from without, but some believe we must arm every citizen with assault weapons to protect themselves from within. Change is scary.
But change can also be good.
With that change, we must look beyond the trends of the past for new valuation techniques and investment opportunities. It has been five years of disruption as change takes hold, and will at least five more years until we can find some certainty in the economy. To respond to this dynamic in the portfolios, flexibility will be key; awareness is critical.
Change and Disruption
This change is creating vast disruption and opportunity in society and the economy. As we refine our investment strategy, we see at least five primary dynamics to watch in the coming year:
- Political histrionics – whatever the crisis du jour may be, it can do severe damage to the economy and our prospects. Manipulating the tax system in a haphazard way, for example, created the decline we saw in markets in November and December. The partisan entrenchment needs to stop before it leads to devastating self-inflicted wounds.
- Investment in infrastructure –there is a need for a coordinated and concerted effort by government (state or Federal) to support and invest in an educated, skilled workforce and new technologies. Without these changes, the US economy will have dismal prospects for accelerated growth in a changing global economy. But Obama’s administration does have an eye towards investing in the workforce, as witnessed by his support of state-run education systems and the community college system. Even such a small change can point to bigger economic gains down the line.
- Inequality and fairness – we have again reached income and wealth disparity reminiscent of the dawn of the Industrial Age. Moral implications of wealth and economic disparities aside, the economic impact of increasing inequality can be insidious. Income disparity at this level results in a concentration of power in the business and political realms. Witness the past election: the fractious debate over taxes for the highest income brackets and the “47%” was almost comical if it were not so real. Despite widespread fraud during the last financial crisis, all escaped punishment. This gets noticed, people get upset, and they lose confidence in the system.
- Reshoring – the movement of our manufacturing sector overseas represented a gross misunderstanding of the importance of manufacturing know-how and innovation. There has been a trend to bring it back over the past two years, and it appears to be growing (witness Apple’s announcement to invest $100mm into a new US manufacturing base). It will only help to improve our trade imbalance and create job growth. Our service economy is not strong enough to provide the jobs growth alone – we need to be a manufacturing exporter again.
- Debt – at all levels we have binged for decades on cheap money and skyrocketing debt. The Federal debt is a minor issue, but the current levels are sustainable if and only if the annual deficits are tempered. The bigger problem is educational and municipal debt. Both are growing enormously, and neither is being correctly measured. Municipal debt could cause a dislocated bond market; educational debt could squash an entire generation of income earners and consumers. Both need serious attention now.
All of these dynamics can be turned into positive change, but the systems are challenged and there is no deus ex machina in the wings. The underlying tension is the consumption cycle; with nearly three-quarters of our economy based on the ability of our citizens to consume, the economy will remain highly volatile and growth will be elusive. We need to get back to consumption levels in the 60% range, and addressing the dynamics above could advance that aim.
The rest of the developed markets are a problem, however. With Europe’s outrageous debt levels, socialist policies creating an unsustainable tax burden, and political dysfunction that makes the US look tame, their recession will likely continue for several years.
Emerging markets, with their population expansion, growing middle class, and unabashed theft of advanced technologies, are going to continue to drive global growth. Investing in any one of these markets is going to be a volatile endeavor as dislocating regional trends resolve, while finding companies such as Apple and CAT that sell into these markets mitigates much of that volatility.
Stocks are likely to continue for another positive year simply from the amount of global monetary easing in the markets. In some cases, the valuations will be strong, with high risk premiums assigned to stocks in general. In other cases, bubbles will continue to emerge and deflate – both on the upside and downside. For this reason, we will cautiously look to increase our stock exposure by 5-10% of overall portfolio allocation. Keep in mind, however, that we are still less than half equities in our managed accounts. Some of this increase might be expressed through the use of stock options rather than the actual underlying stock, giving us a little leverage with a capped downside.
Fixed income, the perennial highlight of our portfolios, is where the coming year will be trickiest. Risk premiums are at their lowest in a long time, on top of a yield curve that is historically low. Both of these factors indicate a bond market top. But unlike equities, there is a known floor on bond values (maturity value), providing a natural mitigation to any bond market volatility – as long as we hold individual bonds and not bond indices. As a result, our bond exposure will come down to fund the increase in stock exposure.
Our ability to hold individual assets (bonds or stocks) allows us to manage the systemic risks I’ve outlined. As a result, in our managed accounts we can make up for a lower-than-average stock exposure through strategies such as call options. The individual bonds also give us a natural hedge against bond market volatility. In accounts where we are limited to using exchange-traded funds, the allocations will vary this year to account for higher levels of systemic risk.
We are maintaining roughly the same commodities exposure as this past year – 10-15% of portfolios – but shying away from energy and focusing more on gold and agriculture. The reasoning in simple: inflation. I don’t see inflation on the immediate horizon, but I do see it as a sizeable risk in this era of unprecedented monetary easing.
And finally we will continue to hold larger cash reserves (10-20%) to buffer against systemic volatility and allow us buying opportunities in deeply stressed markets.
Please don’t hesitate to call or write, and I wish you all the best for a manageable winter.
David B. Matias, CPA Managing Principal