Letter to the Investment Committee - Second Quarter 2012

 

This is what I wrote my institutional clients this quarter:

The global capital markets are having trouble making up their minds.

On one hand, there is tremendous fear and uncertainty about events in the euro zone. 

 

Nervous investors continue to flock to “safe assets” such as U.S. Treasury and German bonds, pushing yield levels on government securities to multi-generational lows.  Higher quality bonds are in many cases offering yields less than the current rate of inflation, yet there is no sign of any slackening in demand.

Meanwhile, in the stock market, risk is being sought and rewarded. 

Lower quality, riskier stocks have charged ahead in 2012, and have left the stocks of higher quality companies far behind.  

According to Merrill Lynch research, only lower quality stocks – those rated B- and below – have outperformed the S&P 500 this year.  The S&P has produced a total return of +9.5% for the first six months of 2012, but higher quality stocks have generally lagged by as much as 400 basis points.  

In short,  while the global government bond markets are signally an almost desperate desire for safety, the global stock markets (particularly in the U.S.) are reflecting a distain for risk, and bidding up the share prices of more leveraged, largely non-dividend paying companies.

This year’s market action has been frustrating for many investors, ourselves included.  Focusing on fundamentals and valuation usually produces strong returns on both an absolute as well as a relative basis, but this has not been the case so far in 2012.

Fundamentals eventually matter in the stock market, and we do not believe this year will be any different.  We expect the performance of higher quality stocks to catch up with the lower quality sector as the rest of 2012 unfolds.

On an absolute basis, the stock market is moderately cheap relative to historic standards.  However, relative to the alternatives – cash and bonds – stocks look very attractive. 

Meanwhile, Back in Alternative Asset Land

Many investors and investment committees have flocked to alternative assets in recent years in a desperate search for better performance.

Unfortunately, in most cases, the performance of these funds - purportedly run by more clever and sophisticated money managers than those at traditional investment management shops - have not only failed to produce returns as advertised.

Mary Ann Bartels of Merrill Lynch has been tracking the hedge fund community for several years now, and puts out a regular report on their performance.

Here's what she said in a report published yesterday;

Hedge funds up 1.26% in 1H’12, underperforming S&P 500

The global diversified hedge fund composite index was up 1.26% for the first half of 2012, underperforming the S&P 500’s 8.31%. Convertible Arbitrage fared the best, up 4.14%. Short bias performed the worst, down 7.11%.

http://rcr.ml.com/Archive/11182388.pdf?w=dglen%40bpbtc.com&q=5mwrEXSECrJLh1aoR6Ankw&__gda__=1341945816_0b176de792c154c47abb536429834224



The 12 month numbers are even worse.

For the year ending June 30, 2012, the composite return of diversified hedge funds was -5.22%.

Returns by category ranged from -0.62% for fund specializing in convertible arbitrage to -10.47% for equity long/short strategies (supposedly a field where smart managers should shine).

By comparison, for the last 12 months, the S&P 500 was up +5.3%.

Now, to be sure, the last year has been a difficult one for active managers.  As I mentioned in an earlier post, most of the outperformance in the equity markets has been in lower quality securities, or one stock (Apple is up +60% over the last year).

But still.

Keynes the Investor (Part I)

Writing in Saturday's Financial Times, columnist John Authers cited a study by David Chambers and Elroy Dimson on the investment prowess of John Maynard Keynes.

Keynes, of course, is mostly known today for the branch of economics that bears his name:  Keynesian economics.

The debate about whether policies using fiscal stimulus (a distinctly Keynesian idea) or monetary tools (think Milton Friedman) to spur economic growth has raged in government and academic circles since the late 1970's, so I will not comment on it here.

However, what is less known about Keynes is that he was a terrific investor as well.

Keynes was supposed to have spent just 30 minutes a day thinking about investing. Typically he would study the morning papers while lying in bed, call his broker if necessary, then spend the rest of the day on his true passion of economics.


Initially Keynes approached investing with the same arrogance he did academic matters.  Not surprisingly, this lead to near-disaster.

Keynes nearly went bankrupt in the late 1920's when his leveraged plays on commodities went badly, and it was only through some clever financial maneuvers (and some stopgap financing from a wealth patron) that he was able to stay afloat.

But this near-death experience taught Keynes some valuable lessons.  For starters, he learned something that should be ingrained in all investors' collective minds:

"Markets can stay irrational longer than you can remain solvent."

But there was more, as the paper published by Chambers and Dimson write.

Keynes took on the management of the investment portfolio of King's College in Cambridge, England.  Here's what Chambers and Dimson conclude about the impact that Keynes made (I have added the emphasis):

The most overlooked of Keynes’s many accomplishments is that he was
among the first institutional managers to allocate the majority of his portfolio to the new alternative asset class of equities. 

At the end of the 20th century both British and US long-term institutional investors had the majority of their assets invested in equities, public and private. In contrast, their ancestors one hundred years earlier regarded common stocks (ordinary shares) as extremely risky and shunned this asset class in favour of fixed income and property.

At the end of the 1930s British life insurance companies still had only a 10% allocation to ordinary shares. Keynes, on the other hand revolutionised the way his own Cambridge college endowment was managed from the early 1920s until his death in 1946. In committing his portfolios to equities where he was free so to do, he exploited the risk premium available to long-term investors over conventional fixed income assets which was subsequently to emerge over the course of the last century (Jorion and Goetzmann, 1999).


http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2023011


For the last 22 years of Keynes's life, from 1924 to 1946, the endowment of Kings College return 15.2% per annum.  By comparison, an index of UK stocks grew at less than half of this rate - +8.1%.

My next post will discuss some of ways that Keynes was able to achieve such spectacular results, and how they might be applicable today.

Feeling Left Behind By This Year's Stock Rally? You're Not Alone.

For the first 6 months of 2012, the S&P 500 rose +8.3%.  If you include dividends, the total return of the S&P has been 9.5%.

But this has been an odd rally.

In a world roiled with concerns about Europe and the global economy,  the best performing sectors in the market this year have been low quality, mostly non-dividend paying stocks.


Based on Merrill Lynch Quality indices, here's a breakdown of price-only performance so far this year:

• C&D rated stocks:  +18.9%
• B- rated stocks: +9.3%

• S&P 500: +8.3%

• A- rated stocks:  +7.5%
• A+ rated stocks: +7.2%
• A rated stocks: +5.9%
• B+ rated stocks: +4.9%
• B rated stocks: +4.5%

source:  Bank of America Merrill Lynch research

A couple of other factoids from the first half of this year:

• Sector outperformance was concentrated in three sectors:  finance; technology; and telecom services.  Big losers were mostly concentrated in the energy and materials sectors;

• While you might think that investors would be most interested in stocks that offered dividends, that has not been the case so far this year.  Non-dividend paying stocks have outperformed the S&P 500 by a whopping 8.98% so far in 2012, while the sectors that paid investors a dividend have lagged the broader market.

Glimmers of Hope from Europe?

The global manufacturing PMI was released on Monday, and the results were worrisome:

The JPMorgan Global Manufacturing PMI™ – a
composite index produced by JPMorgan and Markit in
association with ISM and IFPSM – fell to three-year low of
48.9 in June, a reading below the neutral 50.0 mark for the
first time since November 2011.

Manufacturing production declined for only the second time
in the past three years. Although the rate of contraction
was only moderate, it was nonetheless the fastest since
May 2009. Growth slowed sharply in the US to its weakest
in the current 37-month sequence of expansion. Rates of
decline gathered pace in China, Brazil and Vietnam, while
Japan, South Korea and Taiwan all fell back into contraction.

http://www.ism.ws/files/ISMReport/JPMorgan/JPMorganMfg070212.pdf

However, Ned Davis Research pointed out that while the global index was dragged lower by a sharp decline in U.S. ISM, many countries seem to be showing signs of steadying, albeit at lower levels:

While the eurozone continued to weigh on the global PMI...the sharp drop in the U.S. ISM index contributed most to the monthly decline.  China's PMI also edged down, but a June decline is actually pretty common this time of year.  PMI's posting positive monthly changes actually increased in June, rising to 37%.  Australia, India and several developed and emerging European countries, which had been battered in prior months due to the crisis, posted monthly gains.

http://www.ndr.com/invest/home/docframe.action;jsessionid=E099105FD4E4B2A46C168B4F57CE5135.wt1?objectid=GC201207031.PDF&title=Global+Manufacturing+Falls

Eurozone equities are up 6.7% since the last euro summit, and are back to where they were a month ago - could the markets be signaling better times ahead?

Are Wall Street Analysts An Endangered Species?

Being an analyst on Wall Street investment bank has always been tough work.

Investment bankers want analysts to write glowing reports on prospects and customers so they can generate more business.  Putting even a "neutral" recommendation on a stock could raise the ire of company management, and cost the firm millions of dollars in investment banking fees.

On the other hand, there are the clients:  institutional money managers and individual investors.  They want objective research ideas, including "sell" recommendations, but are reluctant to pay higher commissions to pay for quality research.

Oh, and thanks to earlier Wall Street scandals, analysts today are subject to a myriad of federal and state securities laws.  Violating any of these can not only be career-ending, but could stick an analyst will significant legal problems.

Finally, there is the difficulty of stock picking itself.  Although correlations have dropped significantly so far in 2012, the rise of index funds and exchange-traded funds (ETFs) have made it difficult to find stocks that will outperform like stocks in a given sector.

CNBC had a post about the difficult times facing security analysts ahead:

With markets continuing to move in lockstep to every headline out of Europe, China or the Fed, the days of individual stock analysts may finally be numbered.

Getty Images

“There is an old saying about analysts among the gray hairs of Wall Street: ‘In a bull market, you don’t need them, in a bear market, they’ll kill you,’” said Nick Colas, chief market strategist at ConvergEx Group. “And in a flat market, it seems, both apply.”

... With most stocks moving on these big picture headlines, rather than their individual merits, it’s made the job of a single-stock number cruncher that much more difficult.

“In this type of situation, it doesn’t make sense to spend time analyzing details of specific companies when most movements are lockstep with the prevailing risk appetite,” said James Iuorio, managing director at TJM Institutional Services. “This type of trade should continue as global markets work their way through unusually large event risk.”

http://www.cnbc.com/id/48046536

Amidst the Gloom, Stocks Continue To Rise

http://www.ritholtz.com/blog/2012/07/retail-still-hates-stocks/?utm_source=dlvr.it&utm_medium=twitter


Friday's massive rally on the back of the latest attempt to save the euro still left the S&P at a loss for the quarter.

On a price-only basis, the S&P 500 declined by 3.9% in the second quarter, but it is still up 7.7% for the year.  Including dividends, investors in the broader market average are up +9.5% for the year.

Here's how the Boston Globe described the year in the markets so far:

For all the scary headlines — a bailout of Spanish banks, JPMorgan’s huge trading loss, the sputtering job market, Facebook’s failed initial public offering — it’s a wonder stocks aren’t down more this year.

Actually, stocks aren’t down. That was a trick sentence. At the halfway mark for 2012, stocks are up more than 8 percent.

“People think we’re down because memories are short,’’ says Rex Macey, chief investment officer at Wilmington Trust Investment Advisors. “It feels like the market’s been worse than it actually has.’’

http://articles.boston.com/2012-07-01/business/32474612_1_stocks-corporate-earnings-consumer-goods-makers 

If you're a contrarian, you should bet on a continued rise in stocks despite the continued sense of unease.

Here's one indicator, courtesy of Savita Subramanian, Merrill Lynch's chief investment strategist (my emphasis added):

Wall Street equity sentiment falls further

After triggering a Buy signal in May, our measure of Wall Street bullishness on stocks declined again, marking the ninth time in eleven months that the indicator has fallen. 

The 0.8ppt decline pushed the indicator down to 49.3, the first time below 50 in
nearly 15 years, suggesting that sell side strategists are now more bearish on
equities than they were at any point during the collapse of the Tech Bubble or the recent Financial Crisis. Given the contrarian nature of this indicator, we are encouraged by Wall Street’s lack of optimism and the fact that strategists are
recommending that investors significantly underweight equities vs. a traditional long term average benchmark weighting of 60-65%.

http://rcr.ml.com/Archive/11180129.pdf?w=dglen%40bpbtc.com&q=x1npM4WPOp4L5eorcsQtyQ&__gda__=1341234078_bb907155b86b89132ca946b4a085ad8f

Bonds, meanwhile, continue to be wildly popular with investors, despite yields at multi-generation lows.