Jeff Saut Presents: Knott Capital
Consistency, and the ability to avoid large losses, is one of the major tenets for long-term investment success...
Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.
"Recent economic reports have been a mix of positives and negatives. This has left economists, investors, the media and the Federal Reserve Chairman wrestling over exactly what should be 'read into' the most recent data. Moreover, adding to this challenge are the large revisions to many data series. Statistics that were initially viewed as strong, such as the 'advance 4Q GDP' reported at 3.5%, can be seen as tepid just weeks later (most expectations are now under 2.5% for the same period). Uncertainty – while never absent – is heightened now.
What is clear however, is the continuing downtrend in housing. Defaults, delinquencies and price deterioration continue to plague this industry. January's housing starts (-14.3%) are just the latest in a string of worsening figures. This important sector of our economy is a key tenet to our weaker economic outlook for 2007.
Many have asked why the market has produced a sustained rally in spite of the mounting level of debt as well as the higher degree of risks from a weaker economy. Records indicate that this hasn't happened in at least the past 50 years… nor logically, should it. So, why did it?
The answer lies in the combination of three factors: globalization of business interests, the massive amounts of liquidity that financed this growth, and the willingness of the U.S. consumer to take on increased debt obligations. This transformation could not have taken place without our European and Asian trading partners' willingness to finance US borrowing. For the most part, the benefits of the huge growth in liquidity have largely outweighed the drawbacks. However, these factors don't prevent or preclude a financial accident, which could be nasty given the vast amount of leverage employed, as well as the size of today's ever-growing debt levels. While we are in uncharted waters in this regard, no one can foresee a financial accident, much less know its timing. To avoid investing because this occurrence may one day come to pass makes little sense, even if one is risk averse."
-Charles Knott, Knott Capital
"Gosh, that sounds like something I could have written," I mused while reading the February commentary from Charles Knott, eponymous captain of Knott Capital Management. No wonder my firm likes the good folks at Knott Capital as their investment style so closely "foots" with ours and finds its roots in the writings of Benjamin Graham. Indeed, in the first paragraph of the first chapter of the book "The Intelligent Investor," which Warren Buffett calls, "By far the best book on investing ever written," Ben Graham tell us that:
"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
Notice that Graham says "adequate return," not a "spectacular" return. And that, ladies and gentlemen, is one of the secrets to investment success because investment "pigs" reaching for "spectacular returns" often get slaughtered. Consistency, and the ability to avoid large losses, is one of the major tenets for long-term investment success.
Given the unsightliness of Charles Knott's commentary, I thought I would spend some time expanding on some of his comments with thoughts of my own.
Clearly, my firm agrees with the sense that economic reports over the past few months have seen a mix of positives and negatives. That is the reason we have repeatedly stated that we can't figure out if the economy is going to slow dramatically, muddle forward, or reaccelerate. Interestingly, the economic reports year-to-date (YTD) have been coming in on the stronger than expected side by a ratio of more than two-to-one. And that is why we have opined that the "fooler" for 2007 could be that the economy reaccelerates (led by aerospace/defense spending, a sector on which I remain bullish) and consequently the Federal Reserve, rather than lowering interest rates, either holds them steady or actually raises them.
As for real estate, historically real estate has been an "effect" and not a "cause." In fact, my firm can find no instance in which real estate has pulled the economy into a recession. Therefore, to think it is going to happen here, one must believe that real estate has become so entwined in the economic fabric of the economy that it has morphed from an "effect into a "cause"... and we're just not there. My firm does believe, however, that if indeed real estate has bottomed the recovery will NOT be "V-shaped" in nature, but rather an "L" recovery, or a long, drawn-out affair. Yet it is worth noting that the real housing story may not be in the recent 14.3% housing "starts" collapse, but in the housing "completions" figures, for as David Rosenberg notes:
"Keep in mind that starts are only footings in the ground – they only represent the first 10% of the housing process. So while housing starts have collapsed to 1.4 million units, in that same report we saw on Friday, housing completions barely declined, and are running at just under a 1.9 million rate, or 33% above the current level of starts. And so the most important takeaway is that construction cycles, in the aggregate, don't end until completions converge on the level of starts, and that usually happens 9 to 12 months after the housing starts number hits a trough. With completions running at a near-record pace relative to starts, the worst of the decline in overall residential construction, employment and housing-related manufacturing output is arguably still ahead of us."
So why has the stock market produced a sustained rally in spite of a mounting level of debt as well as the higher degree of risks from a weaker economy? To this question Charlie's answer lies in a combination of three factors: "globalization of business interests, the massive amounts of liquidity that finance growth, and the willingness of the consumer to take on increased debt obligations." Clearly, my firm agrees with the globalization theme given the recommended composition of our portfolios. Likewise, my firm concurs with the amazing willingness of consumers to shoulder debt. Lastly, my firm believes liquidity certainly plays a role and currently the monetary base is exploding. Moreover, it is not just our money supply that is surging but Austrailia's (+13% year-over-year), England's (+13%), the Euro Zone's (+9.3%), Korea's (+10.3%), China's (+16.9%), etc.
Yet as my firm has suggested, while liquidity is unquestionably a driver of asset classes, if investors are unwilling to take that liquidity and buy something with it asset classes go nowhere. Manifestly, you can throw all the liquidity you want at the markets and if investors have no "risk appetite" they will merely take said liquidity and stuff it in a money market fund. We, therefore, have argued that investors' risk appetite is the ultimate driver of asset prices and after the nearly unprecedented rally from July 2006 to February 2007, participants' risk appetites are currently high. When this will change is unknowable, but change it will. Yet as Charlie concludes, "While we are in uncharted waters in this regard, no one can foresee a financial accident, much less know its timing."
The call for this week: My firm likes the Knott organization and continues to recommend it, as well as the mutual fund it manages for Quaker Funds, namely Quaker Capital Opportunities Fund (QUKTX). Still, my firm is not so sure that the economy is going to slow. Indeed, the S&P Materials sector's nearly 10% gain leaves "stuff stocks" some of the best performing names for the year. Ditto, commodities are rallying again with the Goldman Sachs Commodity Index up almost 12% YTD. And don't look now, but gold registered an upside price breakout last week, as did a number of the base-metals, which allowed the Reuters/CRB Futures Index to "tag" another all-time high once again (see chart). Such strength is not indicative of global growth slowdown as things continue to get curiouser and curiouser...
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