Money Often Costs Too Much: Part II
Truly, this game is one of capital preservation...
So does money cost too much now? Or are we at 'equilibrium?'
Greenspan talked about 'conundrums' in the bond market last year, which stunned me; coming from someone that really is at the controls of the world economy. Fortunately, we at Atlantic Advisors are proud to say that we never saw the conundrum (not that I am claiming to be brighter than Mr. Greenspan) and we have side-stepped the bear market in bonds that most have endured. But this brings me to what I think IS a conundrum; but this time, it is for real, and it is at the heart of the FOMC minutes above. It is what, if anything keeps Mr. Bernanke awake at night.
The contents of the minutes are the conundrum. They had a little bit of something for everyone. It talks about rising energy prices, which while inflationary, also act as a retardant to economic growth. It talks about slowing housing and a slowing economy. All of these things are true. But what do you do? Do you raise rates and take housing from 'cooling' to 'disaster?' Do you not raise rates and let oil go to $100 a barrel? Yes, truly a tough position. But just take a look at the chart below that is a revisit to our 'bubble comparison' chart that we have been highlighting for 18 months or so. It compares the Nikkei, NASDAQ and housing stock bubbles. In our Second Quarter 2005 piece, we had a section entitled 'The Housing Mania-Yes, Virginia, There IS a Mania.' It wasn't particularly popular at the time, but as luck (a hair of skill?) would have it, housing has slowed and the mania is gone in stocks (the chart tells us that and is likely a reflection of fundamentals to come). What will be left are bargains for those that recognized the mania.
The chart above shows the destruction in the prices of housing shares (we use the broadest measure of housing shares that Standard and Poor's has) and reflects the slowdown and proof that a bubble existed and has been broken. Where does that leave fundamentals in housing? I profess to NOT be a housing expert but a market expert. I believe that short-term rates are already high enough to have crushed (or soon will crush) all of the speculative buyers of real estate using exotic 'Interest Only ARM's or 'negative amortization' loans to finance overvalued, manically priced real estate. The real damage is likely to be to earnings per share of housing stocks and speculators. Might our homes fall a little or more in price? Yes, of course. But if you were prudent, you simply live through the decrease in price just as you lived through the increase experienced of late. The other group of folks that could get stung are the ones that originated the exotic mortgages in the first place, namely banks and mortgage companies. While not stock pickers, they could feel some pain from a sector analysis perspective, even if the larger, more diversified banks muddle through without the same kind of damage as their earnings have become more diversified over the years. The problem for the banks would only surface if the consumer retrenched for real. Even as the conundrum exists for Mr. Bernanke, we still feel that the economy will continue to slow, stagflation is a possibility and that we will see falling rates from the Fed by the first quarter of 2007. Yes, that is a bold prediction. But consider this, half of the jobs created in the private sector since 2001 have been 'housing-related.' Job creation, as we all know moves the economy along, particularly an over-leveraged economy. And job creation leads to economic activity (consumer spending represents approximately 2/3 of all GDP), so it is our call that we think rates will be decidedly LOWER by mid-2007. Initially, the best performing part of the yield curve should be the 2-year note, where we took a large position just prior to the recent FOMC release. Eventually, if we sniff signs of economic weakness, and don't have a dollar collapse to go with it, we will once again venture back out along the yield curve. This leads back to our old friend, the Presidential Cycle.
The Presidential Cycle is alive and well on Wall Street - will it occur again?
We have written over the years about the Presidential Cycle, perhaps ad nauseum. But when a cycle repeats itself 25 times in a row, it is difficult to ignore (the skeptics say that once a cycle becomes so usual that people are so positioned for it, it stops occurring). For those that would like a refresher, the cycle is basically predicated on two things; what every first-term President wants is a second term, and secondly; what every second term President wants is a great legacy of his work in the Oval Office and his party to be re-elected as he leaves office. It stands to reason, with Mr. Bush's popularity ratings hovering near 30%, that he 'doesn't care' about his ratings at the moment, but that will change as we near the next Presidential election. But, alas, I believe he does and that as we near October and November of this year (October of the second year of a term is usually THE best time to buy stocks during a term - actually the 20th business day of October has been the best day to add to stocks at that time of year). We called for a May 1 top in stocks earlier and this year, a low into mid-June and a final rally into mid-July or early August. So far, so good - the markets topped within a few days after May 1 and remain decidedly below the highs. If the cycle holds, we could expect weakness in stocks and strength in Treasury bonds after that into autumn followed by some sort of fiscal or monetary (most likely monetary) to get the economy rolling into the final two years of the term. I think this is mostly rate related and also related to stubbornly high prices in the commodity sector, particularly the energy patch. This leads me to my final and perhaps most important concept.
Is there a 'Creep' residing somewhere on Wall Street?
No, I am not referring to a horror show, although I suppose it could turn into one. People have talked about there being a 'lag' in monetary policy for many a year. I wrote last week on the Buzz about a possible 'Creep' lurking on Wall Street. What the heck does this mean? In essence, it takes a while for monetary policy (whether rates are rising or falling) and for commodity prices to make their way through the economy. For example, while the FOMC starting raising short-term rates in mid 2004 from 1% to the present 5.25%, many people haven't felt the 'pinch' in the ARM's, etc, from 2005 and into 2007-2008. The rise in oil prices and other commodities like copper take a while too as corporations, sooner or later; have to pass along these prices to consumers. Hence the 'Creep' exists in my mind. It should make earnings comparisons for companies tougher eventually, perhaps soon, and it also makes it tougher on the consumer - a double whammy. Again, Boom Boom's conundrum. It is not unlike past cycles except that more debt exists this cycle. We will just have to see how it plays out, but our guess is that the Creep will make for more earnings 'misses' and falling stock prices into the autumn after the traditional mid-Summer high. Then, 'Boom Boom' starts to bring rates down and our bear market in bonds, at least for a while, could turn into a bull market.
Our conclusion, current positioning and a look at recent performance
As stated earlier, we outperformed our bond benchmarks by a wide margin for the quarter and year to date, as well as against many other indices. Most importantly, high grade fixed income indices for the most part were negative while our returns were decidedly positive. This is the hallmark and key to our investment philosophy - make money or protect assets as others lose precious capital. In addition, we own only the highest quality bonds and we intend to stay that way as we think the corporate and emerging market bond sectors will get hit by the Creep as well (this typically occurs as spreads relative to Treasuries widen as economic confidence is reduced). In equities, our results were just above the S&P 500 for the year and our 'since inception' numbers continue well ahead of the major indices with much lower volatility - again, our stated goal. But to be perfectly frank, we were a bit too defensive with our over weight holdings in health care and it held back our performance. Going forward, we still have faith in this sector, but only until the Fed eases, when traditionally it makes more sense to become more aggressive. This is due to the fact that as the economy slows, health care and shares of consumer staples companies perform much better than both the market and other, more economically sensitive sectors. As we have stated to clients, prospects and friends since 2005, we thought that 2005-2006 would be tough, returns would be below par for everyone and our job was 'to get to October 2006' and look for brighter skies ahead. We are almost there, my friends, and this quarter ahead may be a little bumpy, but we believe we know the best ways to protect capital in tough times and then change position when the time is right to maximize gains. Truly, this game is one of capital preservation-something that I have learned over and over again over my 26 years in this wonderful industry.
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