Quarterly Report Card: Grading the Tape
How have our themes held up?
As last year drew to a close, we revisited our ten themes and weighed them in kind. Many of them came to fruition and others were early but most hit the mark.
As we entered 2008, we offered a fresh set of forward-looking expectations. The jury continues it’s deliberation process as we find our way through the fresh calendar year.
With a conscious nod that we must stay humble or the market will do it for us, it’s time to look back as we peer ahead.
Hedge Funds Buying Brokers
The critical issue facing financial institutions, after years of engineering and risk recreation, is the solvency of their balance sheets (particularly if they're forced to move Level III assets back onto their books). Look for large, well-capitalized hedge funds to take selective stakes in troubled brokers as the financial continuum begins to come full circle.
This theme jumped to the forefront of our collective consciousness when The Wall Street Journal reported that Citadel Investment Group was among the buyers eyeing Bear Stearns (BSC). When push came to shove, JP Morgan (JPM) had deeper pockets thanks to the implicit guarantee of the Federal Reserve.
Marriages in this space are seemingly inevitable and they’ll occur as a function of need rather than want. The risk—to the banks—is that hedge funds can mimic the functionality of broker-dealers without assuming an intricate maze of derivative risk. There is inherent brand and infrastructure value, however, and I expect to these alliances to manifest with time.
Migration Toward a Middle-Class Mindset
As Kevin Depew recently wrote, "If the '90s were about wealth, accumulation and consumption, 2008 will continue the mean reversion toward something altogether more austere, if not more sensible. Debt reduction and the rejection of (and guilt projection toward) materialism will continue what began in 2006 and 2007 as meditations on not just doing more with less, but doing less... period."
The last few years brought the chasm between the haves and have nots to bear as a slimming margin of society accounted for a disproportionate amount of spending. And if you didn’t have money to spend, keeping up with the Dow Joneses was as easy as a no-money down, zero percent signature.
2008 introduced a new dynamic to this discussion, that of voluntary thrift. The reality of real estate, recession and white-collar lay-offs ushered in tighter belts across the classes. Indeed, flashy rides and outrageous spending habits that were badges of arrival during the era of consumption now serve as hollow reminders of misplaced priorities.
Return of the Dollar
While risk remains -- for instance, if OPEC decides to denominate crude in Euros -- it's important to remember that the dollar "crash" already occurred. The greenback is off 37% since 2002 and a stunning 97% since 1913. Factor in the widespread negativity of money managers, rappers and supermodels, and a counter-trend bounce doesn't seem so strange.
Through the lens of “dollar devaluation vs. asset class deflation,” the need for a weaker dollar has never been more acute, stated public policy aside.
The greenback would clearly be stronger without the trillion-dollar government intervention but that’s like saying I would weigh less without pizza and chocolate. There’s no crying in baseball and no rationalizing when trading. I expect the dollar to rally but this muse has thus far been off the mark.
Relative Performance of Pharmaceuticals and Consumer Non-Durables
I still foresee the energy sector reassuming the top weighting in the S&P. As our financial destination isn't as important as the path that we take to get there, however, traditionally defensive sectors such as pharmaceuticals and consumer non-durables will likely outperform on a relative basis as global slowdown fears permeate.
This was a mixed bag with the Morgan Stanley Consumer Index (CMR) off 6.7% and the AMEX Pharmaceutical Index (DRG) 12.7% lower versus respective declines of 7.5%, 10% and 14% in the DJIA, S&P and NASDAQ.
You can’t spend relative performance, as the saying goes, and I expected a better showing in these traditional safe havens as perception of slowing global growth manifested. Look for the pullback in commodities to reduce input prices and improve margins in consumer non-durables such as Sara Lee (SLE), Del Monte (DLM) and Campbell Soup (CPB).
The Other Side of Zero-Percent Financing
While subprime was the first domino to fall, more ominous issues loom. The other side of zero-percent financing will manifest through credit-card delinquencies, auto loans and other forms of consumer-credit deterioration.
Consumers continue to stretch thin as they pay the bar tab after years of pushing out obligations. There is no relief in sight as 8.3 million homeowners are under water, close to 6% of all mortgages are in delinquency (the highest in 23 years) and average homeowner equity percentage has fallen below 50% for the first time since 1945.
Adding fuel to the fire, $440 billion in adjustable rate mortgages are due to reset this year with a like amount coming due between 2009-2011. Be on the lookout for further socialization efforts from the Federal Reserve in this regard, including (but not limited to) a potential mortgage trust that will assume bad collateral with hopes that this too shall pass.
Despite Herculean efforts by global central banks, I believe we will see a market dislocation this year as measured by a 10% move (or more) in a single week. This has been crystallizing in my mind for a few months so I wanted to pass it along despite the steep slippage we've seen thus far.
We often talk about the difference between taking our medicine (as a function of time and price) and being injected with artificial drugs with hopes of staving off the disease. There have been several instances, most notably following the Martin Luther King holiday, when supply seemed ready to overwhelm demand.
To be sure, the Federal Reserve exists to buffer the market and provide liquidity as the lender of last resort. The cumulative nature of the structural imbalances—coupled with the diminishing return of traditional policies—continues to build pressure on the already fragile market machination.
Given the disconnect between equity and credit markets, it’s worth noting that market dislocations can occur in both directions. Therein lies the two-sided risk to this market and the caveats of blind ambition either way.
Vertical Social Networking
Last year, we offered that life-stage marketing would emerge as a media catchphrase and vertical social networking is a direct extension of that. The ability to connect with others who share common interests and similar goals will not only build brand loyalty, but also create organic global distribution that will challenge traditional models of big media. What were once networks will become single channels in the next-generation digital age.
With Microsoft’s (MSFT) courtship of Yahoo (YHOO) and AOL’s (TWX) purchase of Bebo, the nation’s third-largest social-networking website, digital media consolidation continues to gain steam.
The next phase of the evolution will be the reorganization of information across industry verticals. While this isn’t an entirely new concept—ESPN has done it for sports and Discovery has done it for science—the race is on to capture online mindshare.
The rapid growth of Minyanland, Minyanville’s children’s initiative aimed at financial literacy, supports the notion that it’s never too young to build a scalable network of like-minded individuals. The trick—and opportunity—is to identify properties that brand across industry continuums.
We've already entered recession, albeit one that's been masked by the lower dollar and hidden behind economic numbers skewed by a slim representation of society. This dynamic will inevitably manifest into the elections, both stateside and abroad, as political infighting and geopolitical tensions mount.
Societal acrimony is evident in virtually every segment of society. You see it on the streets of New York, you read about it at borders across the sea and you feel in it every day life.
The great debate regarding whether or not we’ve entered recession has become an academic discussion. The more pressing question—yesterday’s rally aside—is how long it will last, how deep it will run and perhaps most profound, how it will manifest in the age of socialization.
All the while, social mood and risk appetite continues to shift as investors attempt to avoid landmines in the landscape and position themselves to take care of… themselves.
Transfer of Wealth
We should continue to see a transfer of wealth as foreigners purchase depressed equities, real estate and possibly homebuilders. While this is an intuitive progression in the era of globalization, it will likely serve more as a buffer than a savior.
After a string of stakes in financial institutions such as Merrill Lynch (MER) and Citigroup (C), foreign investors have been surprisingly quiet. Given how quickly they lost money on their initial investments, I suppose you can’t blame them for taking a step back.
Be that as it may, the combination of distressed assets and the weaker dollar should continue to act as a sexy siren for cash flush overseas funds. Expect high profile homebuilders be absorbed before this process completes.
Run to the Light
The financial dynamic will become increasingly difficult but individuals, instead of burying their heads, will demand greater involvement in their financial decision-making process. This evolution of empowerment, or the need thereof, will be a central tenet of our forward progress.
Capital preservation, debt reduction and financial intelligence will stand tall when 2009 comes knocking.
The first quarter was far from easy and anything but fun. The double whammy of a declining dollar and steep index losses—on the heels of a particularly frustrating fourth quarter—caught many investors by surprise.
As investors grapple with the severity of the debt unwind and the ramifications thereof, this historic evolution will be a process rather than a point. Our first true test will arrive at S&P 1405 and DJIA 12,800 and the reaction to those levels will guide us along the way.
We remain at a critical crossroads, with cumulative imbalances on one side and socialization on the other. The upside of volatility is that there will be many opportunities to prosper along the way. Risk management—rather than reward chasing—should remain a central tenet of any financial strategy.
As the owner of a small business and someone who wants to one day father a family, my sincere wish is that my big picture outlook proves conservative and the market scales a wall of worry. If my greatest cost is that of opportunity, however, I will consider myself fortunate.
Hope, as a wise man once said, has never been a viable investment strategy.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at email@example.com.
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