For our current weekly update, we decided to share some of the insights we receive from the institutional managers we follow by paraphrasing their thoughts in short commentaries. Collectively they represent many of the thoughts we have shared from time to time in our weekly updates, but we feel as we start the new year, it would be helpful to hear things "directly from the horse's mouth."
Specifically, these institutional managers judge security selection, valuation, and patience as key determinants for risk/reward decisions and long-term success, while the markets in general have become more herd oriented whose behavior swings wildly from "risk-on" to "risk-off" and back again - hence the volatility. We believe this is mainly due to the increasing amount of capital controlled by people who are incentivized to take large risks with other people's money; this is caused by massive moral hazard (bailouts, free money), and not being held accountable (blame the markets or government policies).
We point this out because we believe while we don't always get it right, we make real judgments about risk with respect to our clients' assets and understand we have a duty to intellectual integrity and prudent decision making - in a world where private and public money is largely controlled by those who have proven to be some of the most inefficient allocators of capital. It is often difficult to go against the herd mentality, but history shows it has resulted in long term success.
Commentaries
#1
Despite hearing different prognosticators claim that equity investors now face no possibility of near-term losses, and that the coast is once again clear to ramp up risk, we remain unconvinced. Our skepticism is based in part on the Fed's poor track record over the course of our careers, particularly during the past decade-plus, during which short-term stimulative policy often proved short-sighted and resulted in severe unintended consequences later on. The LTCM bailout emboldened risk-takers and inflated the tech stock boom. The multi-year negative real rates implemented to counteract the ensuing bust caused a far greater and far more insidious problem, a housing bubble. One needs only to compare what percentage of Americans own houses to that which speculated meaningfully in stocks, or how housing is inextricably linked to credit, while tech investments were primarily equity-driven, to understand how much worse it was to trade one problem for the other.
Quantitative easing may feel good in the short-term, but the long-term risks seem substantial. A weaker dollar increases energy and other commodity costs for Americans -- essentially a highly regressive tax on the middle and lower classes, who are already grappling with sustained high unemployment and negative home equity. Also, it seems likely that a steadily depreciating dollar will provoke a meaningful response from both our trading partners and foreign holders of USD-denominated assets. These fears seem already to be reflected in the bond market, where long rates have risen quite sharply since late August (from 3.5% to 4.3%) -- not exactly the lower long-term interest rates the Fed claims quantitative easing will engender to stimulate the economy.
#2
Looking ahead, there is certainly room for optimism. Corporate earnings could rise to record levels. Valuations in some areas of the market remain attractive. The economy appears to be gaining strength. Business confidence coupled with healthy balance sheets could lead to increased merger and acquisition activity. An increase in investor sentiment could lead to further multiple expansions on corporate earnings, leading to further gains in the equity markets. The tax package will almost certainly stimulate further consumer spending. On the monetary side, the Federal Reserve continues its efforts to further ease credit markets with unconventional Treasury purchases, hoping that low interest rates spur more borrowing and force investors, perhaps unwillingly, into riskier assets to improve returns.
#3
On the other hand, going into 2011 we wonder just how much of this optimism has already been discounted. Three straight years of positive performance in the equity markets has only occurred twice since World War II. In both cases, the third year saw average returns of just 1.7%. Will 2011 follow suit? We have no idea-the year 2010 was a difficult year in which to handicap the financial markets. Despite what we see as an extremely disappointing economic recovery, the equity and fixed income markets performed extremely well. Looking forward to 2011, we do not know if the S&P 500's return to the level it held before Lehman Brothers collapsed is a confirmation of the market's strength or if the last marginal buyer has arrived and signals a temporary or perhaps longer term lasting market peak.
We have no desire to make any predictions for 2011 other than to expect a certain amount of the unexpected which will lead to at least some volatility in stock prices. At this moment, there are few desirable companies that can be bought with a decent margin of safety. This isn't to say that there aren't a lot of good companies whose stocks are worth continuing to own. But the unforeseen potholes that certainly lie ahead will once again give us opportunities to put fresh capital to work on more favorable terms."
