Manager: Paul Franke, Quantemonics Investing
Model: Relative Value
We are quite pessimistic about the U.S. trade and federal budget deficit situations and their repercussions. We have been preparing investors for a weak growth period in stocks and the economy for several more years, at a minimum. The math on both deficits is quite horrible (I will not get into the numbers or my forecasts here) and they are related to America’s unsustainable appetite for goods and services beyond what we can afford.
Another stock and/or bond market crisis in 2011 seems likely, and patience is in order for investors until we get stronger values overall to buy. By our estimates, the real world sustainable economy in the U.S. is a good 15%-25% smaller than the one we enjoy today, on borrowed time and money.
Along this line of reasoning, the Quantemonics Relative Value portfolio on Covestor will have a lower than fully-invested exposure until we get a big market sell-off. We may hold high levels of cash above 10%, own some inverse ETF as hedges (ETF inverse securities rise in value as the market or sector-focus declines in price), and our stocks will be lower beta, consumer staple and utility-like overweighted for now.
At the same time, my biggest fear at this time for investors is that they are not prepared properly for the advent of high rates of inflation or even hyperinflation that could appear soon, from all the macroeconomic problems we face, and the government’s over-reaction to them.
The President’s advisers, the U.S. Treasury and Federal Reserve leaders, incorrectly believe that our issues can be resolved with higher deficit spending and stimulus, on top of outrageous levels of money printing and liquidity for the financial system. This effort will not work and is doomed to produce a whole new subset of problems that did not exist just 2-3 years ago.
I like to explain to people who will listen that our leaders are playing a game of economic checkers, when the economy is actually a complex game of chess. Unfortunately, our leaders are looking ahead just 6-12 months, when the real issues are more related to what will take place 5 to 10 years down the road, as baby-boomers retire and slow consumer spending.
As a result of (1) short-sighted deficit spending that is quickly becoming a “structural” chronic yearly problem that we cannot mathematically afford much longer, and (2) aggressive liquidity “moves” by the Federal Reserve and Treasury that juice the markets for a year or two but are coming to an end, this country is being boxed into a tighter corner of potential options to deal with a new economic crisis. In fact, a new potential crisis of a Treasury credit downgrade and loss of confidence in the U.S. Dollar’s reserve currency status we enjoy today are a direct result of the quick fix actions to paper over the real estate bust and aftermath.
AAA credit ratings for U.S. Treasury bonds and a stable U.S. Dollar value are foundations for the current global economic system, and western/democratic societies we have built up since World War II. Excessive money printing will actually cause more problems for the world at this stage, in my humble opinion, economically and politically.
At some point we need to “take the bitter pill” to cure the overspending cancer we have (and accept the consequences), instead of sedating the victim that is slowly dying, while the core disease goes untreated.
While the risk of another severe recession and rising bond defaults is real, the odds of greater rates of inflation is equally a concern for me. As a consequence, owning large levels of long-dated CDs and bonds issued both in the business and government sectors, yielding well under 5%, locked-in for many years is quite insane today. I have been screaming for some time that investors need to liquidate bond holdings and either hold inflation-benefiting stock investments or short-term cash reserves until the latest bond market bubble has reversed into bust.
Begin sermon… To be clear, the 2009-2010 bond market boom was largely created by the Federal Reserve under the lack of leadership and foresight by Chairman Ben Bernanke. He deserves much of the blame for the new economic crisis that is developing in 2011, and I have argued without success that he should be replaced to restore confidence in American economic leadership and monetary policy. Ben has been hard at work robbing wealth from savers with near ZERO interest rates to prop up and reflate the idiot bankers that got greedy during the real estate boom years. A smarter long-term policy for the nation would have been to punish the near criminal bankster behavior and shift the ownership and leadership of our banks to a fresh start set of accountable leaders and business reorganizations, characterized by full disclosure. Punishing the innocent to prop up and reward the crooked, creates enormous moral hazard and actually puts at risk our successful and productive free-market, capitalism based democracy… End sermon.
Having said that, the stock market always seems to provide decent investment opportunities for those willing to hunt for them. Greg and I both think many of the drug and medical device companies available for investment are providing better than typical entry points right here. High levels of sustainable cash flows, above average dividend yields, strengthening balance sheets, somewhat recession resistant operating businesses, nice overseas exposure that will benefit from a declining U.S. Dollar value long-term and more have us excited about this sector.
The “values” have largely been created by Wall Street’s over-exaggerated fears about the future of health care pricing in this country. We believe the math is much stronger for these companies than Wall Street understands, and a Republican reversal in 2011 of health care reforms passed in 2010 could provide a welcome boost of interest in this sector soon.
Undervalued asset plays, some smaller growth names, a couple of short-squeeze ready favorites of mine, core safety and inflation-benefiting consumer staples, alongside some diversification ideas will likely be a part of the portfolio soon. Our goal is to deploy more cash into stocks as we find values throughout the year, or after a considerable market meltdown.
– Paul Franke
