A 2010 equity portfolio: the repair process (or, the macroeconomic background)

My world economic “to do” list, with emphasis on the US

This is my checklist of the major economic problems produced by the financial crisis, and where I think we now stand:

1.  world trade. Trade finance is more or less back to normal.  Areas outside the US and the EU which have not been infected by our banking problems have stabilized faster than expected and are beginning to grow again.

China is perhaps the best example.  But the Reserve Bank of Australia has recently announced that it has completed the process of bringing short-term interest rates up from their emergency low early in 2009 to a neutral level.  Singapore is the latest to declare that its economy is looking up again.

Unlike Japan during its heyday, China is taking an active role in world economic affairs, not only by purchasing assets in other developing countries but also dispensing foreign aid.  This serves a dual purpose–spreading China’s influence abroad, as well as shrinking its gigantic pile of US$ reserves.

2.  global economic growth

The economic consensus is that 2010 will be a year of “above trend” economic growth around the world.  Taken by itself, this is a pretty meaningless statement–sort of like saying that things could be looking up for the New Jersey Nets basketball team (now 3-30).

After an economic low point and the application of expansive monetary and fiscal policy, there’s always a bounceback.  For economies like China, India or Brazil, economists seem to be predicting a return to business as usual.  But the forecasts for the US and EU, which appear clustered around 3% real growth for the year, are above trend but only by a tiny bit.  They’re not much more than half the level one would expect in the typical economic rebound.

If the US and EU forecasts are economists’ best guesses and not an attempt to guard against printing a number that may be too high, they are predicting that it will be years before the developed world shakes off the negative effects of the financial crisis.

The estimates have some common-sense plausibility.  Typically, consumer rebounds are driven by renewed purchases of homes, cars and other household durables.  With 25% of homeowners holding mortgage debt that’s more than their homes are worth and with 10% unemployment, will spending have the typical oomph to it?  Maybe not.  On the other hand, economists have always underestimated the resilience of the American consumer.

3. confidence in the US$.

–Are foreigners continuing to buy Treasury securities?–yes, especially at the short end, where the potential for currency losses is smallest.

–will the US do what is necessary to protect foreign creditors from a decline in the real value of their Treasury holdings?  that is,

———-will the Fed raise short-term interest rates from their emergency lows to neutral?–yes (remember, short rates will probably go up by 175-200 bp before the Fed is through)

———-will Congress create a sound fiscal policy that will guard against dollar depreciation?–probably not. I don’t think anyone expects fiscal responsibility from Congress, though.  That’s why buyers are sticking to short maturities and why the Chinese are so eager to reduce their dollar holdings.  My guess, though, is that the world expects at least some action by Congress, other than creating inflation, to narrow the budget deficit.  What Congress actually does could be a source of either positive or negative surprise.  I’d lean more toward protecting against the negative than benefiting from the positive.

4.  financial companies. A lot of progress has been made, but significantly more remains to be done.

–trade finance is back to normal

–business lending.  High yield issuance is booming, as large firms are seeking the greater certainty of the bond market.  This is true in Europe, where companies have traditionally been much more reliant on bank financing, as well as the US.  Smaller firms seem to be waiting for final word on what their health care costs will be before spending on expansion.

–regional banks.  Many are up to their eyes in construction loans, not an enviable position to be in.  So they’re not lending either.

–consumer lending.  Good luck trying to get a loan.  High losses on derivatives, mortgages and credit cards have made all banks squeamish about new commitments.

–stock finance.  It’s booming in emerging markets…not so much in the US and Europe.

–investors.  Data from the Investment Company Institute, the trade association of the investment management industry, seem (to me, anyway) to show that individuals are continuing to act in the same vein they have for about a year.  That is, they are:

-reducing money market holdings

-reducing domestic equity mutual fund holdings

-buying exchange traded equity funds instead

-buying taxable bond funds

rearranging their equity holdings to reduce their exposure to the US and increase it to foreign markets, especially emerging countries.

(One way of making sense of this is to say investors are following a barbell strategy, balancing what they perceive as very risky assets (emerging market equities) against ultra-safe ones (bonds).  Or you might say they’re buying everything but US stocks.  Personally, I don’t get it all, but only time will tell whether this is a prudent strategy or not.)

5.  US industrial firms. Overall, US business have shown strong profit growth in the second half of 2009, mostly as a result of cost-cutting.   Larger firms have begun to indicate that sales are either stabilizing or improving and that they intend to start purchasing new equipment and rehiring workers in 2010.  Temporary help is already on the rise.  Sales to non-US buyers are an area of particular strength, at least in part due to the weakness of the US$.

Smaller firms, on the other hand, appear to be more cautious.  Several reasons:

–they tend to have little overseas exposure, where economies are stronger,

–many are suppliers to larger US firms, and their revenues tend to lag on the way up, as a result,

–some are concerned about the effect new health care legislation will have on their profits.

It’s probably also important to distinguish between manufacturing and service companies.  On the manufacturing side, many publicly-traded industrial companies produce consumer durables, an area I tend to worry about.  IT companies, on the other hand, appear to be doing exceptionally well.  (See the very interesting, if somewhat specialized, blog by tech veteran Daniel Nenni, who points out that semiconductor companies are anticipating an unusually strong first quarter during what is typically a seasonal lull.)

Service companies are, I think, in better shape than manufacturers.  They are also the area where the US has a true competitive advantage over foreign firms–although “creative destruction” is heavily rewriting the formulae for success in entertainment and publishing.

6. The US consumer. It’s a mixed picture.

a.  the positives

–Housing prices probably bottomed sometime in late spring or early summer.

–Layoffs are slowing, and the labor situation may reverse into net hiring in the next few months.

–Holiday spending appears to have been better than (low) expectations.

–Almost two years of recession would imply considerable “pent-up demand” for consumer durables.

b.  the negatives

–Consumers are continuing to trade down, implying they are still not feeling very confident

–Banks are still severely rationing credit to consumers, as well as dramatically raising the cost of maintaining credit card balances

–companies may have discovered during the downturn that they can operate with fewer workers than they thought.  If so, unemployment may remain higher for longer than in past recoveries.  For perhaps different reasons, I think this is the consensus expectation.

c. past patterns

The timing of US business cycle recoveries has been unique, in that the American consumer has typically picked up first and industry has followed later on.  The opposite is true in the rest of the world.  Perhaps the most dangerous words in all of investing are, “It’s different this time.”, but, like the economists forecasting a sub-par recovery,  I wonder…

That’s it for this post.  Next, I want to write about what stock markets have been doing and what their performance seems to be implying for the future.  Then I’ll write about where I see the possibilities to profit this year from the current lay of the land.

A 2010 equity portfolio: the current “exogenous” event

Exogenous shocks

Economists explain the depth of the recessions of 1973-74 and 1980-1982 by pointing to extraordinary shocks to the world economic system that occurred during these periods.  In both cases, the shock involved was a sudden two-or threefold rise in the price of oil in economies very dependent on petroleum.

The current case

In the case of the current financial crisis, the “shock” was the sudden collapse in 2008 of major international banking firms in the US and the EU.  The reason?  –the realization that trillions of dollars of exotic securities that commercial and investment banks created, owned in very large size (and therefore counted as an integral part of their capital) and traded with one another were pretty much worthless.  As a result, many of these financial institutions were essentially bankrupt.

The housing problem

What triggered the crisis?  Many of these “toxic” securities were based on home mortgages taken out by “sub-prime” borrowers, who by and large didn’t have the income to make their mortgage payments.  These borrowers began to default.

What separates the current housing bubble from previous ones is the duration, and consequently, the size of the lending to unqualified borrowers.  Fed money policy in the US was unusually loose (see my June 3, 2009 post in Odds and Ends reviewing  John Taylor’s book on the crisis, Getting Off Track) for several years at the start of the decade. Government and trade groups estimate that:

–over 10% of outstanding mortgages were given to unqualified buyers,

–one in four residential housing commitments were made to speculators, vs. one in ten during a “normal” boom, and

–for a quarter of current mortgage holders, their home is worth less than the mortgage amount they owe.

Other, related, problems

Bad credit and weak banks aren’t the only problem.  the booming housing market signaled continuing economic prosperity.  So housing and commercial construction companies expanded and hired more workers, as did materials suppliers, retailers, hoteliers, airlines–and just about every other economic entity in the US.  When the bubble burst, we found ourselves with an economic infrastructure that is 5%-10% too big for what we can use.

The crisis also underlined the poor state of government finances in Washington, weakened by the Bush administration’s policies of increased social spending and tax cuts, while also waging an expensive war in the Middle East.

Derivatives allowed US problem loans to be exported to Europe and infect the banks there.  France was a hotbed of “financial engineering” expertise, which helped the process along.  The fact that most transactions originated in London, where laws differ from those in the US and where regulatory supervision was lax, poured gasoline on the fire.

Two low points

1.  In September 2008, Secretary of the Treasury Paulson decided to allow the investment bank Lehman Brothers to go into bankruptcy.

This had two immediate unintended effects, which both spread the financial crisis far beyond the housing market.  International trade finance, and therefore the lion’s share of international trade, immediately dried up on intensified concerns over counterparty risk (if Lehman could fail, who was safe?).  Also, worries about counterparty risk spread to money market funds, some of whom had bought Lehman short-term debt to try to raise their yields.  As investors shifted to federally-insured bank deposits instead, they all but eliminated an important source of working capital finance for American industry.

During this time, industrial layoffs intensified.  Armed with sophisticated supply chain management tools, companies could see the full extent of the economic contraction that the crisis was bringing.  Many also realized they had made a mistake during the 2000-2002 downturn by not cutting production–and workforces–quickly enough.  So they cut very sharply this time around.

2.  In March 2009, sentiment reached its lowest ebb when Congress initially refused to appropriate funds for a bailout of the financial system.  For a while, the world feared that the global financial system would collapse, bringing on a new version of the Great Depression of the 1930s–not because the problem, although large, was not understood or was too big to handle, but because of cognitive/intellectual deficiencies among myopic US legislators.

The repair process

A lot of positive things have happened since the darkest days of nine months ago.  The repair process will be the subject of my next post.

A 2010 equity portfolio: two types of recession, two types of recovery

Two types of recession

Looking at recessions in a very simple way–but good enough for our purposes–economist divide them into two types.

1.  The garden variety starts when the economy is growing at a faster rate than the central bank thinks it should.

This means different things in different countries.  In the EU, for example, excessive growth means a rate of expansion that contains the slightest risk of inflation.  In the US, in contrast, the Fed’s job is to encourage maximum sustainable GDP growth, with acceptably low inflation–meaning in today’s world a maximum of 2%.  Let’s consider the US case.

When the economy has expanded to the point where there is very little unused labor, firms that want to expand begin to offer large wage increases to lure workers from other companies.  This wage competition–by raising the overall level of salaries–creates the threat of excessive inflation.

The Fed reacts by raising interest rates to slow the expansion down.  After six months to a year, seeing it has created some slack in the labor market and that the economy is dipping below its growth potential, the Fed begins to reverse course and lower rates again.

2.  The less frequent, but deeper and longer, recessions may have all of the elements of the garden variety business cycle type, including the central bank’s raising rates to attempt to fight inflation.  But the real defining characteristic of the deeper recessions is what economists have called an exogenous event, or an external shock. In the case of the deep recessions of 1973-74 and 1980-82, the external shock involved was the negative effect of an almost-overnight tripling in worldwide oil prices on industrial economies deeply dependent on petroleum.

Two types of recovery

Recovery from the garden variety recession is straightforward.  The central bank, which created the slowdown by adjusting short-term interest rates upward, moves them back down again and the economy gradually picks up speed.

Recovery from deeper recessions is also straightforward–elimination of the causes of the economic slowdown.  But it’s harder to accomplish, and takes longer to achieve, because it involves structural adjustment to a new set of economic realities.

The 2007-2009 recession

The very deep recession which has just ended doesn’t appear at first to fit neatly into the “external shock” category.  There are two reasons for this:  the commodity whose supply/demand characteristics has changed is money; and the source of the systematic shock is not a far-off and exotic land, but the center of the western financial world, the US and the UK.

Nevertheless, as was the case in other deep recessions, recovery in this instance, too, will consist both in adjustment to the new economic realities and in repair of the damage done by having assumed that the old “business as usual” would go on forever.

That’s it for now.  In my next post, I’ll try to spell out the specific recovery issues we now face.

A 2010 equity portfolio

Over the next week or so, I’m going to write a series of posts about the shape I think a portfolio should have for 2010.  The yshould come in the following order:

–the likely course of the US economy in the new year,

–the current state of the stock market,

–what I think the consensus opinions about 2010 are, and

–(most importantly) where I think a portfolio should differ from the consensus in order to perform better than it.

At this point, I don’t have very strong opinions.  But I’ve always found that I begin to form them when I approach the issues in writing.  I hope that will happen this time as well.

There are some general conclusions that I think we can draw, though, even before more careful analysis.

1.  Certainly, there’s no reason I can see to expect that 2010 will be more emotionally trying than 2009 was.  At the same time, 2010 stands to be a more difficult environment to make money in, in the sense that the chance to profit from the panic of the first quarter of 2009 is unlikely to recur.

2.  The average yearly return in US$ on the S&P 500 has been about 9%-10%.  Another rule of thumb is that returns will be inflation + 6%.  I think it’s reasonable to ask whether you think returns will be higher than average in 2010 or lower. My answer would be higher.   Why?

We are in the early stages of recovery from a very bad recession that ended only a few months ago.  Stocks, which had been falling precipitously for almost two years, have been rising for about nine months in anticipation of renewed economic growth.  Upward trends like this typically last for at least two years or more.  Maybe this time will be different, but betting that this sort of history won’t repeat itself is almost always a losing one.

3.  Very large amounts of money remain on the sidelines in money market funds (which yield close to nothing).  Individual investors also appear to have switched large amounts of money from stocks to bonds–where they are very exposed to losses as and when interest rates begin to rise.  In prior market cycles such money has sooner or later reentered the stock market.  I expect the same will occur this time around.

4.  Invariably the Wall Street consensus is wrong about how the economy and the stock market will develop.  That’s not anything new.  It’s never 100% incorrect, however–no one’s perfect.  The real trick for an investor is to try to figure out how the consensus will be off the mark and to concentrate one’s bets against the consensus only in that area.

Remember, too, we don’t need to have opinions about everything.  In fact, we don’t want to have opinions about everything. We want, instead, to have a few well thought out opinions (even one really good thought will do) that are away from the consensus thinking and where our own research tells us there’s a very high probability that we’re right.

Activision: strong company in a weak industry

Invest in companies or invest in industries?

Question:  Which is likely to be a better investment–a strong company in a weak industry or a weak company in a strong industry?

(My) Answer:  It depends.  Outside the US, where equity investors tend to focus more on national and international macroeconomic and political issues and less on individual security analysis (many wouldn’t know an annual report if they fell over it), the merits of the industry far outweigh those of the individual company.   Holding the best companies, without regard to the industries they’re in, is a recipe for disaster.

In the US, on the other hand, which has been a pillar of relative macro and political stability, “big picture” issues have tended to be irrelevant.  Instead, everyone is a stock picker.  Holding the best stocks, without regard for their industry, has been the ticket to success.

US equity trading is taking an unusual path, I think

I’m not so sure that this rule of thumb, extremely reliable in the past, has held in the US in the current bull market.  The two clear patterns I see in this year’s stock performance are:

1.  economically sensitive industries have done well; more defensive industries, like telecom, utilities, healthcare and staples, have consistently done badly.

2.  toward the end of the summer, the market narrowed its focus from looking at economically sensitive industries across the board to focussing more narrowly on the strongest members of the strong industries–that is, from value to growth.

In all of this, it seems to me that stocks in weaker industries have just been ignored, no matter what their merits.

ATVI as an example

…which brings me to ATVI (a stock I own).

ATVI closed last Friday at $10.75 a share.  It’s up about 30% from the lows in March, or about half the gain the S&P 500 has achieved.  It kept up with the S&P fairly well until mid-summer and has been fading since.  What’s wrong?

The simplest explanation, and, given that even the best equity investors are wrong almost half the time, is that my analysis of the company has been faulty.  At least in terms of stock performance, it certainly has been.  But at the risk of keeping on deluding myself, I think there’s something more than that.

The shrink-wrapped video game software industry is in trouble, in a number of respects:

1. Some competitors aren’t doing well.  The long-time industry leader, ERTS, has been faltering for a number of years and new management so far seems unable to straighten things out.  Similarly, TTWO, famous for its Grand Theft Auto series, recently announced it was having trouble with the sports game franchise it bought from the former Sega.

2.  Wall Street is worried about the competitive threat of casual gaming, simple games played for short periods of time on mobile phones or through social networking sites.  This is an issue because the cost of creating a console video game has risen far beyond the point where it can be profitable by only selling to hard-core gamers.

3.  Video games generally are proving less recession-resistant than had generally been thought.  Software sales in the US are down 3% year on year.  That isn’t much, but the consensus expectation had been for a rise.

Why should ATVI be any more attractive than ERTS or TTWO?

1.  ATVI’s first person shooting franchise, Call of Duty, launched its newest version, Modern Warfare 2, on November 20th.  Through the end of the month, according to the NPD data collection service, over 6.1 million copies of MW2 had been bought, making it the most successful launch ever or a video game.  True, two expensive games ($90+) for consumers to buy, DJ Hero and Tony Hawk: Ride have been turkeys so far, selling 245,000 and 114,000 respectively through the end of November.  But their negative effect on results will be swamped by MW2‘s positive impact.

2.  ATVI owns Worlds of Warcraft, by far the most widely-played subscription-based online fantasy game.  What makes WoW unusual is its appeal to audiences in the Americas, Europe and Asia–typically markets with widely different taste in games.Subscription revenue seems to be plateauing at slightly north of $1 billion yearly, implying, say, $800 million in annual operating income.

3.  Although long-delayed, ATVI says it will launch a new version of Starcraft in 2010, intending to try to duplicate the online success it has had with WoW. No one knows yet whether ATVI will be successful, but earlier games in the Starcraft franchise have also enjoyed immense worldwide popularity.

4.  The company has no debt and $2/ share in cash.  ATVI will likely add at least $.50/share to that total by the end of the holiday season.  It has been revising its earnings guidance up–doubtless due to the success of MW2 (which it had a strong hint about through pre-orders).  Assuming ATVI could earn $.70 a share in 2010, it is trading at 15x earnings.  If results are indeed being held down by recession at present, an improving economy might push ATVI’s earnings higher.

A wider implication

ATVI may or may not turn out to be a good stock.  Stock-specific risk is the reason you hold a portfolio instead of one stock–to make sure your success doesn’t rise or fall on one name.  But there’s a wider point I want to make.

It seems to me that the US market has been bought since March in a top-down, industry-orientation way that would be more characteristic if European equity managers or global bond managers were making the decisions.  Bottom-up, traditional American-style growth stock investing appears to me to have taken a back seat.  This implies that looking through laggard industries–healthcare, telecom, even (gulp) media–may be very worthwhile.