Tag Archives: shaping a portfolio for 2011

Shaping a Portfolio for 2011 (l): a macro view

January 6, 2011 By in Constructing a Portfolio, Current Market Thoughts, economics, Shaping a portfolio for 2011, Strategy Tags: , , , , , , Leave a comment

I’m envisioning writing four posts on how I’m shaping my portfolio for 2011.  They are:  a macro view; what’s discounted in today’s markets; what I think about different sectors + overall trends; and, finally, my conclusions.  I can’t guarantee that I won’t deviate somewhat from this plan as I go along, since I tend to use the act of writing stuff down as a way of refining my thoughts.

Today is the macroeconomic view, or at least as much of it as I think an equity investor needs to know.  Actually, better make that as much of it as I’m aware of.

The most basic fact, I think, is that the world is in recovery.  That is to say, global economies are generally starting to grow again in a healthier way than they have been over the past four years or so.  I don’t mean that the world is healthy yet, just that it is in the process of repairing itself.  “Repair” means substantially different things in different parts of the world.

the US

The epicenter of the problem.  In early 2007, what proved to be a massive speculative real estate bubble began to unwind.  Two consequences:

1.  At the depths of the ensuing crisis, the entire world banking system froze up, as financial institutions stopped lending to anyone, even overnight, for fear the counterparty was insolvent and wouldn’t repay.  This problem, which caused the world economy to lurch to a halt, has long since been fixed.

There has been one lasting effect, however.  Industry responded with a rapid contraction of production, including deep layoffs.   Companies have learned that they could operate with far fewer employees than they had imagined.  Therefore, they have been slow to rehire.

2.  Crazy bank lending meant that when the bubble burst and house prices began to decline:

–Lots of people ended up with houses whose value was less than the mortgage and with too much credit card debt

–The country ended up with, to pluck a number out of the air, 10% more houses than anyone wanted/could afford.  The same for commercial–especially retail-oriented–real estate.

This is an enduring issue that is affecting the speed and scope of economic recovery, in the following ways:

a.  Unlike food or out-of-fashion clothing, excess houses and strip malls don’t wear out and can’t be moved.  So until the excess inventories are used up, there won’t be much new construction.

b.  People, especially soon-to-retire Baby Boomers, are trying to get their debt under control and will consume less.  Demand for luxury goods is already back above its pre-crisis peak.  But less buoyant middle- and low-end consumption will be with use for some time to come, I think.

c.  The housing bubble retarded for almost a decade the adjustment of US workers in labor-intensive jobs to the fact of competition from China, India or other low labor-cost countries.  This is likely to be a chronic social problem, and a reason why the unemployment rate won’t improve very quickly.

The federal government response to the crisis has been to flood the country with liquidity by stimulus spending and reducing short-term interest rates to effectively zero.  The idea has been to, as it were, take extraordinary measures to restore a sick person to health, even if doing so may create problems in the future.

From September 2010 onward, signs are that this strategy is beginning to work.  Hiring is happening at a faster rate.  Consumer confidence is rising.  The rate of economic growth is picking up.

My guess is that this trend will continue, and modestly accelerate, through 2011.  I think the recovery will continue to have a 90/10 aspect to it, however.  For the 90% of the workforce who are employed, life is returning to normal.  For the other 10%, however, it seems to me that their situation hasn’t changed for the better so far.

The net of all this is that I think 2011 will be at least as good economically as the consensus expects.  I expect that the aggregate numbers, by ignoring the 90/10 split, will underestimate the strength of high-end consumption and be too optimistic about ordinary Americans.

Two other points:

1.  Not all the liquidity flood has remained in the US.  A lot has flowed through currency pegs maintained by developing countries into the emerging world.

2.  I think there’s still one more economic shoe to drop in the US–state and local budget deficits.  My general picture is that during the boom times, governments of every stripe spent every penny that came in.  Now they are facing retrenchment.  This will mean layoffs of government workers, rather than tax increases.

At the same time, a potential crisis is brewing over the generous medical and pension benefits retired government workers typically have.  Part of this may be envy, part may be partisan politics, part may be dismay that the full cost of government workers has been hidden from the voters–but no matter what the cause, this could become a big issue later in the year.  To what effect?–renegotiation of benefits would result in less spending by government employees.

Europe

The UK is like the US, writ somewhat smaller and with one exception, noted below.  Also, most of the toxic transactions made by US financial institutions flowed through London, even though they may have involved US assets and US parties.  Why?  –UK policy was “regulation lite,” in return for which it got lots of tax revenue.

True, the sub-prime mortgage crisis may have originated in the US, but the ultimate “dumb money” in the banking world is state-controlled banks in continental Europe.  And,sure enough, they have ended up holding tons of dubious debt securities and derivatives.

But that isn’t the only economic problem the EU has.  It’s an association of countries that has agreed to maintain a common money policy, but whose members have had very different growth rates–a slow-growing core (Germany and France) and a fast-growing periphery (most of the rest).  A money regimen that’s appropriate for the center has proved to be as overstimulative for Ireland, Spain and Portugal as anyone imagined–and then some.  All that “extra” money sloshing round in the peripheral countries has not been soaked up by the countries in question through restrictive fiscal policy–as it should have been–but allowed to flow into speculative real estate deals.

What’s worse, Greece has been falsifying its national accounts for years.  And Irish banks somehow passed the European stress tests despite being thoroughly bankrupt.

The EU response to the banking crisis has been waffling.  It knows what has to be done–closer fiscal integration–but can’t bring itself to pull the trigger.

Unlike the US, the EU and UK response to government deficits has been austerity.  That is, higher value-added taxes and severe government budget cuts.  The idea has been to fix the problem no matter what the cost in near-term economic progress or pain to the EU citizen.

Not a place to look for domestic growth in during 2011.

BRICs

International investors have traditionally described emerging economies as acting like options on developed world economic growth, meaning that they move in the same direction as the developing world but with higher highs and lower lows.

That hasn’t been the case this time around.  The financial crisis has been almost completely a developed markets problem, leaving emerging economies relatively untouched.  To the degree that they provide raw materials or industrial/consumer products to each other or to the rest of the world, they have prospered.  And by the World Bank’s purchasing power parity measure, emerging economies in the aggregate product almost half the world’s output–scarcely an option any more.

To the extent that they peg their currencies to the US dollar, emerging economies are in somewhat the same position relative to the US as the peripheral countries in Europe have been to the core.  That is, hugely accommodative money policy in the US is communicated to the local economies, where it’s exactly the wrong thing, though the peg.  In addition, developed world investors have been shifting immense amounts of portfolio capital to the developing world as they search for better returns.  This increases the money stimulus.

The big question for many emerging countries is how to cool themselves down.

Australia/Canada

These commodity-producing countries have by and large escaped the financial crisis.

Japan

In the early Nineties, Japan decided that it would forgo economic progress if that were the price it had to pay to preserve its traditional way of life.  To a Westerner, that continues to be a horrible bargain.  An obsolete industrial base, an aged population and no economic growth in sight.  I haven’t looked for statistics, but I’d be willing to bet Japan is experiencing a huge brain drain as skilled young people move elsewhere.

Shaping a portfolio for 2011: investing in a world with inflation

November 7, 2010 By in Constructing a Portfolio, Current Market Thoughts, inflation vs deflation, Portfolio management, Shaping a portfolio for 2011, Strategy Tags: , , , , , , , , , , , Leave a comment

The way I’m reading the US stock market, investors are only now beginning to discount the possibility that the Fed will be successful in creating inflation through its QEII operations.

important stuff

The last time the US saw rising inflation was in the late 1970s and early 1980s—the pre-Volcker era.  This means that virtually no professionals active in the stock market today have actually worked in an inflation-conscious environment.  In other words, many people will talk in confident tones about the characteristics of inflation—just as they spoke about deflation—without having any knowledge other than wheat they obtained from books on the subject.  Some of these ideas may be really wacky—and translate themselves into actions in the market that, in the final analysis, will make no sense.  These oddities will, at some point, present opportunities for profit.  But it’s always dangerous to put yourself in front of a moving train—even if you know it shouldn’t be there or is moving in the wrong direction.

The key to enduring inflation or deflation is consumer expectations.  Changes in expectations translate into changes in purchasing patterns.  In a deflationary mindset, consumers purchase only at the last minute, since the trend of prices is down.  In inflationary times, in contrast, people purchase in advance of their needs, since they believe that prices will be higher if they wait.

For companies, this means, among other things, a change in behavior toward inventories.   In a deflationary environment, companies want to be as lean as possible.  During inflationary times, in contrast, companies try to achieve profits from holding inventories that rise in value before they’re used.

winners and losers

income statement

In a situation where costs are steadily increasing, the key question for profits is whether a firm is able to pass these extra expenses along to customers, and how quickly it is able to do so.  Companies that have  unusual, scarce, or sharply differentiated products will typically do well.  All other things being equal, the shorter the supply chain, the better.

On the other hand, companies in industries like utilities, where prices are highly regulated, may face strong resistance to raising prices at all, or at the very least a significant lag in their ability to do so.  Commodity-like products—ones where there are readily available close substitutes—like consumer staples, will also tend to suffer.

balance sheet

In an inflationary environment, prices rise.  The cost of money, that is, interest rates, is one of those prices.  So companies with fixed-rate debt, which usually means outstanding bonds rather than bank debt, benefit.  So do firms holding large amounts of real estate.  Capital-intensive firms that already have ample capacity, especially in industries where rivals are becoming capacity-constrained and must add plant and equipment at now-higher prices should also benefit.

my thoughts

It’s not clear how or if quantitative easing will work.  It’s also hard to predict exactly how Wall Street will respond, given that only professionals working thirty years ago have seen inflation at work while they’ve been on the job.

Having said that, one sea change already appears to be occurring.   Investors seem to me to be more conscious of the risk in holding longer-term fixed rate bonds—the clearest losers in an inflationary time.  That concern is starting to flow into the stock market, I think, where the closest analogues, that is, the most bond-like securities, are those whose dividend yields are their greatest (or only) attractions.  I think high-yielding cyclical companies will be ok, but utilities and consumer staples are at risk, because they will likely struggle to achieve inflation-matching earnings increases.  This means they must either up the proportion of income they pay out to shareholders, or let their dividend decline in real terms.  Income-oriented investors already seem to me to be shying away from situations where they must forgo dividend growth possibilities in return for high current yield.

Are individuals coming back to the US stock market?

November 2, 2010 By in Constructing a Portfolio, currency effects, Current Market Thoughts, inflation vs deflation, Portfolio management, Shaping a portfolio for 2011, Strategy Tags: , , , , , , , , Leave a comment

some preliminaries…

A little more than a week ago, I wrote a post I called “Thinking about 2011,” in which I discussed the economic and stock market forecast of Jim Paulsen of Wells Fargo.  My understanding of his position is that the US economy is much farther along the road to recovery than one would imagine from the doomsayers of the “new normal.”  In fact, judging by the experience of the past twenty-five years, this recovery is ahead of schedule, not behind.  More than that, things are about to pick up all by themselves.

If so, the soon-to-be-launched quantitative easing by the Fed is not only unnecessary, but it has the potential for creating a lot of inflation–fast.

I said I thought Mr. Paulsen’s analysis was far from consensus.  My friend Bart, a canny veteran still working on Wall Street, wrote a comment to my post saying that Paulsen is a lot closer to the thinking of institutional investors than I realize.  Although confident that Bert is correct, I replied that I didn’t see this consensus being acted on yet in stock or bond prices.

…bringing us to yesterday morning

Monday’s Financial Times contains an article with a London byline titled “Investors increase exposure to equities.”  The story references two data providers:  the Investment Company Institute, the trade association of the mutual fund industry in the US; and EPFR, a Cambridge, Massachusetts-based data aggregator that I’m not familiar with.

According to the FT, EPFR says funds that invest in US equities have had inflows of $13.3 billion since the beginning of September.  Funds focussed on Europe have taken in $1.2 billion over the same time span.  Last week alone, the inflows were $2.7 billion and $840 million, respectively.

The ICI maintains the official figures for mutual funds based in the US (which may be a slightly different universe than EPFR’s).  These data don’t clearly support the EPFR statements.  What they do show, however, is that in mid-October, redemptions of US-oriented equity funds suddenly slowed from a flood to a trickle.  At the same time, inflows to international funds began to accelerate.

I tried to contact EPFR this morning, without success.  By the way, I’ve been pleasantly surprised to find how uniformly cooperative the information sources I contact as an equity market blogger are.  I expect I’ll eventually hear from EPFR as well.  Whether I do or not, though, the point is still that we may have seen an inflection point in investor behavior.

What does this mean?

The change in money flow may mean nothing.  Or it could reverse itself in short order.  After all, at least according to the ICI data, bond fund inflows haven’t diminished a bit.

On the other hand, government bonds have been weak recently, as have bond-like domestic US stocks.

My hunch is that world stock markets may be in the process of changing their character in a meaningful way and that I don’t have the two months for leisurely thought that I thought I had, if I want to keep positioned in stocks with a good chance of outperforming.

The first thing to consider is what kinds of stocks might be vulnerable if:

–economic growth is picking up steam,

–interest rates are rising, and

–inflation may be a problem, meaning the Fed has got to see to it that rates rise some more.

At this point, I still need to be convinced that any of this stuff is really going to happen.  And I don’t want to launch into an overhaul of my positions without thinking about it carefully first.  All I want to do is to identify potential underperformers and figure what I would need to do to get from overweight to a more neutral position.

I’ve also been thinking that many of the same stocks that have done well over the past eighteen months also stand to be outperformers in a higher-growth, more inflationary world.  But I want to make sure of that, too.

More on this topic over the next few days.