News & Insights
Addicted to Risk: Denial turns to Acceptance - Mr. Market enrolls in a twelve step program
One of the increasingly disturbing trends we have observed since the end of 2003 is the markets' voracious and accelerating appetite for risk. Investors have been pouring money into junk bonds, sub-prime mortgage CDO's, emerging market debt & equity and hedge funds run by inexperienced managers with exotic, untested strategies.
This all has taken place in an environment of ballooning liquidity. By liquidity we mean money created from three sources: (1) central bank monetary policy, (2) investment flows from booming export markets, such as China, into the sovereign debt of importers (chiefly us) and (3) the issuance of loans and securities to support the imprudent adventures of the private equity pirates. "Hey, John let's see if we can get J.P. Morgan & Citigroup to loan us the money to buy Chrysler: the U.S. auto business is such a growth industry!"
Altavista's position, reiterated in our quarterly letters, has been that in this charged atmosphere of easy money, it is more difficult to distinguish between good long-term investments and flashes in the proverbial pan. Bankers and investors have thrown money at wise investments, boondoggles and everything in between. In the last ten days of June, news of the shaky financial condition and possible panic liquidation of two Bear Stearns sponsored investment funds have provided a bracing blast of reality to investors. The question for us is this: what kind of pivot point does this represent, a long needed adjustment or the cusp of a full blown financial crisis?
We believe that financial conditions, while tighter, will not cause the markets to seize, although the increased turbulence that has characterized the last two weeks in June are likely to be the norm. We do not raise the red flag for a couple of reasons. Research reveals that the two biggest external risks to the equity market are tight monetary policy and inflation. Let's take these one at a time.
Inflation remains tame despite the headlines of higher energy and food prices. The prices of manufactured goods and services are actually in a mildly deflationary stance, and in our view the forces of globalization are likely to keep downward pressure on these prices. This is key. Tame core inflation is crucial to our view that current conditions are cause for caution, not panic.
Second, the Fed is unlikely to impose higher rates on a slowing economy and in the face of the dramatic reversal in the housing market. Indeed, such conditions increase the chance that they will lower interest rates to guard against recession. Corporate balance sheets are in excellent shape and that includes the banks that would likely have to absorb losses related to imprudent lending. Also, commercial and investment banks have been adept at packaging much of these high risk loans into securities, thus laying off the risk of default to a broader group of investors.
This should help prevent a crisis in any one sector.
What does this mean in portfolios? Larger, higher quality, dividend-paying stocks should hold up better than the rest of the market, if an equity price correction occurs. Should credit conditions deteriorate, companies with strong balance sheets will be in a position to take advantage of weaker companies' financial distress.
The current increase in bond yields probably represents the high water mark over the next year, so intermediate term government bonds are a reasonable value. We still believe that a fixed income investor should be shorter and higher quality than the market.
Holding an above average level of cash should not penalize investors' returns too much as we see the market churning for the next several months. The safety of a little more cash may help you sleep soundly as the market thrashes around more violently than in the years just past.
International stocks have outperformed the S&P for several years in a row. Foreign shares began this cycle significantly cheaper than domestic stocks. Now the gap between foreign and domestic stocks has largely been eliminated. However, we still believe that a full weighting in international markets makes sense.
Commodities & Real Estate
Domestic Real Estate Investment Trusts are largely overvalued and except for some special situations these should be avoided. Base metal (nickel, copper, etc.) prices also seem prepared to dip in price in line with the softening U.S. economy, energy stocks (crude, coal, natural gas, etc.) seem well supported by underlying supply and demand conditions.
As always, we believe that a diversified portfolio is the best way to balance the risk and reward inherent in the markets. We welcome hedge fund managers, junk bond kings, interest rate arbitrageurs and newly minted private equity billionaires to the club of the cautious but optimistic. Let's hope that their unhealthy addiction to risk can be overcome for the good of all investors.
The Altavista Investment Team - Summer 2007