Trend Management, Inc’s Third Quarter Report 2013
Our prediction from 2012’s year-end letter: “Thirteen years have passed without a party in our industry, and we think that will end now. What we boldly predict is a return to fun in the stock market, compared to the last five years, which have been hell. The Fed will engineer it, whether Congress and the president get their acts together or not. The fight today on the fiscal cliff is about 500 billion dollars; the Fed will print 1 trillion dollars, this year alone. Which is more powerful? We will not fight the Fed, but enjoy the ride.”
Fortunately, the stock market has gone up, as we predicted. Unfortunately, our political leaders have not gotten their acts together. As we type this letter, the government may shut down at midnight. We feel this is a poor way to run the people’s business and appears to be the norm, rather than the exception.
What does this mean for the stock market and the economy? In 1995, the government shut down operations on November 14th, lasting about a month. On the first day, the S&P 500 closed at 589.29. Two months later, the market was trading at 599.82, for a gain of almost 2%. The next year, it was at 735.88.
We tend to think the current, potential shutdown will play out about the same. But make no mistake, this is not good for the real economy. It won’t help consumer confidence at all. That said, we think the Federal Reserve’s policies are more important to stocks right now, than is the debt debate. The only big winners we see in this mess are TV and radio talk-shows.
The public is taking notice; the stock market has been going up. We are aware of a change in behavior in investors’ attitudes about owning risk assets, like stocks. Money is trickling into stock mutual funds, while running for the exits from bond funds. This makes sense to us. Bonds are overvalued, and we have not been shy in telling investors about it. What is more difficult, is stocks are about 4% overvalued today, for the first time since 2007.
We use a five year look-back on earnings to determine fair value for the S&P 500. Right now, the number is in the mid-1600s on the S&P. As I type this, the market is at 1700. We are thrilled the market has recovered from the destruction of the 2008-2009 bear market. Yet it makes our job—to find value--harder.
Previous to this year, we joked about the day coming when you can no longer just throw a dart at the Wall Street Journal’s financial section and make money. We are now there. Prior to this year, investors were so depressed there were lots of companies to choose from, and we had trouble narrowing our buy list to twenty. Today we struggle to find twenty. The markets are no longer cheap, based on the prior five years’ earnings. Because we anticipate earnings, as a group, growing at 5% to 7% per year, you could say the S&P is about a year ahead of schedule.
Does fair value mean you sell out? We hear this comment all the time: “I don’t want to go through another 2008.” Neither do we. When your account declines in value, so does our pay. We are on the same page, here.
We have written in the past about how we deal with this, but for a brief recap: When the Federal Reserve starts to tighten credit, you usually have two years before the economy begins to slow down. In our view, this quarter’s tapering discussions in the press about slowing down the printing of money do not represent tightening. To us, tightening equates with less money in circulation than before, and that won’t happen for a while. If we thought the Fed was restricting credit, we would reduce the amount of stocks you own.
Our second fallback is the price of those stocks owned. We evaluate every stock to determine whether we should continue to own it, regardless of what the Fed is doing. If we don’t like the stock, we sell it. If it’s overvalued and its growth is slowing, we will reduce the size of the position or just sell it. Lose confidence in its management, and we get out.
A third fallback is bonds. If U.S. bonds or another country’s are a better investment than stocks, we will sell some of your stocks and invest in other asset classes. It is in this third area, where we have spent a lot of time of late.
If we don’t have a good idea for the money from selling an investment, we will put it in cash, until we find something we believe will do well. For the first time in six years, we actually have some cash in your account--a sign we are struggling to find new opportunities for investments. Your account may soon reflect this slightly different approach. If those investments are made, we will write about them in our next newsletter.
To sum this up, our process to avoid another 2008-2009 is a market call, based on what the Fed does, judging your individual stocks on their own merits, and comparing them with other asset classes. If you want more detail, feel free to call us and we will go over it.
A recent development involving banks and regulators isn’t receiving much press. For perspective, it rates mention, one agreed-upon cause of the housing bubble was the incentive politicians and regulators gave banks to make loans to home-buyers, whether those loans made sense or not. Banks then sold off sub-prime home loans, before borrowers defaulted and turned them toxic. But because everybody knew those loans were rotten, interest payments were broken up into tranches.
A tranche divides a mortgage payment into pieces and prioritizes each piece. For example, let’s assume a homeowner’s $100 mortgage payment has twenty tranches. The first tranche is $5, the second tranche gets the next $5, continuing on until the 20th tranche receives the last $5 of the $100 paid.
Then times get tough. The homeowner pays only $10 of the $100 mortgage amount. Tranches one and two will take their respective five bucks each. The remaining eighteen tranches receive zero. Hence, the market rated the first tranches as triple-A credits, and the rest in the Bs. Last decade, bank regulators said a AAA-rated investment required a very small amount of collateral to back up a loan, versus a lower-rated one.
Breaking up mortgage payments into tranches encouraged banks to write bad loans and sell them off as quickly as possible. Banks could sell AAA-rated loans quickly, because those loans required the banks to keep less collateral for them. As a result, banks levered-up their balance sheets. Hypothetically, before tranche-ing a loan, where a bank could hold a million dollars-worth of home loans, they could now collateralize five or ten times that amount. In our opinion, this was the major cause of the housing bubble.
In July 2013, the Federal Reserve issued new bank regulations, which said: (and we paraphrase) “Any bank loan to a corporation carved up into payments (tranches) will only need 20% collateral to back it up, versus a normal corporate loan.”
This ruling immediately had us thinking, Here we go, again. A restart of subprime loans, except for corporate bank loans this time, not real estate.
The Fed’s motivation is to grow the economy by encouraging bank lending to corporations. It may succeed, but we feel it may also encourage companies to borrow money and buy out each other.
In a low interest-rate environment, banks look for yield and a AAA credit rating. They will achieve both with these loans. The ruling allows them to hold five times the corporate loans on their books, if they buy tranched loans. It tempts banks to write bad loans to bad companies, like they did before in real estate, causing a housing bubble. Our guess is, this time, it increases the odds of a stock market bubble. At the very least, companies may buy out competitors, because the financing will be there. This is a big nudge to corporate America to lever-up again.
Is it a coincidence, Verizon bought Vodaphone this quarter in the largest takeover in recent history? We don’t think so. Banks are getting the message and aggressively lending.
We continue to assess how new regulations, legislation, and politics may affect what we own. On the banking side, new lending rules are very positive for stocks. Also helping stocks is the Fed printing $85 billion per month. That money is inflating your Trend Management account, and we like that.
On the downside is Obamacare. No matter what political party you root for, the Affordable Care Act’s implementation will slow the economy. For now, we believe the positive flow of money into stocks will outweigh the ACA’s fiscal drag. As always, we reserve the right to change our minds, but that’s how we view it today.
If you’re financial situation has or is changing for employment reasons or any other factors, please let us know, so we can update our files.
The Christmas party is slated for December 19th at Highland Springs. A reminder will be mailed after Thanksgiving, but do mark the date on your calendar. We hope to see you there!
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR