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Hide and Seek - Trapeze Asset Management

March 02, 2014 | About:
CanadianValue

Canadian Value

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Hide and seek. A game investors played as children but should not forget these days. Currently, investors need to hide safely to protect from some unfavourable developments in an environment that could hurt them.

First and foremost, the S&P 500 is near a record high and based on our work is fully valued. The U.S. markets did correct recently, but there’s likely more to come. Particularly confronted by recent unfavourable economic news and some turbulence.

We believe that market sentiment has been too bullish, which combined with a fully valued market at our TRAC™ ceilings, warrants a correction. We don’t believe this is the onset of a bear market, just a healthy correction. The S&P 500 is fully valued based on a multiple of over 16x 2014 expected earnings, on price to sales ratios, on price to book ratios and even based on its dividend yield, leaving little, if any, upside except from earnings growth.

Based on our TEC™ indicator we don’t foresee any looming recession; we just anticipate slower than normal growth.

U.S. Economy Uncertain

In the U.S. the economic news has been mixed. On the plus side, U.S. GDP for Q4/13 rose at an improved annualized 3.2%, helped by an ongoing housing recovery and by consumer spending, the biggest driver of the U.S. economy, which rose the most since the last quarter of 2010. U.S. exports also contributed, up 11.4% last quarter, the most in 3 years. U.S. manufacturing in February grew the quickest in almost four years seemingly recovering from the ISM manufacturing index decline in January from December. Furthermore, the U.S. budget deficit should shrink this year to $514 billion, or about 3% of the economy, the lowest since 2007. And this is the stuff that’s no doubt encouraging the Fed to continue tapering its stimulative monthly bond and mortgage purchasing by $10 billion per month, now down in the last 2 months to a monthly $65 billion.

But wait, there is lots of negative news too. Recent economic releases have been below expectations. While Q4 GDP growth was better, for all of 2013 the economy grew by only 1.9%, down from 2.8% in 2012. And, while U.S. consumer spending rose in December, lower consumer confidence in January could impede growth in this quarter. Consumer incomes for December were weaker and their savings fell, which could slow their spending this year. Retail sales fell in January to the lowest in 10 months. The housing recovery may be stalled too. Home builder sentiment just recorded a record drop. Housing affordability is declining sharply from higher prices (rising faster than incomes) and higher mortgage rates impacted by the Feds tapered purchases of bond and mortgage-backed securities.

Pending home sales in December had their biggest one-month drop in 4 years. While new house sales rose by 9.6% in January, existing house sales dropped 5.1%. Unusually extreme winter weather hasn’t helped either.

January non-farm payrolls were up a disappointing 113,000, though the unemployment rate fell to 6.6% (from 6.7% in December), mainly from people dropping out of the work force. U.S. farm incomes are expected to drop this year to the lowest level since 2010. Auto inventories in January were at the highest level since the recession in August 2009. Generally speaking, this economic recovery has been weak compared to past recoveries from recessions.

And the Fed knows this too, despite its tapering measures voting to keep interest rates near zero, even if unemployment drops below 6.5%. Continuing the needed tailwind.

Global Economy Weakening

Investors also need to be wary of the implications of a general global economic slowdown. Some worrisome stuff, for sure.

The second largest economy, China, is slowing. Its GDP growth rate is down from 12% to 7% and some pundits believe it could be on its way lower, to about 5%. Interest rates have risen materially in China from funding stresses as it tries to shrink the government share of the economy and end its credit bubble. China’s Purchasing Managers Index (PMI) for January was down to 51.5 in January from 52.5 in December. Although, positively, its January trade surplus was better from higher exports.

Japan, endeavouring to recover from years of deflation and its recent nuclear power disaster, has unhappily seen the Yen rise lately and its Nikkei index correct by over 10%. Its economy grew more slowly in Q4/13 than anticipated, from weaker consumption and exports, suggesting continued money printing and currency devaluation.

The ECB, concerned with low inflation (the slowest since '09) and a fragile recovery, has kept its benchmark interest rate at a record low of 0.25%. Countries such as Greece, Hungary, Poland and the Czech Republic continue to struggle.

But the emerging markets may be the icing on the cake, or rather, the bricks on the raft. Capital had been flowing into emerging markets, attracted by higher interest rates and formerly stable currencies. Now, despite growth in most of them slowing, Turkey, South Africa and India perversely have all had to hike rates last month to support their currencies and restrain capital from fleeing. Other currencies, including those of Brazil, Mexico, Russia, Poland and Hungary, have fallen heavily as competition for capital has increased. Argentina and Venezuela, in the face of soaring inflation, are becoming basket cases. Puerto Rico too, cut to junk. Emerging countries represent a significant portion of global imports. Adios growth.

Hide In Safe Places

Time to hide from those places that are not necessarily safe and seek safety in those places that are safer. Clearly the U.S., Germany, the U.K., France, China, Japan and Canada, and the developed countries generally, are safer. Growth in the U.K., Germany and France seems to be improving. In Canada too. The Canadian economy gained 29,400 workers in January, the biggest jump since August. The Bank of Canada is forecasting 2.5% growth this year and keeping its key interest rate at its near record low of 1%. However, factory sales, led by aerospace and autos, unexpectedly fell in December. And December retail sales also dropped in December more than anticipated pushing the loonie lower to under US$0.90. But, the declining loonie should help stimulate exports and the earnings of exporters, including aerospace and autos, and the Canadian energy and mining producers we hold, while at the same time restraining any deflationary forces at work and help exports to avoid the recent monthly deficits experienced. Canadian consumer confidence in Q4/13 was the highest since the first quarter of 2011 and consumers should keep spending. Of course, the lower loonie raises the prices of imported consumer goods and hurts some industries, such as the airlines.

Seeking Safe Asset Classes

So now that we know the geographic places to hide from and where to seek, what are the kinds of investments we should hide from and what are those we should seek? Our objectives are to obtain potentially high, market-beating, after-tax returns, without undue risk of loss.

Well clearly, these days, even our favourite countries, the U.S. and Canada, are more risky. While the U.S. Federal deficit has been declining, its debt is still a whopping $17 trillion, equal to GDP. And the debt limit keeps having to be increased by Congress. The Federal Reserve’s debt is also $4 trillion. These are big numbers, especially big if interest rates rise. Which, however, currently appears unlikely in the near term. Especially if the U.S. dollar becomes the currency to default to, which could diminish inflation, and perhaps even raise the risk of deflation. Interestingly, even while interest rates are being kept artificially low and money printing artificially high, it has failed to generate money growth in the private banking sector—the so-called velocity of money.

There are also risks in the U.S. markets. With the 10-year Treasury bond yielding 2.7% (down from over 3% from the recent stock market weakness) and no clarity on the inflation outlook, bonds are not without risk and may not be a good place to hide. Remember, this bond bull is being supported by artificially induced assistance from the central bank. We prefer markets that don’t need artificial sustenance. Remember the adage, the Fed can always remove the punchbowl from the party. As we have noted, cheap money is generally good for an economy, especially those of places such as the U.S., the Eurozone and Canada, where inflation is not an issue. Not yet anyway. Low rates are good for consumers and for business. And good for the attractiveness of equities, making their returns more attractive relative to fixed income, increasing P/E ratios, and allowing inexpensive margin leverage to enhance returns.

On the other hand, as we have noted, the U.S. markets are in our opinion fully valued, so investors need to be careful. To hide and seek carefully. U.S. profit margins are at record highs (we repeat, “record highs”) and profits are at an all-time high. High profit margins may be sustainable for some time, but normally regress to their mean. The markets have been supported by buy-backs and increased dividends, as opposed to revenue growth which has been anemic. Margin debt is at a record high. And some recent IPOs, like Twitter, have indeed proven to be risky. Shell and Exxon Mobil both suffered from Q4 profit declines. Retailers, such as Best Buy, J.C. Penney and Radio Shack, struggling and shrinking. Huge consumer companies, such as Wal-Mart and Mattel, have had disappointing results, somewhat, understandably, from weather issues. And while Amazon.com benefited from better online shopping, it still had results below expectations, hurting its share price. Which is acceptable if you’re short it, as we are.

Seeking Undervalued Stocks

We want to be defensive, to avoid the stocks that are fully valued and seek those that are undervalued, by at least 20%, and buy them at floors in our work. In accounts that have authorized short selling and options, we seek to hedge risk by short selling the overvalued companies and buying put options to protect from a market decline.

Our analysts work diligently looking for the long and the short opportunities. A great investor once said, “Seek and ye shall find,” and we’re obeying.

Herbert Abramson and Randall Abramson, CFA February 27, 2014

About the author:

Canadian Value
http://valueinvestorcanada.blogspot.com/

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