December 27, 2009
David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).
We are starting this commentary with two quotes that superbly summarize the state of the wealth effect, economy, and the outlook for applied stimulus. Cumberland’s strategy and rationale follow the quotes. We specifically acknowledge the effort of Howard Simons of Bianco Research for his repeated seminal work on how markets measure well and forecast much less well.
“The Federal Reserve Flow of Funds report showed a marked deterioration in the state of household balance sheets in Q3. Household net worth fell 4.7% q/q in Q3, translating to a $2.8 trillion loss in household wealth and marking the biggest y/y decline in the history of the series. Household real estate wealth fell 2.8%, reflecting the sharp decline in home prices… The decline in household wealth was accompanied by a decline in mortgage debt, which fell 0.5% q/q, the first decline since 1983. Homeowner equity fell to 44.7% of household real estate, marking a new record low. Household balance sheets also suffered from a 4.5% q/q decline in financial assets, driven by a sharp drop in the market value of corporate equities and mutual fund shares.”
– December 12, Julia Coronado and Michelle Meyer, Barclays Capital
Followed by this:
“The economy’s recovery depends critically on an energetic fiscal policy by the new Administration and Congress…President-elect Obama…will quickly enact significant stimulus for the economy. This is sure to include major new tax reductions…Also to be included is sizable additional spending on infrastructure, broadly defined to include support to state and local governments for a wide range of outlays.…On the monetary side, the Fed will soon be lowering its official rates close to the vanishing point…Yield penalties on investment-grade securities relative to Treasuries are likely to narrow once the extraordinary pressures created by year-end portfolio “window-dressing” pass, but if they do not, the Fed will broaden further the types of securities it buys…With such vigorous support, retail sales, housing starts, and business inventories may stop declining by mid-2009… even in such an environment of near-zero GDP growth, aggregate profits of non-financial firms (except those related to construction, autos, and, perhaps, oil), may actually hold steady or rise, cushioning the decline in capital spending. Net revenue will be well maintained as labor and import costs tend to decline…”
– December 12, Dr. Albert Wojnilower, Craig Drill Capital
Cumberland Advisors’ portfolio management strategy starts with a few assumptions. In the United States both financial policy engines are at full throttle: they are the fiscal engine (deficit spending of $1.5 trillion or more) and the monetary engine (see: www.cumber.com for the weekly updated description of the Federal Reserve’s balance sheet and programs). As Dr. Wojnilower notes, and we agree, this “vigorous support” is expected to arrest the economy’s decline by the 2nd half of 2009. The Fed’s own forecasts are reasonably consistent with this conclusion; they argue that it is the target of Fed policy to bring this result to reality.
This massive stimulus is applied because there is (1) an extreme negative wealth effect (see the Barclays quote above) and (2) a decline in employment and (3) pressure on incomes. Note how this may not play out into a profits debacle (outside of the financial, housing, and consumer discretionary sectors).
Also note how the appearance of no positive outcome prevalent in many forecasts is dependent on the failure of the two-engine stimulus.
We are on the other side. Instead of saying that stimulus fails and the economy just sinks and sinks and sinks, we are saying that stimulus in this massive amount succeeds and that the economy will stop sinking and plateau. Subsequently it will start to expand as all the pent-up demand begins to convert to spending and economic activity.
We are saying that markets change their pricing because they are forward looking. They usually bottom in the midst of the bleakest outlook and they often bottom BEFORE the economics appear to turn. History shows that over time, financial markets are able to change prices to reflect forthcoming changes in economic data. That is why markets are viewed as leading indicators. They are not forecasting the change; they are measuring the behaviors and sentiment of the investors who are forecasting the change. Markets move as a result of actions by those who are seeing a change earlier than economists can compile the data to demonstrate that the change is at hand.
Financial Markets do NOT forecast well in a strategic sense. If they did the oil futures curve would have warned of $140 oil when the price was $40 and it would have warned us of 40 dollar oil when the price was $140. Markets did neither accurately.
Financial markets measure the present consensus sentiment. They price it every day as folks make their real money commitments. The price tells you what the existing psychology is; it doesn’t tell you what it will be and it doesn’t tell you when it will change. Markets measure; they don’t forecast.
Here are some samples of current measurements that are not forecasts. Readers may judge for themselves if these are market forecasts of doom or if they are measurements of market dysfunction and extremes of psychological damage. Then each reader may decide and act according to his/her own view. In doing so he/she will become one of the many agents that make up the very markets we are measuring. Readers and their actions will be measured along with all the others.
Here is the evidence. You decide.
When the 90-day T-bill trades at zero interest it is measuring something. It does that on the same day that the two commercial banks used by Cumberland Advisors for our firm’s own deposits are paying us over 3% on our cash. Both of those yields are backed by the United States of America. The risk of loss is equally nonexistent. So why are they so different? Because they are measuring two different things: zero interest on US government Treasury obligations is driven by one set of investors; 3% interest is driven by a different set. Each is measuring a unique subset of cash and cash equivalent yields. Market measure; they do not forecast.
You can loan your money to the United States of America for 30 years at 3% and that is a taxable instrument. You can loan your money to a high-grade state credit and get 6% (in some jurisdictions we are getting clients as much as 7%). The tax-free yield on long duration in the United States is double the taxable Treasury yield. Markets are measuring the psychology of fear. They are not forecasting that all states and local governments are going to default.
Those who do not accept this principle that markets measure are doomed to lose sleep trying to understand behavioral malfunction in the realm of sentiment. In dysfunctional market periods like the present one it is critically important to sort through this issue. Each investor has to determine what they are missing when they see an anomaly. Understanding what the market is measuring helps clear up the puzzle. Remembering that markets are measuring and not forecasting maintains the balance while the puzzle is being solved. Here are more examples.
The credit default swap on the State of California is priced higher than the credit default swap on the country of Turkey. Does anyone really believe that the US is more likely to default than Turkey? No disrespect for the Turks is intended. Maybe if California Governor Schwarzenegger had the Turkish parliament instead of his legislature, he would have a budget passed and his credit default swap would be priced differently.
The credit default swap price for the United States is higher than the credit default swap price for Campbell Soup. No disrespect to Campbell Soup. I like it on a cold winter day. But I think the US has a better chance of paying its debt than the soup maker. And both of them use the US dollar to make the payments. Campbell makes soup; I own some cans of it and bought it with my dollars. The US government makes those dollars and has unlimited dollar productive capacity and negligible cost of production or materials.
Markets measure; they don’t forecast. If they were forecasting, they would be saying that Turkey soup is more likely to pay the dollars it owes than is US Treasury and the US’ largest state.
Ok. Let’s sum this up as we approach 2009. We believe the economy will bottom in 2009 and the bottoming will be in the data during the second half of the year. We believe that the stimulus combination of massive fiscal and massive monetary will work. And we are applying that assumption in our portfolio management.
Clients who do not agree with us have asked us to take a more cautious view, and we do so for them. We are a manager of separate accounts. We are not a common fund. Our job is to meet the client’s objectives and not impose our will on the client. If the client asks, we offer what we think is our best guess of the future. If the client wants to be riskless and in US government credit only, we do it.
That said, we are recommending to our clients that they use an asset allocation of 50% stocks and 50% bonds. Cash is at zero. Remember that the classic efficient frontier is 70% stocks and 30% bonds. So we are 20 points under on the stocks side and 20 points over on the bond side. The reason is that bonds are soooooo cheap that they warrant overweight.
Both sides in this 50-50 stock-bond mix are fully invested. On the stock side we only use exchange-traded funds (ETF). We do this domestically in the US, and we do this abroad. And we do this in other asset classes like currencies and commodities and precious metals.
On the bond side we are emphasizing high-grade credits. The junk bond market is very cheap, but it requires a special set of skills and we do not apply them at Cumberland. Clients who use junk bond allocations are using other managers. We are in investment-grade bonds only, whether taxable or tax-free. On that note, our clients are also fully invested and favor longer duration.
As this financial turmoil period enters its third year in 2009, we expect the various sectors to heal and the spreads to narrow. This will occur piecemeal. We already see it in some areas. The results of the application of stimulus by the Fed will be seen sector by sector and will have its own accelerator. Investors who wait until the air has cleared are taking no risk, but they are also not going to get a reward.
Right now markets are measuring extremes in risk aversion by investors. That explains high cash balances and zero-interest T-bills. As each market clears it will gap to another level. It will not trade there calmly and slowly. The lesson to be learned from high-volatility measures like the VIX is that markets can gap. When they do so, an investor sitting on the sidelines has very little chance of getting in. The most money is made in markets when measures of risk aversion are extremely high and then markets turn.
Remember, when you see a parabolic curve you have no way to know when it will stop and turn. You can only learn that after the fact. Most markets today are showing us this parabolic formation. They are measuring extremes at several standard deviations from mean and at record levels, levels that have never been seen before.
I know this statement is redundant; I repeat it for good reason: Market spreads and risk indicators are at levels never seen before. They are measuring, not forecasting.
2009 may just work out to be a good year. 2010 may be even more robust. At Cumberland we want to be in it, not out. Stay tuned.
David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok -at- cumber.com
Cumberland Advisors supervises approximately $1 billion in separate account assets for individuals, institutions, retirement plans, government entities, and cash management portfolios. Cumberland manages portfolios for clients in 42 states, the District of Columbia, and in countries outside the U.S. Cumberland Advisors is an SEC registered investment adviser. For further information about Cumberland Advisors, please visit our website at www.cumber.com.
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