How big? How low? How now brown cow?

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, including Morning Call, Power Lunch, Kudlow & Company, Squawk on the Street, Squawk Box Asia, and Worldwide Exchange. 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).


How big? How low? How now brown cow?
December 1, 2008, David Kotok, Chairman & Chief Investment Officer

“How low can things go?” Or “How bad can things get?” We keep getting these questions from clients and consultants. Let’s look at a few items.

Interest Rates. Our metaphor is World War 2. During that period the Federal Reserve kept the 90-day T-bill rate at 3/8 of 1%. The long term US Treasury bond yielded 2%. The Fed actually placed unlimited bids and bought whatever was offered by the Treasury or the market at those yields. This enabled the US government to finance the war. So the answer to the question is that we could see these rates again if the Fed deems it necessary.

Cumberland’s outlook. The short term Treasury rates are already at or near the bottom with yields between zero and 1%. They cannot go much lower. The longer term Treasury note and bond rates could be forced lower if the Fed buys them without any limitation. The Fed can also facilitate this indirectly because it is engaged in global swaps from its balance sheet so that the actual buyers may be foreign official entities and the Fed would be transacting on their behalf. All interest rates worldwide are headed down or will be flat.

Cumberland’s strategy. We are avoiding positions in Treasury bills, notes and bonds. We are buying inflation indexed treasuries (TIPS). Care must be used in this sector since there is a risk of a negative accrual if the Consumer Price Index declines for an extended period of time. So far the CPI has shown negative response mostly due to falling gasoline. That is a one time adjustment. Watch Owners Equivalent Rent (OER) for clues revealing a prolonged declining trend.

Unemployment Rate. We are in a stiff recession but will not get to a Great Depression level. In the 1930s one out of four workers was unemployed at the bottom. That is NOT the metaphor for today.

Cumberland’s outlook. This coming Friday we will see the UR get close to 7%. In Europe in the euro zone countries we expect it to be close to 8%. In both of these large global economies the UR is likely to rise for the next year with an 8% peak in the US and a 9% peak in Europe.

Cumberland’s strategy. UR is a lagging indicator. It usually peaks after the recession has reached its bottom and during the beginning of the recovery. We are underweighting the consumer discretionary sector that is impacted by a rising UR. This also means the housing recovery will be tepid in the beginning. We continue to underweight that sector as we have for the last several years.

Credit markets. This has been the key element in triggering the serious degree of recession we face. Credit spreads are wider than historical norms by a wide margin. The deteriorating events occurred over the year and a half starting in summer of 2007. In the first period we witnessed firm specific events like Countrywide, IndyMac, Bear Stearns or Fannie & Freddie. In mid-September Lehman Brothers failed and that triggered the second and vicious leg down. Post-Lehman spreads reached levels where entire sectors were frozen. The Lehman-triggered contagion was a global catastrophic effect which lasted from Mid-September into November. In six weeks the worldwide destruction of wealth was about 25% of total global stock market value. Bond yields soared except for Treasury debt. Marked-to-market losses for investment grade bonds were about 10% in only a few weeks.

Cumberland outlook. In the US the Fed is determined to break the freeze and force credit spreads to narrow. The use of the Fed’s balance sheet has no historical metaphor. See for our weekly graphic update and explanation. As each sector in the bond market resumes functionality, the price changes are seen in a gapping way. An example is in the tax-free municipal market where price changes from their worst to present are often as much as 10% in a matter of weeks. There are few capital market firms supporting these markets. That means trading ranges on bonds are exceptionally wide. Pricing references by matrix-based services are highly suspect at this time. These services offer a single point estimate of each bond’s market value. In fact the actual trading range of that bond may often be several points higher or lower.

Cumberland’s strategy. We are now very aggressive and active in the managed bond accounts and are seizing the trading opportunities which abound. This is the time to be a buyer of bonds. Care must be exercised and research done on each bond to be sure of the credit quality and of the structural internals. The days of complacency about bonds and reliance on bond insurers or credit rating agencies are long over.

Stock markets. From its October 2007 peak to the October-November lows the stock markets of the world have lost half their market value. This occurred in a highly correlated way after the demise of Lehman. Only recently has the correlation of world market declines started to diminish from its peak and then only in part. The market showed signs of a selling climax on October 10, 2008. It has retested those lows and broken through them in the pre-Thanksgiving selloff. The market rebound in the face of bad news suggests that the market bottom has occurred. Of course, that will not be clear until many months from now. US GDP is contracting now and the profit share of that GDP is falling. This is a world wide phenomenon and not just in the US. That means reported earnings of companies will be poor for the next few quarters. Stock’s aggregate value is well below one year’s GDP. This level is usually a strategic buying opportunity which is rare in history.

Cumberland’s outlook and strategy. We believe the market has an upward bias through yearend. Stocks are a discounting vehicle and they are looking for signs that there will be an economic recovery beginning in 2009 and accelerating in 2010. So far those signs are not evident nor should they be expected to be visible now. Stocks will lead them. We believe that the amount of stimulus in the federal pipeline in both monetary and fiscal form will encourage the 2009 forecast to become reality. With confidence rising rather than falling the 2010 recovery could be surprisingly robust. That is our outlook. We do not believe a protracted period of deflation over the next 3-5 years is in our future. Stock market accounts using only exchange-traded funds (ETF) are moving to a fully invested position and most of that buying has already occurred.

Asset allocation. Traditional efficient frontier, longer-term allocation models divide about 70% stocks and 30% bonds. Cash reserves in longer term models are usually quite low. These models failed during the last year and half as markets in both stocks and bonds punished investors. In the post-Lehman contagion only cash and Treasury debt had a positive return. Fear-induced panic prevailed. The amount of cash available for investment and sitting on the sidelines today is variously estimated at between 40% and 50% of the total stock market value. This is the highest level in history.

Cumberland’s strategy. We have committed cash to markets and taken the level of cash to the lowest that a specific account requires. Cash is now earning next to zero. Our asset allocation is 50% stocks and 50% bonds. Stocks are much lower than our normal range and bonds much higher. The wide credit spreads are the reason. In many jurisdictions the taxable equivalent yield of high grade tax-free municipal bonds is close to 10%. And that is based on present tax rates and does not include any estimate for higher tax rates in the future. Remember the higher the tax rates the greater the value of tax-free Munis. Our taxable fixed income accounts are invested at very wide spreads to treasuries. Our conclusion is that bonds are offering unusually high yields and have the potential for capital gains as well as the interest income as the credit markets unfreeze and the Fed’s determined stimulative policy approach succeeds. We believe the Fed will succeed and credit spreads will narrow.

No Great depression. Those who disagree with us argue that we will see a protracted period of deflation and that markets are headed much lower. Some even predict a modern version repetition of the Great Depression era. If they are right, the stock markets will be much lower and the only debt to own is treasury debt. If they are correct, there will be massive dislocation and many bankruptcies. If they are right, there are no safe assert classes other than direct obligations of the government.

We disagree with this Great Depression outlook for two reasons. During the 1930s the world turned to protectionism and the amount of global business contracted immensely. Today, governments and policy makers worldwide have committed themselves not to repeat that history.

Also, during the Depression the central bank contracted money and credit. Bank failures resulted in huge losses to depositors. Their money disappeared. Our Federal Reserve and federal agencies like the FDIC are committed to liquidity and preservation of the system. During the Depression the first large failure (Bank of the United States in December, 1930) intensified bad policy.

Today the failure of Lehman and subsequent global contagion jolted the Federal Reserve and the federal agency response into proactive results. In the Depression it took until 1933 and the election of Roosevelt to get a policy change. In 2008, it took only a few weeks after Lehman for the federal authorities to radically alter course in favor of massive and unprecedented stimulus.

“Aren’t you worried about all this debt and future inflation?” We are often asked this question. The answer is not now. For the immediate future the issue is narrowing credit spreads, offsetting the credit contraction, stimulating the economy and liquefying markets. Inflation and debt loads will be an issue down the road. Investors who focus on them now are acting too far in advance of their arrival.

In sum, the economic outlook seems bleak and foreboding. Stocks usually bottom when things appear to be only negative. Credit spreads are usually at their widest when that occurs. The sequence of restoration is usually credit markets first and then stocks. We are seeing the first signs of the credit contraction being unwound. Stocks will follow. In the yearend 2008, year-start 2009 market recovery, we believe this sequence will happen much faster than in previous cycles just as the post-Lehman contagion occurred with rapidity. Investors who are not in the markets may not have much opportunity to get in without chasing it higher. We believe “gapping” may be the key word to describe what lies ahead.

-David Kotok, Chairman & Chief Investment Officer


Cumberland Advisors is registered with the SEC under the Investment Advisors Act of 1940. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services. Such an offer can only be made in states and/or international jurisdictions where Cumberland Advisors is either registered or is a Notice Filer or where an exemption from such registration or filing is available. New accounts will not be accepted unless and until all local regulations have been satisfied. This presentation does not purport to be a complete description of our performance or investment services.

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