Being in the Sweet Spot (twice)

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).


Being in the Sweet Spot (twice)
July 29, 2009

At the moment we are in the “sweet spot” in markets and soon, in Maine. We must enjoy it while it lasts. Some bullets follow.

1. Fed policy is on hold at Quantitative Easing (QE), which means short-term interest rates near zero and plenty of liquidity in the financial system. The Fed has said it will continue this posture for a period of time. Markets do not expect any change until well in to 2010 at the earliest.

2. The much-feared Obama healthcare initiative seems to be stalled. Markets are relieved, because this initiative, as it was presented, amounted to a huge transfer payment that would be funded by future tax increases. The tax hikes would come on top of those already discounted by markets. Lifting the double tax whammy has given stocks a boost.

3. Foreigners are buying US Treasury securities again, and that has quieted the fearmongers who have been crying that the US will be abandoned and the dollar will face a crisis. That may still occur, but the day of reckoning for our fiscal profligacy seems to be postponed. Markets like dodging this bullet.

4. Markets have not priced in any risk premium on the Bernanke-stays or Bernanke-goes debate. Markets are also not pricing any risk premium on how and when the Fed will exit the QE strategy. Right or wrong, markets are now powered higher by bullish momentum coupled with positive economic signs. The Fed and other central banks in the world are on hold. Markets like stasis and have it for the time being.

5. Markets are not pricing any substantial inflation risk in the near term. TIPS yields are a market-driven indicator of this measure. Longer-term inflation risk is priced higher, but it is derived from forward rates and is subject to change as conditions unfold. That means it is not impacting short-term market movements.

In our view the biggest news this week will arrive on Friday. There will be an advance estimate of second-quarter GDP. But that is not what I mean. In fact, that estimate has little meaning to money managers, and markets are likely to ignore it as old news.

The really big news will be the revisions in the benchmark national income and product accounts. These are revisions done infrequently and substantively. They are the basis for much of the work done by analysts and economists. These numbers are critical to the development of national policy and to the longer-term valuation of financial markets.

We do not know what the release will say, of course, but we do have some expectations. We think the revised savings rate will be higher than the currently computed series. If so, that will give the markets some comfort. The newly revised numbers will also help in the projection of a longer-term growth rate for the United States, and they will give guidance on inflation and productivity. We believe that the forthcoming revisions will be positive on both counts.

If we are correct, the revisions will become an economic data platform that will support arguments for a higher movement of stock prices. The upward trend that has been powerfully active since March 9 will continue. In Cumberland’s ETF accounts, we are fully invested and have taken our target for the SP 500 index to over 1100 by the early part of 2010. Our global ETF accounts are similarly positioned.

Our managed bond accounts continue to favor spread positions over Treasuries. That is true for tax-free municipal bonds, which are very cheap for individual investors, and also taxable securities. We are placing a lot of emphasis on Build America Bonds. We caution investors to do the homework on each issue and to understand the cash flows that secure these bonds.

We continue to expand our use of certain ETFs that offer protection from interest-rate risk in accounts that are large enough to justify their use. These securities can lower the overall risk profile of an account when they are properly used. We note that many retail investors are trading these securities, and we caution that they may be doing something they do not really understand. Duration matching against a parallel yield-curve shift is a complex task. It takes a lot of effort on our part to do it. Folks who are doing so without fully understanding how these securities work travel at their own peril.

Next week is very busy, so Cumberland market missives may be in short supply. Bob Eisenbeis, Bill Witherell, and I will be presenting at the National Business Economic Issues Council (NBEIC) meeting in Samoset, Maine on Tuesday and Wednesday. This is a closed meeting that operates under Chatham House Rule, so no information will be published about it without specific permission of a presenter.

At the end of next week, Peter Demirali and John Mousseau will join us at another sweet spot, in the village of Grand Lake Stream, Maine at Leen’s Lodge for the annual Shadow Fed fishing retreat (nicknamed Camp Kotok by Becky Quick). CNBC will be broadcasting live on Friday, August 7, starting very early in the morning and running for much of the day. We are 34 attendees, plus Steve Liesman, Matt Greco (a Squawk Box producer), and the CNBC crew. The attendees are by invitation only and have traveled from as far east as Abu Dhabi to as far west as Vancouver and Newport Beach and from as far south as Dallas. We have booked the entire camp and will be testing its capacity.

David R. Kotok, Chairman and Chief Investment Officer, email:

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