Delusions of optimism

The cover of this week’s Barron’s refers to an article on page 7 with the tease, “Bullish news: Fear is rampant.” The author, Jonathan Laing, cites a report put out by James Paulsen, Wells Capital Management’s strategist and long-time talking head on CNBC:

Also bullish is the fact that investor sentiment is in the dumpster. [Paulsen] calls it “dominance of doubt.” Investors put little trust in bullish developments such as the much-maligned economic green shoots, the sharp narrowing in the yields of all manner of fixed-income instruments over Treasuries, or even corporations reporting better-than-anticipated earnings. This psychology could lead to huge upside price potential in stocks once the bears become converted, he argues.

Leaving aside Paulsen’s credentials as a perma-bull who failed to see the greatest economic crisis since the Great Depression coming, the evidence of bearishness appears thin. For starters, Newsweek declared on the cover of a recent issue, “The Recession is Over!” The “VIX,” a measure of expected volatility (referred to as the “fear gauge”) hit a low of 23.09 on July 24. This was the lowest reading since September 8, 2008 when the S&P 500 stood at 1268, right before plunging 37% in 2 1/2 months. The Investors Intelligence poll, which showed 47.2% of newsletter advisers bearish in early March, is now down to just 26.4% bears. Similarly, the Consensus Inc. survey showed just 18% bulls at the March low vs. 51% today.

Our favorite sentiment indicator is still the asset mix of Rydex bull and bear funds. Currently just 26.4% of the assets in these “directional” funds are betting on the downside. At the height of the credit bubble the lowest bearishness reading was 30.8% on October 31, 2007. At the time the S&P 500 stood at 1549; yesterday’s close was 1006. For perspective, at the March 9, 2009 bottom (S&P 500 at 677), 52.0% of the assets in Rydex’s timing funds were positioned for a further decline.

Contrary to the claims of the bulls, there is no “dominance of doubt,” just a preponderance of delusion.

Note: The Fund’s equity short position was 136% on September 8, 2008, 21% at the beginning of this year, 2% at the March 9 low, and 67% as of yesterday’s close.

Slope of Hope springs eternal

Hope springs eternal with regards to government attempts to re-create the bubble economy of 2003-2007. Since August 17, 2007, when the Bernanke Fed first began cutting rates, the bubbleonians have bought into every announced intervention. The lessons of the past 20 years were clear: when the Fed turns the lights green, put the pedal to the metal. When that advice failed, the Paulson Treasury came in with the message, “we have your back.” $700 billion blank checks for Wall Street? Buy stocks!

Three weeks ago, after 1 1/2 years of pumping massive doses of “liquidity” into a lifeless corpse, investors were beginning to accept that the plug would be pulled. Among the assets in Rydex bull and bear funds, 54% were betting on further declines. Then the patient’s finger twitched. The Fed hatched a scheme to buy long-term bonds with printed money (so-called “quantitative easing”) and Treasury announced a “public-private partnership” to buy toxic assets from zombie banks so they could lend again (with the taxpayer taking on 85% of the risk, of course). Investors, with visions of the Steven Seagal character in “Hard to Kill,” rallied the S&P 500 25% off its intraday low. At Rydex, just 39% of market timing assets are now in the bear camp. The Slope of Hope is on the mend.

In the Bearing Fund, we came into March with an equity position of 14% net short. On March 9, with the S&P at 677, we took that down to 2%. (See our post about the case for being market neutral.) As of yesterday, with the S&P at 832, we were net short over 16%.

The case for market neutrality

We are currently torn. The portraits of risk and opportunity, as viewed through the three lenses of economics, valuation, and sentiment, are unusually blurred. The economic landscape is ablaze, with government spraying gasoline through their various hoses of zero interest rates, bailouts, and stimulus. The valuation setting is tranquil and serene, with prices for high quality companies at some of the most enticing levels of the past two decades. The sentiment picture is in the grey area, with obvious signs of despair, yet still more room for panic, capitulation, and pitch black.

All in all, we believe a compelling case can be made for a market neutral position.

… more later.

End-of-year portfolio allocation

The case for optimism

Was this morning’s 200 point selloff the final capitulation, at least for the intermediate-term? No one knows, but we were buyers. What we do know is there are many great companies and valuable assets selling at the most reasonable prices we’ve seen since at least the mid-1990s.

There is a dichotomy taking place between long-term survivors and economic roadkill. In the latter column we find most of the “too big to fail” politically-connected financial sector. We remain short the “Chosen Ones” begging for a life preserver: Goldman Sachs, JPMorgan Chase, Citigroup, Bank of America, et al. We continue to mostly avoid consumer discretionary and luxury goods purveyors.

Our buy list has several characteristics:

• companies providing necessities, e.g. food and energy
• resource-based companies
• solid balance sheets, high cash levels
• high barriers to entry
• ability to remain profitable and perhaps even grow in a difficult environment
• providers of value-oriented products, e.g. discount retailers
• global consumer brands
• cheap valuations, high margin of safety

Besides cheap valuations, a second reason for optimism is that the political class is feeling real pain, despite fleecing the taxpayer to cover its gambling debts. Citigroup stock broke $5 today, down from a high of $55. Saudi Prince Alwaleed is buying the dip. The self-professed “Warren Buffett of the Middle East” is in denial. His beloved Citigroup, the foundation of his reputation, is insolvent. Our hope is that the curtain is finally being pulled back on these “Masters of the Universe.” What happens to the “Goldman effect,” where every key cabinet position goes to a former employee of Goldman, if the company turns into Enron times 100? Without question this would be bullish long-term for the country.

Of course, the case for pessimism remains: decades of fiat money, moral hazard, and social engineering created an epic mess, made worse by government hampering the healthy corrective process. The financial elites have done irreparable damage to the economy, yet the public continues to allow them to operate their wrecking ball… at least for now.

The chess game continues…

Since we began maintaining this blog 14 months ago, we’ve focused on three themes:

1. Government intervention is toxic.
2. Intervention is driven by the schemers and dreamers. The schemers – political capitalists like the big banks and investment banks – leverage themselves to perpetual asset inflation. As their bet turns sour, friends in high places intervene on their behalf.
3. This intervention, unlike the experience of the past 20 years, does not reflate the asset balloon. In fact, it is utterly doomed to failure. (Note: The Fed has expanded its balance sheet by $637 billion, or 74%, the past 12 months, yet residential real estate lost roughly $4 trillion in value and the stock market shed over $6 trillion.)

This Greek tragedy has unfolded in several phases.

• Phase 1: An epic credit bubble begins to burst.
• Phase 2: Speculators refuse to leave the casino, emboldened by government attempts to keep the party going. They simply move from the financial craps table to emerging market poker and commodity roulette.
• Phase 3: Speculators go into full blown panic mode as they realize all the monetary tea in China can not save them. The overextended are taken out of the casino in bodybags while their facilitators counterfeit wager chips on a massive scale.

As we move well into Phase 3, what is the appropriate strategy for protecting wealth? On the one hand, every multi-billion dollar intervention is like sticking a needle into a voodoo doll of the economy. On the other hand, inflation hedges are on sale. For example:

• The 30-year T-bond yields 3.97% and the Bullish Consensus is up to 69%. We remain short and shorting rallies.
• Gold briefly dropped below $700/oz. today, more than 30% below highs set last March. We own and continue to buy physical gold held in the vault of the oldest private bank in Switzerland.
• Gold stocks (as measured by the “XAU“) are 67% below their highs. We hold a significant stake (roughly 11%) and continue to buy on weakness.
• Commodity-related stocks have been decimated with fertilizer stocks more than 70% off their June highs, the Natural Gas Index (XNG) 49% off its peak, and the Oil Index (XOI) 48% below its top. Even with crude oil cut in half to below $70/bbl, oil and gas stocks reflect significantly lower prices. We have built a significant position in ag/energy (roughly 9% in fertilizer, seeds, coal, oil and gas, uranium) while hedging somewhat with crude oil (1.7%) and grain shorts (1.5%). We are avoiding more economically-sensitive commodities and remain short copper (0.8%).

In order to hedge against our current economic swan dive trajectory, we remain short the credit sector, commercial real estate, and the broad market (though we’ve been covering on weakness).

The difference between gold and commodities

We are having a hard time understanding the recent hand-wringing over gold. Since July 11 its price is down just 14.8% in dollar terms (currently $818.60/oz. on the Dec. futures contract), this after a 3.7-fold rise over a 7 ½ year bull market. During the past 2 months gold has also lost 9.3% of its purchasing power vs. the S&P 500 and 4.6% against the euro. However, gold now buys 3.8% more copper, 9.0% more corn, 32.3% more crude oil, 44.0% more silver, and 58.6% more platinum.

We were actually expecting a correction in gold and were underweight 2 months ago. Since that time the case for gold has clearly improved with the lower price and better fundamentals (i.e., massive bailouts moving us closer to the day of running the printing presses flat out). We now have our gold/gold stock weighting back up to about 19%, and expect to take this higher.

Commodities are a different animal, its inflation-hedge credentials questionable heading into a global recession/depression. That said, we actually did some nibbling in the food/fuel area yesterday on the weak open (in part because there has been a bit of capitulation by some commodity bulls like Ken Heebner). Over the long haul, we’d prefer to own the businesses instead of the actual commodities. Michael Aronstein stated the rationale against owning physical commodities very well a few weeks ago:

“The whole cycle that began around the turn of this century ended. Human ingenuity creates productivity, and the real price of almost everything that’s extracted or manufactured goes down over time. That’s the nature of human progress.”

This is not to say commodity-related businesses can not do well in a declining price environment; witness Dell Computer in the 1990s. They just don’t prosper in a weak economy. As for industrial commodities, we’ll relegate these to the penalty box at least until the global malaise is constant front page news.

Commodity boom meets demand destruction

Apparently, even the 7-year commodity boom is not immune to the laws of supply and demand…

Gold
According to the World Gold Council, total demand for gold dropped 19% in the second quarter from a year ago to 735.6 tonnes. Jewelry demand was particularly sensitive to higher gold prices, with the greatest declines coming from India (down 47% to 118 tonnes) and the U.S. (down 30% to 33 tonnes).

Crude Oil
According to the Department of Transportation, Americans drove 12.2 billion fewer miles in June 2008 than in June 2007, a decline of 4.7%. “Since last November, Americans have driven 53.2 billion miles less than they did over the same period a year earlier – topping the 1970s’ total decline of 49.3 billion miles.”

Recession
Finally, in a bearish article on gold, silver and commodities on LewRockwell.com, Gary North states the obvious: commodity demand does not fare well in consumer-led recessions.

If we are talking economic fundamentals, gold and silver have had their big run. From now on and for months ahead, the pressure will be downward. Why is this the case? Because the recession is real. If the rest of the world moves into recession, as I think is likely, the demand for commodities will fall. The value of commodities has nothing to do with value in themselves. They are valuable only because the consumer goods that commodities are used to produce are expected to rise in price.

Strategy
The Bearing Fund has traditionally held a significant long position in gold and gold mining equities, as well as a small long position in commodities. As of July 31, the fund held its smallest position ever in gold (6.15%) and gold stocks (11.35%), and its largest short position ever in commodities (15.31%) which is comprised of crude oil, grains, and copper. We have, however, been slowly adding to our holdings in physical gold and gold shares on recent weakness.

Dipping a toe in the water on the long side

Despite the 7% decline in the S&P 500 year-to-date and double digit gains in the fund, we have managed to judiciously increase the equity long position (excluding mining stocks) from 14.15% to 15.62%. Breakdown by by market sector:

• Capital goods: 0.45%
• Consumer goods: 1.79%
• Defensive: 0.67%
• Energy: 0.44%
• Financial: 0.39%
• Food & agriculture: 3.22%
• Health care: 4.24%
• Real estate: 1.00%
• Technology: 2.15%
• Transportation: 1.27%

For the first time in a long time we are beginning to find value, particularly among biotechnology and pharmaceutical stocks. Our gold & silver mining weighting has dropped slightly from 16.71% to 16.31%.

Entering what we believe will be a brutal economic environment, we are focused on several themes on the long side:

• cash-rich companies
• health care (especially established biotech and Big Pharma)
• consumer staples (including companies hurt by high commodity prices, such as poultry producers)
• consumer discretionary companies that do business primarily in the Oil Patch and Farm Belt
• companies whose businesses should hold up reasonbly well or benefit from a recession (e.g. discounters, bankruptcy specialists, teen retailers)
• companies with long-lived tangible assets in depressed areas (e.g. timberland)
• deep value stocks in Japan
• fallen growth stocks
• broken private equity deals