Tis’ the Season
Greetings and Happy New Year,
With the passing of another year, ‘Tis the season of analyst forecasts that come in all shapes and sizes. Although at DCM we do not spend a ton of time making forecasts, we’ll go ahead and take a crack at it in the spirit of a new year. As has been the case for many years now, the driver of not only the US, but indeed the World economy has been the actions and inactions of central banks. Thus, the center of our thesis will revolve around what we expect central banks around the world to do.
For some banks they have reached the end-game as far as interest rate policy is concerned. Both Swiss and German banks now charge for the privilege of letting them hold your money. That’s no typo! Germany will charge you 1/5th of a percent to borrow your money for two years, while Swiss 2-year bonds will cost you 82 basis points. Such craziness begs the question of just how much people are willing to pay to own Swiss debt? That’s a forecast far beyond my pay grade, as I personally can’t imagine a world in which I’d pay a government to hold my money.
What I do know is that with interest rate policy not providing the necessary support to thwart the dreaded deflationary pressures faced by the Eurozone & others, the ECB has decided to up the ante through a 1.3 trillion dollar QE program. I’d say it’s fairly safe to wager that rates in Europe are likely remain steady to lower for some time to come.
In our last quarterly update we covered the deranged Japanese QE program, which simply purchases Equity ETF’s of the “right” companies, deemed to stimulate the Japanese economy. I certainly would not want to be a Japanese company on the outside looking in. Their counterparts from down-under just reduced their rates this month, accelerating the losses already incurred by the Australian Dollar. Even China joined the fun as well, announcing in November a 50 basis point cut that will go into effect Feb 5th.
Who appears to be the one outlier in this widespread trend of easing monetary policy you ask? The United States. The US remains the one nation that seems poised to raise rates. It seems every time you turn on any business channel you’re bound to hear one or many talking heads forecasting, when, why and how much the US rate hikes will be. Most forecasts, we believe, are far too aggressive. Even if the Fed were simply judging US economic growth, it’s far too anemic to warrant aggressive rate hikes. Throw in the Global struggles and we find it exceedingly unlikely that the Fed rate hikes will be persistent or substantial. Rather, we’d expect a Q2 announcement of 25-50 basis points in Q3, followed by a sustained period of inactivity.
Unfortunately, the Fed may be getting pushed in a corner with respect to their policy as the world seems to be accelerating the various currency wars taking place. It’s beginning to seem that each country is trying to outdo the last in a race to devalue their money. If the Fed is too aggressive it could come at a very high cost with regards to competitiveness.
I suppose the real question is whether all of the world racing to the bottom will actually be productive? Will each central banks’ theoretical models accurately reflect reality? Such a high stakes game has never been played before. At DCM we tend to believe that the real winner of the QE fad, has been the US. The others are late to the game and as such their efforts to stimulate their respective economies will be watered down at best. Remember this is indeed a global economy we live in. Therefore, much like with any innovation, the first to market usually is rewarded with the most prosperity.
A popular idea floating around Wall Street right now is that we are nearing a time when the return on an Investment; equity, bond, real estate or otherwise will begin to stagnate. Many believe this will lead to the persistent deflation that every Central Banker has nightmares of. Well, I certainly agree with a portion of that premise. Without going into all of the details, a driver or perhaps even THE driver of expected return on investment is the risk free rate. You shrink that down small enough for long enough and it begins to have a substantial influence on your expected return. Let me explain.
We are in a time when rates have been so low for so long, that valuations of literally almost everything that’s not a commodity, are stretched. Just throw darts at asset classes and you’ll see it. For example, the S&P 500 is trading at 2050 when it was 700 only a few short years ago. Treasuries are at all-time highs, Swiss bonds demanding nearly -1% for 2-years of “safety.” How’s real estate in your area? Chances are it’s a heck of a lot higher than it was a few years ago. If you live near me, it’s probably 10-20x the average family’s income to own a single family home.
Perhaps you can see where I’m going with this. Even if you earn income on your investment, there is still SUBSTANTIAL price risk. Price risk driven by lower interest rates and all of the QE policies being implemented around the world. Thus it’s possible that even with all of the money printing in the World, these poor bankers won’t stimulate the economic or wage growth they treasure so dearly. Why? Eventually the price risk substantially outweighs any income that can be earned from the investment. Obviously that level is different for everyone and in an investment environment driven by mandates far more than risk management principles, who knows where that level lies.
Said in simpler terms, when you have portfolio managers with Billions in AUM, who have orders to allocate cash, they will allocate that cash, blindly if need be. This fuels maniacal buying as well as selling when it all comes unraveled. Make no mistake, it’s not a matter of if, but when the unraveling comes. With that thought in mind, I’m going to do something I don’t do a lot of; prognosticate again. We are in the camp of risk beginning to outweigh reward. Although we could see prices easily expanding to all-time highs and quickly, we believe the writing is on the wall so to speak. There are structural cracks in this market indeed.
At some point over the next 24 months, we fully expect a 15-25% correction in US equities, most likely to the pre-crisis highs. Rather than focusing on this negative outlook, we suggest focusing on how to manage your risk. We make this suggestion because we feel prognostication is like procrastination, which is like… well you get the point. Risk management needs to be at the forefront of any equity investments going forward as there is no value in knowing where markets are headed if you can’t profit from that knowledge. We are of the opinion that we are about to enter a time where the managers who can truly deliver Alpha earn their keep.
We have maintained our Russell ETF shorts and traded in and out rather successfully over the past several months. In addition, we have recently and successfully engaged in outright shorts of the S&P 500 with dynamic option hedges to reduce or under the right circumstances, even eliminate upside risk. We will continue to work our short-side bias with options to protect us, just in case we are in fact early. It certainly wouldn’t be the first time. Fortunately, as DCM’s VP Dave Jeffers recently mentioned “the worse our entry, the better we tend to do.” Confusing I must admit, even Dave followed that statement with it seemed “somewhat bass-ackwards.” With that said, the one thing we don’t want to see at DCM is a stagnant market, which seems unlikely to us.
As some of you know, a portion of our portfolio is tied up in long-only positions. So how do we manage that with a bearish bias now in place? Similar to our short thesis, we hedge ourselves with options to the downside and write options near expiration, at or near the money. The recent spike in volatility has been a boon for anyone writing near the money options (35 handles for at the money calls with 2 ½ weeks). Just in case the market decides to take off we have a fairly substantial upside long call position, which would make up for our nearly neutral positioning otherwise. This portion of our portfolio was positive in January with the broader averages down in excess of 2.5% for reference. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS
Speaking of performance, our flagship fund as of the date of this letter is sitting firmly at equity highs. Our recent success is in large part fueled by our counter-trend oil longs using the aforementioned dynamic option methods. It wasn’t much but the 2-day crude oil pop in January was enough to drive a large chunk of the gains we had recently. Interestingly, even though our long-term bias was long, our algorithms were able to catch a good chunk of the activity from the short-side over the past 30 days.
From a longer-term perspective, we are still somewhat unsure of what the end game is for the Global Economy. We still hold to our belief that math simply dictates that all of the money sloshing around will lead to inflationary pressures. But what if the inflation isn’t where the Central Bankers want to see it? I mean asset inflation has already occurred, but is paper inflation what they have been shooting for this whole time? I’d say no, that real growth and innovation as we mentioned over a year ago now, are the goals. Goals whose likelihood of success is starting to come into question. Perhaps, there is a real possibility of Stagflation? With that outlook, we reiterate our stance from last quarter:
- Reduce Equity exposure especially on overbought conditions or have down-side hedges, including outright short positions as hedges or as a dominant theme. Be prepared for substantially lower returns going forward.
- Maintain fixed income exposure of 3-5 years.
- Maintain exposure to income producing commodities & assets that provide inflation hedges.
In closing, I’d like to refer to poker again. I feel as though judging a manager on their ability to forecast the markets is like judging the professional poker player on their ability to forecast cards. Even if great at guessing the cards, you still have to know how to manage risk and wager correctly. Indeed, there are many managers who consistently have sound theses, yet bafflingly lose money for their clients. A casino is successful by only taking bets that have a favorable outcome. At DCM, we make diligent efforts to do the same, long, short or neutral.