Issue 65- September 28, 2010


Progress in the Absence of Milestones

The Federal Reserve meeting on September 21st formally stated that they are on standby for further easing.

“The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.”

They noted that over the course of the summer, the pace of the recovery had slowed.

"Information received since the Federal Open Market Committee met in August indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts are at a depressed level. Bank lending has continued to contract, but at a reduced rate in recent months.”

As recently as this spring the Federal Reserve was asked to testify about how they would drain liquidity from the system thereby implicitly tightening credit for an economy that would be rebounding. We noted at the time, these economic bulls were being delusional given the rates of unemployment (high) and capacity utilization (low) and the condition of the banking system (poor). We also noted that enough intellectual dishonesty could be as debilitating as actually economic weakness.

Perhaps now that the Federal Reserve has publically stated what many were already thinking, we can begin moving forward. The Financial Times of London has deemed this episode as the Great Disappointment. However the latest news is only a revelation to those with sales sponsored blinders on. Green shoot exuberance has given way to double dip pessimism. But this is a disservice. The economy does continue to plod forward and the healing process is now well underway. To the extent the groundspeed is deemed inadequate by the Federal Reserve, we should not be surprised to see them act proactively in the absence of any absolute milestone. Support at this time would come under the heading of “Quantitative Easing 2” or “QE2”, where we would likely see the Federal Reserve buying longer dated US Treasuries in an effort to further flatten the yield curve. As we noted in our last newsletter, this is by no means a short term panacea, but rather a non traditional approach to rebuilding equity across a number of markets. It would be in keeping with the Federal Reserve’s message that this recovery is a very long term affair.

Changing Nature

Historically, our economy has experienced tremendous disruptive changes. Consider that prior to 1872 when the railroads met to create common timetables, we did not keep common time or use time zones. The telephone, wireless, light bulb, and diesel engine all followed shortly thereafter. It would be interesting to know if the good people of the late 19th century felt empowered or besieged by their new normal. As investors, recent episodes of creative destruction have been met with remarkable investing opportunities as well heartbreaking failures and reorganizations. The advent of the PC as well as the follow on of the internet was the death knell of more than a few mainframe manufacturers as well as traditional retailers. Even old Ma Bell had to reinvent herself! Fast forward to the present and just this month we saw the bankruptcy filing of Blockbuster Video, a company that came public a mere eleven years ago.

What distinguishes our current economy from those of our past is perhaps the confluence of our times. The changing nature of demand and consumption, coupled with the changing nature of how we work are all taking place within the backdrop of deleveraging and it is happening across multiple industries simultaneously. At present, there is neither any geography nor any particular industry that is not beset by overcapacity. Limited mobility brought on by the housing crisis is frequently cited as a rate limiting step for this recovery but in fact there is no Sun Belt construction industry waiting to absorb a generation of workers. The current level of technology driven productivity coursing through so many businesses simultaneously will no doubt pay handsome dividends to future generations as productivity has always done. In the short run, it is having both a therapeutic effect on businesses bottom lines and a deleterious effect on overall employment.

Correlations & Valuations

Even if we find ourselves in a new economic environment – dubbed the new normal by many, nobody repealed the simple rules of basic economic value.

Market participants of all stripes have been frustrated all year long by a variety of trends. Underperforming equity managers bemoan the fund flows into fixed income as unsustainable. Underperforming hedge fund managers have been citing the lack of trading volume as the source of their woe and underperforming Real Estate funds have been beset by so much money that they have been potentially overpaying for certain structures or have been forced to return capital to investors for lack of opportunities. In each of these cases, we have seen a much higher level of correlation between asset classes than what is normally found and which is indicative of a lack of discrimination and purchasing discipline.

There will always be periods of time when macro themes dominate market performance. There will also be periods when differing styles come in and out of favor. But the current wail that stock picking is a dead art form is simply misguided. How could earnings not matter? We are still picking through the rubble of the mortgage related securities that were manufactured and purchased by those who did no credit work. Now, it is deemed ok to do no company specific valuation analysis? Talk about unsustainable.

In 2009, we saw the strongest performance turned in across capitalizations by those companies with the weakest balance sheets. The thinking at that time was that a strong recovery was in the offing and speculative companies would be the biggest beneficiaries. Ok, that was 2009. Now we are in 2010 and it seems clear that those companies with the strongest balance sheets and organic growth will be highly advantaged over their weaker peers. Yet we are not seeing this play out in any meaningful way in terms of stock prices - yet.

This lack of discrimination is being blamed on the rise of high frequency trading and/or the rise of the multitude of exchange traded funds. The move in trading to more electronic exchanges might explain more of the absence of traditional sources of volume as opposed to the high correlations. If we consider what possible new players may have entered the markets recently that are relatively indifferent to valuation, one set of suspects rises to the top: the new and exotic exchange traded funds.

Synthetic Securities

Equity markets have not historically seen the same level of financial engineering that fixed income markets have enjoyed. Bond cash flows are well suited mathematically to be parsed and paid to differing entities over the life of any particular loan. Ownership structures, not so much. Rather, the emphasis in the equity world has been on providing access to professional management, increasing cost efficiencies, and access to hard to reach markets.

The rise of the mutual fund gave life to the original market sector index funds. More recently, these had been improved upon with the rise of the exchange traded index funds. These securities possess a number of structural advantages over their predecessor funds such as trading in real time and owning their own cost basis. Cost efficiencies remain high in both cases.

From here however, we have been off to the races. Investors, who for decades had been frustrated by their inability to speculate in commodities, were delighted to see the rise of the exchange traded funds in oil – recall the summer of 2007 where the index hit $147 before crashing to $36 – and now gold which races past all previous all time highs. Historically, regulators limited the amount of speculation that any commodity market might require for liquidity purposes. Now, the GLD exchange traded fund owns more gold than all the banks in Switzerland!

As money flows into these funds, they are required to put it to work immediately. These purchases are therefore indiscriminant in the sense that the underlying valuations are not particularly relevant. Furthermore, many of these funds are just proxies for their underlying collateral. They do not actually own all of the stocks, or bonds, or physical commodities in any particular index and the returns are not going to necessarily match the benchmark. This is what is known in the business as “tracking error”. Enhancements such as leverage and inverse correlation have driven tracking error to higher and higher levels.

If we consider all of these elements together: access to previously restricted markets, indiscriminant buying discipline, and leverage, we have a recipe to create at least short term valuation distortions across many markets.

The more investors move away from individual companies or portfolios of individual companies and into these synthetic products, the more distortions we are likely to see. This is not to say that all ETF’s are by their nature bad. In liquid markets, there are ETF providers that hold baskets of securities and maintain a rigorous process around replicating transparent benchmarks. The perversion occurs most blatantly in illiquid and commodity markets with leverage exacerbating the problem.

Markets have always enjoyed the blessings (and the curses) of financial innovation with some elements proving to be far more lasting than others. With these innovations we have seen certain excesses and dislocations but in no case did we really have a “this time it is different” experience. Valuations always ultimately matter. Companies with real managements, and with real boards, and with real measurable earnings will always be the bedrock of any market.

Best Wishes,

Patsy and Jen


In this Edition

  • Progress in the Absence of Milestones
  • Changing Nature
  • Correlations &Valuations
  • Synthetic Securities

Huntington Steele

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Suite 3700
Seattle, WA 98104



Past Issues

64 - 08.18.10
A Tricky Diagnosis/ Traditional Treatment/ Bad Medicine/ New Age Medicine/ Homeowners/ The Banks/ Pension Plans/ Bull Flattening

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln
/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward

58 - 12.29.09
2009-The Year in Review/ 2010 - The Year of "The Exit"/ Deflation or Inflation?/ 4 Cylinder Economy/ Rates and Returns

57 - 11.04.09
Banks-Back to the Future/ Navigating the Tsunami/ TARP 3.0/ Implications

56 - 09.15.09
Are We There Yet?/ The Beginning? The Present/ The Journey is the Destination

55 - 08.04.09
A Transformation is not a Recovery/Not All Economic Data is Created Equal/
Smallest, Lowest, "Shortest"

54 - 06.24.09
Aftershocks/ Fragility/
Inflation and the Fed

53 - 05.29.09
A Brave New Road to Recovery/ Vehicle Choice/ Speed Limits

52 - 04.07.09
The Things We Know/The Things We Don't Know/Savings and Sensibility

51 - 03.25.09
The Correct Problem/ The Need for Speed/ No Good Deed Goes Unpunished

50 - 03.05.09
Rebuilding Credit/ Under Repair/Problems Persist/Big Chore

49 - 01.12.09
The Year in Review/ The Path Forward/ 2009

48 - 12.15.08
An Old Fashioned Swindle/ Who,What, Why, & How/ The Lure/ Getting Back to Fundamentals

47 - 12.05.08
Unwinding/ The Past/ The Present/ The Future.

46 - 10.07.08
History/ Changing Hands/ Dominos/ The Road Block.

45 - 07.02.08
Black Gold/ The Federal Reserve, The Banks, & The Earnings/ Moving Forward/ The Recovery

44 - 06.03.08
Shallow Waters/ Odds and Evens/ Changing Times

43 - 04.09.08
Q1 2008/ The Call/ The Response/
Investing Opportunities

42 - 02.27.08
Credit Hangover/ Busy Banks and Brokers/ Insurance Cleanup
Risk vs Reward

41 - 01.02.08
2007-Year in Review
2008 - Outlook



More Past Issues
can be found in our

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Market Highlights

  09/27/10 06/30/10


12/31/09 12/31/08 12/31/07 12/29/06 12/30/05 12/31/04
DJIA US 10,812 9,774
S&P 500 US 1,142 1,031




Nasdaq US 2,370 2,109
EAFE Int'l Equity 1,567 1,348


5 Yr Treasury 1.31 1.80 2.55 2.71
5 Yr AAA Muni 1.23 1.7 1.80


10 Yr Treasury 2.56 2.96
10 Yr AAA Muni 2.54 3.09
30 Yr Treasury 3.73 3.9 4.71
30 Yr AAA Muni 4.12 4.43 4.46
EUR Currency 1.35 1.23 1.35
JPY Currency 84.22 88.77 93.42


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