Issue 85 - December 13, 2012


Giving Sausage a Bad Name

The ongoing debate on matters of Federal spending and entitlements has to date not elicited any meaningful progress. In fact, it is fair to say that the politicians may have done more damage by undermining both domestic and international confidence in the ability of the United States to address entrenched imbalances. IMF head, Christine Lagarde, recently warned US leaders that they would be their own worst enemies by failing to reach a settlement. The uncertainty is clearly paralyzing capital investment, hiring, and planning decisions. We have often spoken of the economy’s ability to deal with bad or disadvantageous news and its inability to deal with uncertainty. Furthermore, if the current episode is not resolved into a solution, the next chapter featuring the debt ceiling scheduled for February, will likely lead to all out political trench warfare. Needless to say, this would be bad for the economy and the markets.

There are, however, reasons for modest optimism and progress. The economy is currently running below trend but still on a positive note. Whether it is called the new normal or a gentleman’s “C”, it is not a recession. Revenues have been weakening for larger US corporations, but that is due in no small part to their 19% exposure to foreign operations. Earnings overall, however, have continued to slightly exceed expectations, once again demonstrating the skill that corporate managers are using to navigate their respective environments. State and local governments have continued to go where their Federal cousins fear to tread on structural reforms. These legislators have moved beyond anger and denial and are working towards difficult solutions. Market participants have rewarded these efforts by accepting the lowest municipal rates since 1967. Looking toward 2013, the investing landscape looks much as it did in 2012 and 2011. Consider that BLS employment data for 2012 was virtually a duplicate of 2011 at 151k/month versus 153k/month. Quality investments should continue to outperform not so much as a result of a rising economic tide but through shrewd management and at the expense of their lesser competitors. Quality also implies reliable and sustainable cash flow which remains a dominant theme in our approach. Changes to tax policy may alter relative values at the margin but not on this fundamental level.

Drowning in a River 2 Feet Deep

There is an old parable about the statistician who drowned in a river that averaged 2 feet deep. Bill Gross, the CEO of Pimco, in writing his November outlook letter cautioned investors to temper their expectations. Pimco’s emphasis on diminished average returns may in reality speak to the fund behemoth’s need to temper their own investor’s expectations. The market has been dealing with this current set of circumstances for four years now. During this period many individual companies have managed to thrive. We have also witnessed a remarkable energy renaissance which portends a bright competitive future for domestic manufacturing. Even the Euro Zone, which through their actions, appears to be making every effort to become less relevant on the global stage, saw many of their native companies extend their reach into those more profitable parts of the world. This is by no means an ideal investing environment but there are real opportunities that the “averages” might be masking.

We continue to believe this is a market which is far better suited to investing than trading. The “risk on – risk off” argument has left many advisors lagging badly as the strong periods of advancement this year have come in short and unpredictable periods. Jim Bianco, of his eponymous firm, cites frustrated hedge fund underperformance as exhibit A that individual company metrics have been overwhelmed by monetary influences.

“Now, we are in a world where CUSIP’s don’t matter, it is all big picture stuff. The Fed does this. The fiscal cliff does that. Europe does this. Everything goes up. Everything goes down. And you could spend all your time looking at individual securities, but they are all going up together, and they’re all going down together.”

However, when we speak with individual managers they have a very different take. They are excited by their company prospects – not in a naïve or Pollyannaish way – but in a calculated, capitalistic way. These two perspectives are consistent in that the hedge funds are typically active traders versus the managers who tend to invest for much longer time frames.

This is another powerful chart from our 2 foot river department. In a nutshell, stock specific selection does indeed matter.

Scarcity in US Treasuries

What’s that you say? How can there be a shortage of US Treasuries when we are running trillion dollar deficits? Enter the Federal Reserve and balance sheet expansion. In addition to outright purchases of US Treasuries and Mortgages, the Fed has been selling their shorter dated securities and using those proceeds to buy longer dated bonds. This procedure is known as “Operation Twist” and was an effort to “flatten” the yield curve by spurring demand for longer bonds relative to shorter maturities. However, the Fed is now running low on short dated bonds to sell and the average maturity of their overall portfolio has risen to 8.5 years.

This maturity extension has profound implications for any potential unwinding of the Fed’s policy. If the holdings were much shorter, say under three years, one could imagine a scenario where the Fed could step aside by allowing their portfolio to roll off through maturities. The Treasury would have to find new buyers through more normal market mechanisms which would presumably involve higher rates. However, with a portfolio of this length, the Fed would have to wait much longer to affect a passive exit. On the other hand, what is the practicality of a more active unwinding process where the Fed would be a huge seller of US debt along with the US Treasury?

Meanwhile, other forces are at work to keep rates low. Primary US Dealers have recently become far less willing to short US Treasuries which would reflect a view of rising rates. Now, this may be that after four years, the dealers no longer wish to fight the Federal Reserve’s efforts to drive rates lower, or it may be that the anticipated implementation of the “Volker Rule” which would restrict the ability of banks to trade for their own account is having an impact. Regardless of the attribution, a lack of dealer involvement from the short side will act as yet another powerful headwind towards higher levels.

Many impatient pundits continue to call for higher rates and of course we could see modestly higher levels from today’s low marks. But a return to rates of 4-5% would be both remarkable and calamitous given the forces allied against this happening. The Federal Reserve announced at the conclusion of the December meeting that they will continue their existing policies of mortgage purchases and in addition they will be purchasing outright another $45BB of US Treasuries per month. Together, this will take the balance sheet to approximately $4 Trillion.

Global policy makers do appear to be working in concert for better or worse. Mark Carney, the current head of the Bank of Canada and the incoming head of the Bank of England, made comments supportive of hard limits on employment and inflation as guiding principles that mimic US policies. This may be because they are mainly Goldman Alumni, but no doubt they are trying to avoid working at cross purposes. The question remains how specifically the transfer mechanism of bond buying will be expressed into labor markets, but these governors remain undeterred.

The next few months will be challenging for markets given the sheer volume of topics to be addressed (or not). Diversified portfolios should be able to ride through this turbulence and risks exist to both the up and downside. Should a deal be reached that exceeds expectations, we could see markets move strongly upward. Clearly the Fed actions show that they are hedging their bets. Whatever the outcome, we look forward to working with each of you in the New Year.

Best Wishes,

Jen & Patsy


In this Edition

  • Giving Sausage a Bad Name
  • Drowning in a River 2 Feet Deep
  • Scarcity in US Treasuries

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

84 - 09.19.12
Plus Ça Change/ Fantasia meets the Euro Zone/ Cue the Federal Reserve/ Shifting Transmission/ Bottom's Up

83 - 08.21.12
Summer Time Slows but the Lawyers are busy/ Whatever it Takes/ Heavy Weight Fight

82 - 06.29.12
Half Time 2012/ 19 Euro Summits - A Tiger by the Tail/ The Crystal Ball

81 - 06.11.12
Next Chapter/ Election Lessons/ A Gentleman's C/ Opportunities

80 - 05.10.12
Choices/ Texas Hedge/ Outcomes

79 - 04.09.12
13,000 x 1,400/ Lessons Learned/ It's Not Insider Trading When Congress Does It/ Crystal Ball

78 - 03.21.12
Goldman's Casablanca Moment/ Mr. Macy meet Mr. Gimbel/ The Fiduciary Standard - The Gold Standard

77 - 03.05.12
Punxsutawney Greece/ Foaming the Runway/ "The Euro Crisis is Behind Us/ Healing Hoopla/ What Price Income?

76 - 01.09.12
2012 - The Continuum/ Europe - Working in the Injury Time/ "Risk On - Risk Off"/ The Road Ahead

75 - 12.05.11
The Problem/ What Could Go Wrong/ Compound Interest/ Germany or Bust/ The Cavalry/ Stress Tests/ Next Chapters/ MF Global

74 - 09.29.11
Broken Transmission/ Chickens and Eggs/ Where to?

73 - 08.29.11
The Confluence/ The ECB/ US Economy - Distinction without a Difference/ A Different Kind of Exit/ Gold as a Thermos/ Where to Now?

72 - 06.28.11
Sovereign, Central, Commercial/ Why we call them "Banksters"/ "Extended Period" just got a lot longer/ Forward.

71 - 05.24.11
The Question is... How Many Years?/ "Unexpected" Housing Weakness/ P.I.G.S. Can't Fly/ Stages.

70 - 04.11.11
Inflation for thee, but not for me/ On the Other Hand .

69 - 04.05.11
Implications - A Bevy & A Wedge/ Implications - Quantitative Easing 2.0/ Implications - Rules Rules Rules/ Catching Up with the Can.

68 - 03.03.11
What Ever Happened to Housing?/ Where Do Loans Come From?/
Where Do Loans Go?/ The Last Straw/ The Path Forward/ Equity/ Clearing Mechanism/ Restart Your Securitization Engines.

67 - 01.10.11
Curiosity of the Federal Reserve/ Complacency & Fragility

66 - 11.12.10
Phew/ Taxes and Employment/ Quantitative Easing Returns/ Incentives & Unintended Consequences/ Dear Mr. President

65 - 09.28.10
Progress in the Absence of Milestones/ Changing Nature/ Correlations & Valuations/ Synthetic Securities

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



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Market Highlights



6/29/12 3/30/12 12/30/11 12/31/10 12/31/09 12/31/08 12/31/07
12,880 13,212 12,218 11,578 10,428
S&P 500 US


1,362 1,408 1,258 1,258 1,115
Nasdaq US
2,935 3,092 2,605 2,653 2,269
EAFE Int'l Equity
1,423 1,553 1,413 1,658 1,581
5 Yr Treasury .70 .75 1.07 .85 2.02 2.71
5 Yr AAA Muni .73 .86 1.03 .94 1.75
10 Yr Treasury
1.73 2.28 1.96 3.38 3.92
10 Yr AAA Muni
2.05 2.24 2.08 3.44 3.26
30 Yr Treasury 2.88 2.78 3.33 2.914 4.325
30 Yr AAA Muni 3.06 3.56 3.72 3.82 4.9
EUR Currency 1.30 1.26 1.33 1.29 1.34
JPY Currency 82.86 79.49 82.08 77.36 81.32
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